Market Review October 2011

Markets in October were looking for some sort of resolution to the eurozone debt crisis and showed some welcome upwards movements, especially towards the end of the month. All sectors posted promising increases with the winner of sector of the month going to the Far East for the first time with the largest upward market movement for quite some time at almost 10%.

The announcement on 27 October seemed to support the rare feeling of positivity when the European summit provided some more encouraging news on what to do with Greece.

To help focus on the resolution it may be worth casting our minds back to see how we ended up where we are now.  Henderson Global Investors have written an excellent article on “Europe – chronology of a crisis”.  Whilst the article is much longer than our normal monthly offering it is well worth the read and our thanks go to Henderson Global Investors.

“Europe’s sovereign debt crisis has been brewing for more than 18 months and has approached boiling point in recent weeks.  The fiscal crisis has increasingly become the main trigger that turns financial market sentiment on or off around the globe.  The plot of the story thus far reads like the script of a play with the final scene still to be written and the main actors as yet undecided on how to play their role.

The summer of 2007, when the financial crisis first hit the global economy, was when the Eurozone sovereign debt crisis would begin to germinate but the seed of the crisis was potentially sown much earlier.  Knitting together economies travelling at different speeds with one interest rate policy would ultimately lead to overly rapid expansion in the fringes of Europe, paving the way for asset bubbles and the recent collapses. In 2002 and 2003, the French and Germans would flout the very fiscal rules they had insisted on at the outset of the single currency by borrowing more than 3% of gross domestic product (GDP). By watering down the 1997 Stability and Growth Pact to suit the larger states this created an ineffectual stick with which to demand adherence from the rest. 

The global financial crisis, the credit bubble that preceded it, the crash in the US subprime market and the downfall of Lehman Brothers in September 2008 is well documented but its role in the recent crisis was to create a severe economic downturn in Europe that heightened problems in the Eurozone’s weaker member states. In April 2009 the EU ordered France, Spain, Ireland and Greece to reduce their budget deficits.

The story of the European sovereign debt crisis began in earnest in November 2009 when, following the sovereign debt crisis in Dubai, investors became concerned about funding in several European states. At the same time the newly elected government in Greece announced the country’s debt had reached €300bn, amounting to 113% of GDP. Greece unveiled its Stability and Growth Programme in February 2010 aimed at cutting its huge deficit, which was met with riots and violence on the streets of Athens.

In the face of continuing stress in the financial markets and more violence and protests on the ground in Greece, a small package of emergency loans (€30bn) was agreed in April to help Greece. Yet Greek borrowing costs soared as markets doubted the long-term viability of the plan, creating fears over European banks with exposure to Greek government debt and contagion worries intensified. In order to restore calm in May 2010, Eurozone members and the International Monetary Fund (IMF) created the first bailout package worth €110bn for Greece.

Despite the bailout, markets remained under pressure and following several Eurozone country downgrades in June, European finance ministers created a bailout fund for the entire Eurozone – the European Financial Stability Facility (EFSF) – which was intended as a temporary measure to safeguard financial stability in the Eurozone. The €750bn EFSF would be backed by a €440bn contribution from all Eurozone member states, €60bn from the European Financial Stabilisation Mechanism, backed by the European Commission and EU, and a €250bn loan from the IMF.

Despite the creation of the EFSF, attention turned to the Republic of Ireland in September 2010 as the government began a further bailout of Anglo Irish Bank (€34bn), which took its annual deficit to 32% of GDP. As Irish bond yields soared, on 21 November the country reluctantly accepted an €85bn bailout.

Recognising that the euro needed to be better prepared to tackle financial crises, on 16 December 2010, the European Council agreed to an amendment to a treaty that would permit the creation of a permanent stability mechanism. By March 2011, the treaty amendment was approved by the European Parliament and the path was laid for the establishment of a permanent bailout fund – the European Stability Mechanism (ESM) – worth around €500bn. The bailout fund needs ratification by all members by December 2012 and will come into force in July 2013 replacing the temporary EFSF.

In April, it was Portugal that needed rescuing. The result was a €78bn bailout in May 2011. Events took a faster turn in June triggered by Eurozone ministers demanding new austerity measures in Greece before the release of the next tranche of their loan, without which the country would default. However, the Greek parliament approved the new and drastic measures in July ensuring the release of the monies.

In the same month, following weeks of political and market turmoil, European officials took further steps to safeguard the euro and avoid contagion to other European countries by agreeing to expand the EFSF to include pre-emptive credit lines and bond purchases in the open market and providing a second bailout for Greece worth €109bn, which offered more lenient terms to Greece but required bondholders to accept ‘voluntary’ haircuts. The amendments to the EFSF required ratification by all 17 member countries, which was only completed on 13 October 2011 when Slovakia became the final Eurozone country to approve the changes.

The squabbling over the US debt ceiling and the US downgrade, weaker global economic data and rising bond yields in Spain and Italy meant anxieties were becoming firmly entrenched over summer.

As pressure mounted on EU leaders from all corners, the pace of activity picked up and in early October financial markets were somewhat lifted following the ECB emergency loan measures to help banks and the news that Germany and France had reached an accord to resolve the crisis.

Next steps?

At an EU summit in late October, agreement is expected to be reached on means to recapitalise the region’s banks, boost the firepower of the EFSF and to determine how to solve Greece’s debt problem, including greater haircuts for bondholders. Leaders are also considering the option of speeding up the creation of ESM by a year and implementing wide-ranging reforms to establish a more centralised EU authority over national economies.  The European Council has announced it will outline proposals for an EU finance minister and new bonds collectively backed by all members.

Whilst events are evolving, in the early hours of 27 October 2011 European leaders agreed a “three-pronged” approach intended to solve the regions debt crisis. Banks have been persuaded to accept ‘voluntary’ 50% haircuts on Greek government bonds, the eurozone bailout fund’s firepower will be extended to around €1 trillion and banks will be required to increase capital adequacy.  The next key dates in this drama are a G20 summit on 3-4 November, and another EU summit on 9 December at which the leaders will discuss increasing the size of EFSF and moves towards greater fiscal union.  The causes that led to this crisis may have been long in the making and measured in years, but the time available to find an effective solution is not nearly so generous.”  Source: Henderson Global Investors November 2011

So whilst things were all looking nice and rosy for the first time in a long time Greece threw a spanner in the works by announcing that they would put the resolution to the people and have a referendum.  Needless to say markets did not like that and have subsequently reacted badly.  It will be interesting to see where we all go from here.