Contagion fears turn to reality in Italy

Contagion now seems to be affecting Italy, the third largest economy in the Eurozone

Positive news from the Greek parliament approving a $41bn austerity budget caused equities to rally at the end of June, raising hopes that Greece would avoid a disorderly default. But already this is a distant memory, as contagion now seems to be affecting Italy, the third largest economy in the Eurozone.

Despite the rally, equity sales ended June on a negative note, says a Lipper report, thanks to continuing sovereign debt concerns in Europe, but also to supply-chain disruptions caused by Japan’s earthquake and concerns about weaker economic growth. Last week, all the main global indices suffered losses. In London, the index of 100 leading shares slipped 1.38%; in Milan, the stock exchange lost 4%, while spreads on 10-year Italian bonds reached a decade high of almost 6%; the Dax was down 1.98%, and the Cac fell 1.75%. Also to follow suit were the Nasdaq (-2%), the Dow Jones (-1.2%), the Nikkei (-1.5%) and the Hang Seng (-2%).

Equity funds were down 0.20% for the quarter ended June 30, 2011, their first quarterly loss in four. Lipper preliminary flows numbers showed equity mutual fund investors became net redeemers of equity fund assets, pulling out an estimated $0.8 billion from the conventional funds business (excluding exchange-traded funds) during second quarter 2011. For May and June, on renewed interest in income plays, investors continued to add new money to bond funds, injecting some $46.1 billion net into the fund coffers, and were once again influenced by net outflows of $5.3 billion from the beleaguered muni bond fund group. With new-found interest in ETFs, investors injected $5.1 billion into equity ETFs.

Audrey Childe-Freeman, head of currency strategy EMEA, J.P. Morgan Private Bank, says: “In Europe, the sovereign debt crisis has come back with a vengeance and has spoilt the party for euro bulls over the past few weeks. While an imminent Greek default situation has now been averted, we believe that the underlying problem has not been solved yet. Contagion risks remain and that this whole issue risks coming back to haunt the euro this autumn.”

An emergency meeting of the Eurogroup finance ministers has made slow progress towards finding a policy response to the sovereign debt crisis, beyond an agreement to take ‘further measures’ to limit contagion. One such measure was to ‘enhance the flexibility and the scope of the EFSF’, which suggests the expansion of funding for the EFSF and participation in the secondary bond market. Other measures include the lengthening the maturity of loans and lowering interest rates. It also suggested that liquidity and loans will be made available to ensure that the banking systems of the weakest member nations (which now includes Italy) are safe.

Italy is the most pressing problem. It has €175bn of debt set to go to auction this year alone, part of its massive €1.6 trillion debt burden. This week, a sale of 1-year short-term bills was all sold, but the bid-to-cover ratio was weaker compared to an auction in June, and interest rates were much higher at 3.67% versus 2.14% last month, says Kathleen Brooks, research director at
This level of financing cost is not sustainable for the long-term. Italy’s Finance Minister Giulio Tremonti left the finance ministers’ meeting in Brussels early raising expectations that a Parliamentary vote on fiscal consolidation measures will now take place earlier than expected.

Meanwhile, the prospect of contagion across the eurozone continues to build, making debt maintenance costs and budgets for the affected countries ever more difficult to control. Brooks says: “Against this backdrop, and one in which there remains an overhang of USD short positions against the EUR, we expect continued depreciation in EURUSD.”

Jane Foley, senior currency strategist at Rabobank, says: “The contagion that is eating its way through the Spanish and Italian and other European bond markets has a self-prophesising element to it.” She says: “Core Europe needs to decide how much EMU is worth and this decision needs to come quickly. Too much more delay and EMU could implode.”

Contagion is set to keep the EUR under pressure near-term. Brooks says: “Selling pressure on the euro stepped up overnight and has continued into the European session. It has fallen through its 200-day moving average and is firmly below 1.3900. The safe havens are flying and EURCHF has broken below 1.1650 (opening the way to 1.1500) and EURJPY is below 111.00.
Selling pressure continues in Italian and Spanish debt markets, she says. “Italian bonds are now trading just below 5.9% and Spanish bonds are trading above 6.2%. It’s now easy to imagine the worst case scenario: if we continue to have intense days of selling in the Italian and Spanish bond markets, then the 3rd and 4th largest economies in the Eurozone may have no choice but to apply for bailout funds and withdraw from the capital markets altogether.”
The Eurozone desperately needs a buyer of last resort, says Brooks, the most likely candidate being the ECB. Such a move would require a change to EU treaties and closer fiscal ties, both of which present daunting political challenges. The ECB has so far refused to take on this role, so countries like Spain and Italy will be left to flounder until the necessary political decision is taken. 

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