By GRAHAM FROST 17/01/2012
On Friday 13th S&P downgraded French and Austrian government bonds to AA from AAA. Since the same credit rating agency downgraded the US last year, and this move was reasonably well broadcast in advance, what impact is it likely to have?
Bond markets are pretty efficient and have been effective historically in discounting events in advance. The French 10-year bond was trading above 3% ahead of the announcement compared to less than 2% for a German bond, indicating a lower quality credit already. France’s debt-to-GDP ratio is worse than Germany’s and the public sector more bloated and so difficult to finance.
Ratings cut for 9 countries
S&P cut the credit ratings of a total of nine countries, including Spain, downgraded to A from AA and Portugal to non-investment grade. One area of concern is the impact on the European Financial Stability Fund, which owes its AAA rating to the underlying ratings of sponsor countries.
Markets seem to have priced in such an outcome and as we have seen in the US and Japan, AA doesn’t mean you can’t borrow. Of course, the US Federal Reserve has been willing to print as much as is necessary to support its markets, whilst that has not been the case with the European central bank.
Of more importance is the Greek issue. A deal to bailout Greece is still not fully resolved and a default, which could cause a domino effect around the rest of Europe, may make it very difficult for governments to raise funding at any price. It could also see the euro weaken further as investors flee to what they perceive as safe havens.
Looking ahead
Investors seem to believe the Greek issue will be resolved, and the S&P downgrades may even reinforce political action to make sure it happens. There are a variety of bond auctions this week for the likes of Spain, France and even the European Financial Stability Facility, and they are likely to provide a decent test of investor demand for the issuers.
Markets have got off to a decent start to the year, as US growth pleased on the upside and more liquidity was provided to markets by central banks. On their own, the S&P downgrades are unlikely to damage sentiment too much provided they do not engender even harsher austerity measures. They are likely to be more damaging for Sarkozy’s re-election campaign in May.
Investor focus should remain defensive and well diversified. Within equities, quality globally competitive companies that can continue to grow in a difficult environment should remain in demand.
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