Buying time or a real solution?

The announcement of a comprehensive list of actions at the EU summit on 26^th October has been warmly greeted by the market, with a real sense of optimism that the announcement could find a solution to the European sovereign debt crisis that has dogged markets for the best part of eighteen months.

The mere fact that the EU leaders appear to have reached a consensus does provide some cheer, as for many months it did not appear that a common view was shared. However, as ever, the devil is in the detail. The first measure announced was the size of the European Financial Stability Fund (a special vehicle financed by EU members and designed to provide assistance to its members as necessary) is to be increased to €1tn. This should allow sufficient capital to reduce lending costs and provide liquidity, but would fall short in the event that both Italy and Spain were about to default.  Secondly, bondholders in Greek Government debt (mainly other European banks) are to take a 50% “haircut” (loss) on the value of their Bonds. This will ease the immediate pressure on Greece a little and potentially could reduce their debt levels to 120% of GDP by 2020. However, the country still has a long road ahead, with austerity measures likely to continue for many years, and will also involve the privatisation of some Greek institutions.  Any deviation could still ultimately lead to Greece defaulting on its’ debts.

Additional measures announced include a requirement for European banks to bolster their cash reserves by mid 2012, with initial estimates suggesting a total of €106bn will need to be raised. The European Banking Authority has recommended that Banks unable to meet the criteria withhold bonuses and do not declare dividends, before seeking fresh capital from Governments. Any further bank bailouts would, of course, prove unpopular, but may be necessary.

However, the deal is not done, as the Greek Government had announced that it intended to hold a referendum on the bailout package in January. Given the unpopularity of the austerity measures, it is quite possible that any vote would go against the package, sending the crisis back to square one. However, it now appears that the referendum has been shelved for the time being, as a compromise between the two main Greek political parties. 

Whilst providing a short term fix, the deal still does not tackle the fundamental issue that Eurozone growth is negligible at present, and unless the prospects for growth improve rapidly, other Eurozone nations (other than Greece) with large debt to GDP ratios, such as Italy, Spain and Portugal, will continue to face the same issues. In short, debt levels in these nations are increasing still, and until this reverses, the problem will not go away. Indeed, market attention is likely to refocus on the likes of Italy and Spain, which are much larger economies than Greece, and in that respect, a bigger problem.

The debt crisis has also provided something of a “smoke screen” to cover the other crucial factor, that the US, UK and Eurozone economies are perilously close to fall back into recession. Whilst initial market reaction has been positive, and I do expect Equities to be more positive than of late, weak economic data flowing through for the final quarter of 2011 should keep any substantial Equities rally in check.