Waiting on the US deficit Super-Committee
Eurozone headlines have continued to dominate recent market attention, but we think that may soon shift as the so-called U.S. deficit reduction Super-Committee (SC) appears headed for a stalemate. The latest comments from SC panelists suggest the two sides remain far apart on a package of spending cuts and revenue increases, but the SC may still meet over the weekend if no agreement is reached Friday. While we agree that in Washington it’s usually ‘darkest before the deal,’ our base case expectation remains that deadlock will ensue as the Nov. 23 deadline comes and goes.
If no agreement is reached, as we expect, then we would look for credit ratings agencies to voice concern on the outlook for US sovereign ratings, potentially with Fitch joining Moody’s and S&P indicating a negative outlook (S&P cut US ratings following the debt-cap debacle in July). While there are many potential outcomes, including partial deals, two-step processes, etc., we think global financial markets may respond in negative fashion similar to the debt ceiling debate reaction, which saw the S&P 500 collapse by over 18% in late July/early August. It won’t be based on the fiscal issues involved, but rather on the lack of political cooperation inhibiting any long-term stabilization in US deficits or debt levels. Additionally, mandatory across-the-spending cuts triggered by a deadlock, while not set to take effect until FY 2013, will further weigh on the outlook for the US and global recoveries. We would expect back-up plans galore to be floated in the aftermath of a SC deadlock, likely meaning a new legislative drama begins on the other side of the Atlantic into the end of the year.
Absent a deal, we think risk sentiment is ripe for a further plunge, with the USD potentially seeing strong safe haven demand despite potential ratings’ concerns. Most likely, though, in our view, CHF and JPY will be the bigger winners if risk comes off sharply. Alternatively, should a last minute package be reached, risk sentiment is likely to improve sharply given the low expectations for a result.
ECB digs in against sovereign bailouts
Even as the market chorus calling for an ECB back-stop for sovereign borrowers grows louder, the ECB appears to be digging in against using its balance sheet to stem the contagion. The euro stabilized somewhat at the end of the week on reports that the ECB might consider lending to the IMF, which would in turn provide funding to endangered Eurozone governments. But comments from ECB Pres. Draghi on Friday, in which he declared that the ECB would stay focused on its inflation mandate and called on politicians to find a solution, suggest the ECB/IMF initiative will not materialize. Germany remains adamant in its opposition to allowing the ECB to provide unlimited lending, and until there is some further crisis in credit markets, we don’t see Berlin relenting.
Meanwhile, the Eurozone economic outlook continues to deteriorate, intensifying the negative feedback loop where weak growth aggravates debt burdens, which raises credit costs, adding further to debt burdens, and on and on. Spanish elections on Sunday are expected to see the conservative opposition People’s Party win a landslide victory on a platform of additional austerity measures. While the market reaction to the elections may be briefly positive for EUR and Spanish debt, we think it will be extremely short-lived as the reality sets in that further austerity will do nothing to alleviate the negative debt dynamics in Spain and elsewhere, bringing markets back to the view of toxic Eurozone government debt. We would also note that the British press on Friday revealed a leaked report from the German foreign ministry which indicated policymakers should prepare for additional orderly defaults beyond Greece, likely meaning Italy, Spain and others. We don’t think this bodes well for Eurozone credit markets in the near-term, but we’ll also be looking to see exactly how much Italian/Spanish debt the ECB bought in this past week. If they stepped up purchases to significantly more than the sub-EUR10 bio of recent weeks, it may provide some further stabilization. Lastly, we would look for the ECB debate to come to a head around the next EU summit on Dec. 9.