6 February 2010 - Global Markets Review

Good Morning Ladies & Gentlemen,

The two most common questions posed to me this week:

What is happening in Europe? And why is the US Dollar so strong?

Let me start with Europe - and this is very simple as long as we can separate mainstream Europe from Eastern Europe - because we cannot tar both regions with the same brush.

Central European currencies softened and stock markets dropped on Friday as the region's financial community reacted to the troubles experienced by the debt-laden economies of Greece, Portugal and Spain, but the overall impact of the turmoil in the Eurozone was smaller than expected.

Unlike a year ago, when the region had been seen in danger of a meltdown due to the global economic crisis, investor interest in the more solid economies of central Europe such as Poland and the Czech Republic remained strong.

The Warsaw stock exchange's broad WIG index was down 3.29% on Friday while the Prague exchange fell by 3.6%. The zloty fell by 0.42% to 4.09 against the Euro.

Euro-denominated bonds were still in demand and Polish credit default swaps were 149 basis points, or $149,000 to insure $10m debt annually over five years, more than half of Greece, while Spain was 161bp. The Czech Republic was at 87bp, more or less the same as the UK, a G7 country.

"We are a safe haven," said Dominik Radziwill, Poland's deputy finance minister, who helped place a €3bn 15-year bond issue last month. "We have become an alternative for investors who are looking at the periphery of Europe. We can see an increase in interest on the part of foreign investors in Polish debt."

Poland was the only EU country to not fall into recession last year, reporting growth of 1.7%. The government is predicting growth of 3% in 2010, with the deficit at 6.9% of gross domestic product and public debt near 55% of GDP. It is particularly attractive for investors because interest rates are higher than in the Euro-zone and the zloty is expected to continue strengthening after the tumble it took following the collapse of Lehman Brothers in September 2008.

The Czech Republic, which has the most solid banking sector in the region, reported a contraction of 3.9% in 2009, while growth of 1.3% is forecast for this year. The deficit for 2010 is expected to be about 5.3% of GDP.

Market confidence in Hungary and Romania - both IMF aid recipients - has also increased but significant political and fiscal risks remain, with Mr Christensen saying that those economies face the greatest jeopardy of contagion from Western Europe.

Hungary successfully issued $2bn of ten-year debt last month after finance minister Peter Oszko told the Financial Times that the country no longer required assistance from the IMF's €20bn programme.

The forint gained about 15% after a technocratic government took over last April and promised to cut Hungary's budget deficit to 3.9% last year, among the most frugal budgetary targets in the European Union.

However, investors remain concerned about national elections in April that are likely to return the opposition Fidesz party to power.

Fidesz has warned that this year's budget deficit could be around twice as high as the current government's target of 3.8%, which the IMF has said it will not tolerate.

Government debt is in any case expected to reach 80% of GDP this year.

The perception of risk in Romania has improved markedly since January, when parliament passed a budget, allowing the IMF and European Union to unblock more than €3bn in financial assistance.

Romania's new government has frozen public sector wages and pensions in order to cut the deficit to 5.9% in 2010, from 7.3% last year.

But now let us look at Central Europe: Fortress Europe is now under attack by the market.

For months, the conventional wisdom in Europe was that the speculative aims of bond traders and hedge fund investors would remain largely focused on Greece, Europe's chronic problem child.

But this week the cost of insuring the debt of not just Greece, but Portugal and Spain as well, rose to record levels - causing stock markets to tumble, the Euro to fall, and borrowing costs in the most vulnerable countries to soar.

As a result, governments in the 16 countries that use the Euro must now confront a new and disturbing reality: The deal they struck more than a decade ago to create a common currency area, hoping that a single central bank could manage to paper over the divergent economic and financial conditions of its members, is finally being challenged.

On Friday the cost of insuring Greek, Spanish and Portuguese debt eased from their record highs - perhaps on comments made by Dominique Strauss Kahn, the managing director of the International Monetary Fund, that the fund was ready and willing to help Greece if asked to do so.

But the billions of Dollars being traded in the market for credit default swaps on government bonds suggested that investors were not retreating from their expectation that the gap between Europe's laggard periphery and its recovering core - Germany, France and the smaller countries of northern Europe - would keep widening.

As this is an effective bet that peripheral governments will not have the stomach to push through tough reforms, bond investors are spending as much time analyzing the power of Spanish and Greek unions as they do the spreads on credit default swaps.

In Deutsche Bank's weekly fixed income report, for example, analysts highlighted a Greek public sector strike on Feb. 10 and another one on Feb. 24 while also drawing attention to the possibility that Spanish unions might strike later this month to protest the increased retirement age.

The Greek government's ability to make a good impression on its coming road show to America and Asia next month will also be a key benchmark.

While Greece's finance minister has said that yields of almost 7% are high enough to give investors a good return for the risk involved, the fact that the Greek government must raise almost half of its funding requirement of 53 billion Euros this spring in an increasingly skeptical market gives investors concern.

Investors will be also wary of any more incomplete bond auctions like the one that hit Portugal on Wednesday when the government pared back the amount of bonds it was going to sell due to a sharp spike in the bond yield.

Adding to the unease in Portugal is a showdown next week in parliament that could force the government in Lisbon to admit that it will not be able to keep its promise to hold the budget deficit this year to 8% of G.D.P.

And another gloomy economic report from Madrid on Friday showed economic activity was down a sharp 3% for the final quarter of 2009 from the year before, meaning that Spain remained one of the few major countries still in the grip of recession.

The speculator's bet is a simple one.

In an era in which government budget deficits have soared in response to the financial crisis, the same bond vigilantes that forced President Clinton to balance the American budget in the 1990s have turned their attention to the countries on Europe's southern flank.

