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EU Summit: A step in the right direction

Measures agreed at the EU Summit exceeded market expectations, but did not produce a major breakthrough. (Pictet & Cie)

EU Summit: A step in the right direction
Our view

Luca Paolini, Chief Strategist, PICTET ASSET MANAGEMENT STRATEGY UNIT, reports on the views of the PSU.

EU summit addresses immediate concerns. European Stability Mechanism (ESM) rescue fund will be able to inject capital directly into banks. ESM will also buy bonds to help lower borrowing costs for stricken countries, and this will not be contingent on additional austerity measures.
ECB to become regulator and supervisory body for Eurozone banks, in a first step towards a banking union. However, incomplete plans lacks clear roadmap, does not equip ESM with adequate firepower, and faces implementation risks given political hurdles.
Global growth remains weak and no aggressive policy action has materialized - the post-summit relief rally provides an opportunity to reduce risk in portfolios.

Positive progress

The €100bn ESM bailout loan to Spanish banks will not have seniority, and will not add to the country’s sovereign debt. In the future, ESM funds can be used to provide assistance to banks directly, by‐passing national governments. Both measures will help break the bank/sovereign debt feedback loop and reassure private holders of Spanish sovereign debt.

The ECB will be the pan‐European regulator and supervisory authority of EMU banks by year‐end ‐ this is a structural change of how the EU operates and may indicate that more tangible steps towards a banking union have already been agreed.

The ESM will buy peripheral bonds in secondary markets through the ECB, thus helping to lower the funding costs for Italy and Spain. This intervention will come with lighter conditionality measures attached (i.e. no additional austerity).

Growth will be supported through immediate measures amounting to €120bn or 1.3% of EMU GDP. This includes €60bn of new lending by the European Investment Bank, the reallocation of unused structural funds (€55 billion) and the pilot phase of Project Bonds for energy, transport and broad‐based infrastructure initiatives (€5 billion).

Also of note, the release of the EU summit decisions was well‐timed. A written announcement was published halfway through to test the market reaction and leave some room for adjustments. The final statement came on the last day of the quarter, during market hours (i.e. ideal for creating a short squeeze), and on the day of the German vote on the ESM, giving both credibility to the summit deliberations and weight to Merkel in her negotiations.

What still concerns us

However, in our view, some issues remain unresolved:

Lack of detail
The official statement is only one page long and short on detail. No surprise then that its interpretation has varied across EMU governments, especially on conditionality – the Finnish and Dutch governments said no changes had been agreed, whereas Monti and Rajoy said less conditionality will be attached to future ESM assistance.

Funding issues
The ESM is yet unfunded and, together with the capital left in the EFSF, only has around €550 bn of lending capacity. It can hardly cover Italy and Spainʹs financing needs, which amount to €260bn and €100bn for H2 alone. The size of the ESM will now become the central issue, with any increase becoming more problematic in Germany, where the government may have exhausted its ability to convince its already recalcitrant lawmakers to vote for additional support.

EFSF/ESM bond purchases will not take place before the Eurogroup meeting on July 9th and the ESM‐funded bank bailout will have to wait until the single bank supervisor is in place ‐ by year‐end at the earliest.

Ratification risk
Only 7 out of 17 EMU countries have ratified or approved the treaty and the new provisions effectively make the ESM more onerous for core EMU countries, raising the risk of a rejection. The German Bundestag’s approval of ESM legislation has already been challenged at the German Constitutional Court. A ruling is expected this month.

No cap on sovereign spreads
The agreed measures do not fix the funding issues of Italy and Spain as the ESM intervention does not propose to cap bond spreads at a certain level, as suggested by the Italian government. The absence of strict caps (and the need to sign a Memorandum of Understanding) raises the implementation risk.

No decision has been taken to establish a EU‐wide deposit insurance scheme, which we regard as a critical step to stop the deposit flight from the periphery.

No clear indication of progress towards fiscal union. Angela Merkel rejected eurobonds “as long as [she lives]”. We think this is necessary to provide the ECB with a political “cover” to unleash some quantitative easing, or at least a reactivation of the SMP bond‐buying programme on a big scale. In this respect, it is interesting that the Austrian Chancellor came out in favour of a debt reduction fund and a bank licence for the ESM. The latter would effectively leverage its lending capacity by a factor of 4-5x via repos with the ECB.

Legal issues still open. The ESM treaty may have to be re‐drafted and sent back to national parliaments as in its current version, it clearly states that financial assistance to banks should be via loans to the sovereign entity. Additionally, the transfer of the supervisory authority to the ECB would likely require parliamentary approval in the EMU member states, even though this looks less controversial.

The subordination of private bondholders will likely apply to future bailouts, even in cases where it is not clearly stated in treaties or charters.

The political repercussion are also not easy to discern. The Spanish/Italian ambush on the growth compact, in which they threatened to block any deal unless Germany and other nations backed their demands for easy access to bailout funds, is probably a major event for political leadership in Europe. The German/French historical duo has been broken and replaced with a quartet which now includes Italy and Spain. While this is good news in the short term as it may lead to a watering down of austerity measures, it may also trigger a political backlash in core Europe against further assistance to the periphery. A first test could be the Dutch elections scheduled for September.

We would also highlight that any final assessment of the EU summit will have to wait for the deliberations of the Eurogroup. Eurozone finance ministers will meet on July 9th and may announce further steps towards a fiscal and banking union, including measures addressing some of the negative points listed above.


Overall, we think the EU summit decisions are positive at the margin but fall well short of a credible and systemic solution to the EMU crisis.

This is another step in the right direction but we think the Euro crisis cannot be solved without resolute ECB action in which the ECB has unlimited firepower and immediate implementation. Overall, what was lacking from the summit was a common, well‐defined roadmap which would have provided grounds for the ECB to take more aggressive measures such as unlimited QE or a cap on bond yields. As such, we doubt the EU summit decisions are enough to push the ECB into action, and if anything, the risk is that the ECB actions will be underwhelming, in our view.

With a background of weaker global growth, lack of aggressive policy action, and sentiment indicators not abnormally bearish, we regard the short‐covering relief rally following the EU summit as a good opportunity to reduce risk in our portfolios. We achieve that by reducing equities and emerging markets to benchmark from a marginal overweight.

In the Fixed Income space, the convergence trade makes Italian bonds attractive and reduces the case for having long Bunds as a hedge ‐ we reduce exposure in favour of US bonds.

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Lundi 9 Juillet 2012