Indebted Europe

Story Highlights:

• S&P lowered its outlook on Italian debt, and Fitch downgraded Greece again on Monday.
• Despite the lowered outlook, Italy has so far done a good job of meeting debt and deficit targets.
• Election drama in Spain also contributed to PIIGS debt concerns—the ruling Socialist Party was soundly beaten by the more conservative Popular Party.
• Even among the fiscally weakest PIIGS, their issues aren’t uniform—some are more easily (relatively) resolved than others.

On Monday, S&P announced an outlook change on Italy’s debt, and Fitch downgraded Greece again. Combine that with another hard-to-pronounce Icelandic volcano erupting, and you might think you’d stepped back a year in time over the weekend.

However, between Eyjafjallajokull and Grimsvotn, a few things have become rather clear about the ongoing sovereign debt saga in Europe: First, it will take clear leadership in the eurozone’s periphery to implement economic reforms and stick to debt-reduction plans. Second, not all nations commonly referred to as the PIIGS are uniformly confronted with the same issues.

In Italy, S&P cited concerns not about the country’s deficit, but about political gridlock and weak economic growth as reasons for its lowered outlook. On one hand, Italy has been largely unscathed during the past year’s default fears, and interest rates on its debt are the lowest among the PIIGS—the 10-year rate is 4.8%, which is paltry relative to double-digit Greek yields. On the other hand, Italy’s 0.1% Q1 GDP growth was far from what they’d hoped for and cast some doubt on the country’s ability to meet government growth forecasts of 1.1% for 2011. Thus far, Italy has done a good job of meeting debt and deficit targets—and if it continues along this vein, S&P’s lowered outlook may be completely unwarranted. (Remember, too, that ratings agencies’ pronouncements are frequently not worth the paper they’re printed on.)

In other news, a regional election over the weekend in highly decentralized Spain also stoked debt concerns. Prime Minister Jose Zapatero’s Socialist Party received a beating in elections, losing several regions to the more conservative Popular Party. There are worries a political party change could result in exposure of significant hidden debts (if hidden debts do exist, new leadership wouldn’t have any incentive to keep them hidden). But at the same time, the Popular Party is widely considered more fiscally hawkish than the Socialists—meaning they could have more gumption to push forward with austerity—which could be a long-term benefit to the country.

In Italy and Spain, the two non-bailed PIIGS, debt and deficit issues haven’t been as acute to date as in, say, Greece. But even among bailed-out nations, the issues aren’t identical: Greece and Portugal (to varying degrees) likely require economic reform to boost their competitiveness with healthier European economies like Germany and France. Ireland, however, is mostly confronted with deficit problems stemming from recapitalizing its banks. (For example, few would argue Ireland’s corporate tax rate isn’t competitive, considering the debate surrounding the issue.) To some extent, Financials woes are tied to sovereign debt issues, and now, it seems more banks are raising capital through selling loans previously thought troubled to private investors—who are snapping them up. Should that continue, it could help alleviate some of the pressure on banks’ balance sheets.

There’s likely no quick fix for multi-speed Europe and its multi-faceted sovereign debt woes—which EU leaders seemingly acknowledged last year when they approved the joint bailout package to try and solve them. (The existence and effectiveness of which makes a dramatic unwinding of the euro a highly unlikely event in the next few years.) But what it doesn’t do is prevent all short-term volatility tied to ongoing talks. As we’ve said, the difficult decision-making along the way could easily contribute to back-and-forth broad market action in 2011.