The monster that keeps on coming: debt worry is back

LIKE the Terminator, it is a villain that won’t go away. Despite a torrent of invective, and a €750bn bailout fund, the sovereign debt monster keeps coming back. Yesterday, yields on Portuguese and Spanish sovereign debt hit their highest levels in the history of the euro, at 7.17 per cent and 5.57 per cent respectively while the premium on Belgian debt over German bunds hit its highest level since 1993. European stock markets have had a remarkable run over the last six months – should contract for difference traders (CFD) be prepared for a crisis led correction?

The current reanimation of the crisis came from a report in Der Spiegel published at the weekend. According to the German newspaper, “experts” in the French and German governments have been putting pressure on Portugal to accept bailout funds pre-emptively, rather than test the bond markets. At least partly as a result of the relevations, many European equities dropped back yesterday. The FTSE 100 was down by about 0.47 per cent while the Eurofirst 300 – an index of large cap European stocks – was down by 0.97 per cent.

Those fears could well intensify soon. The Portuguese government is due to auction fresh bonds tomorrow, followed by the Spanish government on Thursday. The Portuguese prime minister issued a stern refutation of the allegations in Der Spiegel, but many traders see ominous similarities between these murmurs and the crisis in Ireland last November.

SELF FULFILLING PROPHECY
According to Alastair McCaig, market analyst at World Spreads: “The worry is that the markets are picking off countries one by one. . . When sentiment turns, it can be something of a self fulfilling prophecy”. Rather than Portugal, McCaig points to Belgium as a potentially weak link in the Eurozone, mostly as a result of its political problems.

Regardless, however, of which country may cause a panic, traders would seem well advised to take a bearish line. David Jones, chief market strategist at IG Index, stressed that the future direction of European equities “is very difficult to call”. But he also said: “The markets are very nervous right now – there’s a lot of waiting and seeing”. Given the strength of the stock market rally since July – the FTSE 100 has gained 24 per cent since July – Jones reckons there is definitely scope for a correction.

In that outcome, the biggest losers would be likely to be heavily exposed banks such as Lloyds and RBS, as well as indices such as the FTSE 100 that contain many volatile stocks vulnerable to a loss of confidence. Conversely, the German stock market proved to be quite resilient during the Irish panic – and so might well do better, not least thanks to the impressive performance of the German economy in recent months. CFD traders might be well advised to go short – but they should be careful when doing so: not everything will fall in price in a crisis.

Because as McCaig observes, part of the cause of last year’s extraordinary stock market rally was the fact that investors simply didn’t have very many options. “With so much liquidity in the market, we’ve seen a significant reallocation of debt into equity” he observes.

According to McCaig, heightened fears over Portuguese or Spanish debt might well lead to a negative “instant reaction” for equities. But in the medium run, the further undermining of sovereign debt could actually sustain the rally yet further, as investors flee debt and move heavily into shares.

And of course, it may be that no new sovereign debt crisis emerges just yet – the European Central Bank eased worries yesterday by aggressively buying Portuguese bonds. But even so, the Terminator has not yet been defeated: many European countries remain far from solvent. CFD traders should be ready to profit if they fall.

POSSIBLE WINNERS AND LOSERS

Winners
The Dax: The German economy is roaring, thanks mostly to exports to the developing world. When fears about Irish solvency were depressing the FTSE 100, the Dax held up much better, losing only around 3 per cent of its value and regaining it quickly. The index would be likely to weather another crisis well.

Banks with low exposure to sovereign debt. Fear has led some relatively safe banks to be undervalued. HSBC in particular seems rather cheap right now.

Exporters. Renewed uncertainty about the possibility of a sovereign default is likely to push the euro lower. Yesterday, the single currency hit a four month low against the dollar. That translates into more euros for any company with large overseas revenues such as Volvo or Rolls Royce.

Losers
Financial firms with heavy exposure to European sovereign debt. That includes British banks such as RBS and Lloyds, as well Spanish and Portuguese banks like Santander. Santander has a total exposure to European sovereign debt of €60.3bn, most of which is in Spanish and Portuguese debt.

Stock markets in the most vulnerable countries. Spain is already dealing with unprecedented unemployment, high debt and the remains of a burst property bubble. If investors start deserting European stocks, they are likely to start with the Ibex 35 – the principal Spanish shares index.

The euro. If another Irish style crisis erupts, questions about the long term viability of the single currency will undoubtedly be raised once more. As a result, traders are unlikely to want to hold the currency too tightly.