Moody’s Monday Mass Downgrade

We stress again that the loss of AAA is not the end of the world, and one could make the case that AA is indeed the new AAA. However, the Moody’s news comes a time when markets are nervous about Greece, and so some limited fallout to the euro and EM FX appears likely near-term. The fallout for GBP may be longer-lasting, since it was expected by most to retain its AAA rating.

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By Win Thin

With Moody’s mass downgrades coming today after the long-awaited euro zone downgrades by S&P last month, we thought it would be useful to assess again just how close current ratings are now to our own sovereign ratings model. We agree with some, and disagree with others. However, the negative outlooks for virtually every euro zone country by virtually all the ratings agencies suggest that the debt crisis will remain an issue for the markets for much of this year.

According to Moody’s, the main drivers behind these latest actions are: “1) The uncertainty over (i) the euro area’s prospects for institutional reform of its fiscal and economic framework and (ii) the resources that will be made available to deal with the crisis. 2) Europe’s increasingly weak macroeconomic prospects, which threaten the implementation of domestic austerity programmes and the structural reforms that are needed to promote competitiveness.

3) The impact that Moody’s believes these factors will continue to have on market confidence, which is likely to remain fragile, with a high potential for further shocks to funding conditions for stressed sovereigns and banks.”

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The biggest surprise to us was that Moody’s cut the UK outlook from stable to negative. We have long warned that the UK remains vulnerable to losing its AAA rating despite the fiscal tightening implemented by the Tory-led government. UK’s implied rating in our sovereign model is AA/Aa2/AA vs. actual ratings of AAA/Aaa/AAA. Note S&P cut its outlook to negative back in 2009, but then moved it back to stable in 2010 when the new Tory-led government pushed through austerity measures. It has gotten a pass from the agencies so far, but we think the slowing economy has brought focus back on the UK. We see UK downgrades in 2012, as we view AA+ France as a better credit than AA UK. With S&P downgrading France and Austria below AAA, we believe relative credit quality will require a cut to the UK in order to maintain consistency across countries. Eventually, we think S&P will follow Moody’s down the downgrade path.

France outlook was cut from stable to negative. This comes after it was cut one notch by S&P last month from AAA to AA+ with negative outlook. Our sovereign ratings model rates France at AA+/Aa1/AA+ vs. actual ratings of AA+/Aaa/AAA, and we have long felt a downgrade was warranted. S&P noted that another cut could occur if the government deficit were to remain near current levels, which would likely see debt/GDP (estimated at just above 80% in 2011) rise above 100%. The fact that Moody’s downgraded several French banks in 2011 due to Greece exposure suggested that its sovereign Aaa rating will come under pressure, and that has come to pass. Fitch has a negative outlook on its AAA too.

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Austria outlook was cut from stable to negative. This comes after it was cut one notch by S&P last month from AAA to AA+ with negative outlook. Our model has Austria safely as AAA/Aaa/AAA vs. actual ratings of AA+/Aaa/AAA, and so we do not view these downgrades as justified. S&P said the reason was due to strong linkages to Italy and Hungary, and that Austrian bank balance sheets could suffer and require government support. The same contingent liabilities from the banking system could haunt most of the other countries too, including Germany, and so Austria probably should not have been singled out.

Moody’s cut Italy from A2 to A3 with negative outlook. This comes after Italy was cut two notches by S&P last month from A to BBB+. Our model rates Italy A-/A3/A- vs. actual ratings of BBB+/A3/A-. We took issue with what we see was an excessive move by S&P, but agree with Moody’s move. S&P said Italy could be cut again due weak growth that keeps debt/GDP in upward trajectory or a failure of the technocratic government to implement structural reforms needed to boost competitiveness. Fitch’s A+ rating is now most out of line with our model. All three agencies have negative outlooks on Italy.

Moody’s cut Spain from A1 to A3 with negative outlook. This comes after Spain was cut two notches by S&P last month from AA- to A with negative outlook. Our model rates Spain as A-/A3/A- and so we think the recent cuts were justified. S&P said further cuts would be likely if additional labor and structural reforms fail to materialize and keeps unemployment high, or if the government does not take further measures to meet its 2012 and 2013 budget targets. Actual ratings of A/A3/A thus remain vulnerable to further downgrades, and all three have maintained negative outlooks. Fitch and S&P are equally out of line with our model now.

Moody’s cut Portugal from Ba2 to Ba3 with negative outlook. This comes after Portugal was cut two notches by S&P last month from BBB- to BB with negative outlook. Our model rates Portugal at BB-/Ba3/BB- compared to actual ratings of BB/Ba3/BB+ and so the recent cuts are justified. S&P warned of a more severe economic contraction ahead, and that ongoing austerity without improving growth could lead to higher unemployment. With all three agencies keeping a negative outlook, further downgrades appear likely and justified. Fitch is most out of line with our model now.

Slovakia, Slovenia, and Malta were also cut with negative outlook, but our model does not rate these smaller euro zone countries. Moody’s left its Aaa rating intact on the EFSF, since the Aaa ratings for France and Austria remain intact as well. If those two are eventually cut, then we would expect a downgrade of EFSF as well. That’s what happened back in January, as S&P followed its sovereign cuts with a cut to the EFSF as well, to from AAA to AA+.

While the S&P and Moody’s downgrades have been so well telegraphed, the fallout should be limited. However, this risk rally looks ripe for a deeper correction, and so perhaps this is the news that will trigger it. We do note, however, that concerns about negative fallout from the US losing its AAA proved to be unfounded, as did the downgrades to the euro zone last month. Contrary to Chicken Littles everywhere, the sky did not fall when countries lost their AAA, and the world instead continued to turn. Indeed, US and euro zone borrowing costs are lower now than before the downgrades by S&P. This is the lesson that European policymakers should take to heart. We stress again that the loss of AAA is not the end of the world, and one could make the case that AA is indeed the new AAA. However, the Moody’s news comes a time when markets are nervous about Greece, and so some limited fallout to the euro and EM FX appears likely near-term. The fallout for GBP may be longer-lasting, since it was expected by most to retain its AAA rating.

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