Market Analysis

Differentiate Before You Downgrade

S&P placed 15 eurozone countries and the EFSF on credit watch negative Monday—but that ignores significant variety among European countries, in our view.

S&P stirred the pot again Monday, putting not only 15 eurozone nations on credit watch negative, but also the EFSF, the eurozone’s bailout fund. Which is something of a no-brainer—if the underlying countries are on watch (which probably surprises very few), makes sense the bailout fund they support would be, too. But it’s not the first time a ratings agency’s told us something we already knew and probably not the last, either.

The only two eurozone countries not included in S&P’s announcement were Cyprus (already on credit watch negative) and Greece, who’s long since been considered “junk.” So basically, S&P’s threatening to downgrade everyone. Interestingly, though, Merkel and Sarkozy largely shrugged at the news, stating jointly they “took note” of S&P’s move. What other response could they have, really? They’re busily planning steps aimed at further addressing continuing eurozone woes, and S&P warns it may downgrade them anyway—shrug.

In a way, it’s reminiscent of the US’s experience in the run-up to this summer’s debt ceiling deadline: Amid a game of politics as usual, ratings agencies cautioned they didn’t like the political game. But as we suggested at the time, when push came to shove, politicians raised the ceiling—and S&P downgraded the US anyway.

And S&P’s again citing politics as the primary motivation behind their concern. All well and good, but isn’t it about a year and a half late? The reality is, European politicians have been (at times, painfully) deliberate throughout the entire debt drama, yet have thus far managed to maintain the union and avert disaster. (And indeed, they have every incentive to do so.) That S&P chose this particular summit to indicate its concern is a bit arbitrary, to say the least.

But it still needn’t spell anything disastrous for Europe. For one thing, as we’ve pointed out before, there’s no law saying the ECB or other eurozone financial institutions have to base their collateral rules on ratings agencies’ assessments of sovereign debt creditworthiness. And they’ve already demonstrated willingness to be flexible in that arena—once with respect to Greece’s debt and again this summer when Portugal was downgraded. Which could introduce its own risks—like potentially heightened concern among investors—but that’s a risk they’ve seemingly been willing to take in the past, and if it’s that or face a spiraling debt crisis, chances are they do it again.

Furthermore, S&P’s assessment of European politics doesn’t much change the fact there are still pockets of positivity there—like German manufacturing , which saw orders sharply rebound +5.2% in October from a decline the prior month, or eurozone retail sales, which rose 0.4% in October. And while eurozone GDP was up only 1.4% year over year in the third quarter, growth is still growth.

And consider the significant variety among eurozone economies—from Germany and France, both sizeable economies who’ve thus far weathered eurozone struggles for nearly two years, to Greece and the other PIIGS, who’ve experienced far more difficulty. A point Q3 GDP illustrates fairly well, with Germany and France growing 2.6% and 1.6% y/y, respectively while Greece contracted -5.2%. That the eurozone as a whole continues to notch positive numbers at all speaks to the disparity among their economies and points to an interesting post-unification phenomenon: Folks, like S&P, seemingly increasingly consider and discuss the eurozone as a single entity, but that just isn’t the case.

There are some valid occasions where discussing the eurozone as an entity makes sense, but tread carefully here. Roughly equivocating eurozone nations to entities like individual US states can lead to some odd conclusions. It’s fine to consider California’s struggles versus North Dakota’s boom to understand the US economy’s granularity, but since we have a fully integrated nation at the federal level, what matters most is the US’s overall economic health.

But that’s not so in Europe, where individual countries are still individual countries. Though their economies may be more integrated than ever, fact is the woes of one or even several needn’t spell doom for the rest. Perhaps a eurozone-wide recession does occur. But even then, it’s highly likely there would be significant differences in the magnitude.

So at the end of the day, we continue to take ratings agencies’ opinions—and their warnings of blanket downgrades of a widely varied region—with a grain of salt. European leaders seem to, too—and we don’t much blame them.

If you would like to contact the editors responsible for this article, please click here.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.