In effect, they have challenged those relatively weak governments to raise taxes and impose harsh spending cuts on a restive populace to bring down their deficits from over 10% of G.D.P. to the benchmark levels close to 3% of G.D.P. called for in the European treaty that created the Euro.

While such moves are highly unpopular politically, a failure to do so could send government borrowing costs soaring, enriching those who are betting that Greece, Portugal, Spain and perhaps even Italy will not be able to follow through on their commitments.

Joseph Stiglitz, the international economist who is an adviser to the Greek government, sees the investor demands as lacking in merit. Indeed, he points to the inherent contradiction in allowing the richer countries in Europe to borrow heavily to pull themselves out of recession while the poorer countries are forced to take a knife to the very programs intended to soften the blow of an economic downturn.

"If you tighten the way the markets seem to want you will get a political response that is non-viable," he said, drawing a comparison to Iceland, where popular discontent forced the country's president to abrogate a controversial agreement to repay foreign creditors. "These are democracies - not dictatorships."

Mr. Stiglitz proposes that Europe's richer countries like Germany and France take the lead in aiding Greece - for the sake of the European whole, however shaken it might be.

But that may be easier said than done.

The charter establishing the Euro, while supposedly ruling out any bailouts by the European Central Bank or member governments, also failed to establish any mechanism for providing funds to countries in financial trouble. That is the kind of role normally taken on by the International Monetary Fund, but Europeans are determined to keep the I.M.F. away from nations within the Eurozone because of the questions it might raise about the viability of the common currency.

European Union nations outside the Eurozone, like Romania, Latvia and Hungary, have received support from the I.M.F., which then imposed various fiscal requirements intended to insure they can pay back the loans.

But for those countries using the Euro the stability pact that was charged with monitoring member country finances was thought to be sufficient to keep countries in line. Greece's consistent and premeditated pattern of skirting the fiscal standards set by the European Commission has dashed those beliefs.

The time has come for Europe to acknowledge that it has neither the technical expertise to monitor government behavior nor the ability to quickly raise rescue funds. Only the I.M.F. is capable of truly doing that job.

Greece's economic fundamental are by far the worst in the Eurozone. The I.M.F. coming in would also help the other countries and restore confidence.

But in Brussels, turning to the I.M.F. is seen as conceding that the monetary union cannot care for its own.

Whether Europe can hold out much longer, though, remains in doubt.

The rising borrowing costs for countries like Greece and Portugal are a sign that the economic problems in Europe's south are deep and will not disappear without a long and painful readjustment.

It is a fact that people are just dumping debt. It is pure risk aversion that is pushing spreads higher.

For Greek, Spanish and Portugal governments that still need to raise billions from these very markets over the next few months, that is bad news indeed.

For the Dollar - this is very simple and quick to answer.

Fundamentally, there is no Dollar strength currently - it is much more Euro weakness and a simple flight to safety amidst risk-aversion.

In the short-term, I expect the US Dollar to sustain the current levels and maybe gain a little more - say to 1.30 against the Euro.

But in my opinion, this is a very short-term movement and I stand by my view that in the medium-long term, the Dollar is only going one way - down!

On to the numbers on the boards for the week:

US Markets

How the US did this week .....

US Summary The selloff in global markets accelerated, then abruptly reversed late, leaving commodities and the Euro down on fears about the potential global fallout from Europe's sovereign debt crisis but US stocks up.

US Treasuries, a traditional safe haven in times of global turmoil, rallied while the Dollar soared, pushing the Euro below $1.36 to its lowest level since May 20; the common currency hit its weakest point against the Yen in almost 12 months. A steep drop in oil futures triggered losses across the commodities spectrum, as investors nervous about the pace of the economic recovery gravitated toward the Dollar.

US stocks were deep in the red for much of the day before eking out a gain on a dramatic recovery after a much better-than-expected reading of US consumer credit in December. But the reversal came to late for stock markets elsewhere, which slid amid fears that the fiscal woes of Greece, Portugal, Spain and other Euro zone countries could ripple further, pushing a global economic recovery further out on the horizon.

For much of the day, the sharp market moves appeared to beget additional declines, with stock market investors citing the soaring Dollar and vice versa.

The Dow Jones Industrial Average ended up 10.05 points, or 0.1%, to 10012.23, escaping its first close below 10000 in three months. General Electric fell 1.6%. The Nasdaq Composite Index gained 0.l7% to 2141.12. The Standard & Poor's 500-share index added 0.3% to 1066.19.

Analysts said the veracity of the moves across financial markets was likely exacerbated by the fact that Friday is the last trading day ahead of the weekend. Finance ministers from the Group of Seven, including Germany, France and Italy as well as European Central Bank President Jean-Claude Trichet, are meeting this weekend in Canada and there is potential for other political developments in Europe.

The Dow saw three triple-digit full-day point moves this week, ending with a weekly decline of 0.5%. That has frustrated traders who focus on earnings and economic data, which have often been overshadowed lately by concerns about fiscal policy in major industrialized countries around the world.

The Nasdaq Composite Index managed a 0.7% gain. The S&P rose 0.3%.

Concerns have swirled the last few days regarding the financing of governments in Greece, Portugal, and Spain. Those worries kept pressure on the Euro, which fell to $1.3664 from $1.3741 late Thursday. The Dollar Index, which represents the greenback against a basket of six currencies, jumped 0.9%.

Health insurer Aetna rose 1.4% despite reporting a 15% decline in fourth-quarter earnings.

Airgas soared 40% after rival Air Products & Chemicals offered $5.1 billion, or $60 a share, for the industrial-gas company. Air Products shares fell 6.9%.