German loss at EU summit must be put into perspective

The decisions taken at the EU summer of last week received a warm welcome on the financial markets. The weak EMU countries face looser conditions for financial assistance from their Eurozone counterparts, reducing the risks of a euro(zone) collapse. Is this enthusiasm justified?

 

Financial markets have reacted positively to the decisions taken by EU government leaders last week. Has this marked a critical turn in financial market trends? In our view, it does not. We foresee optimism lasting for some weeks at most, before old downtrends in equity and bond prices (of the weak EMU countries) resume. Incidentally, part of the sudden market movements of last Friday can be explained by the covering of positions before the end of the second quarter.

 

The decisions taken were more or less in line with expectations. That is, they reflect the wishes of strong euro countries to move towards a fiscal, banking, and political union based largely on German-style governance. This hinges on austerity requirements attached to financial support. Although these have proven to be too strict, resulting in weaker growth, the desire to maintain strict requirements remains; it is the only way to make the weak countries competitive and healthy again. The adverse consequences had largely by-passed Germany. However, as financial market pressures brought the Eurozone to the brink of collapse, Berlin had to concede somewhat:

• The EU emergency funds (EFSF and ESM) might be used to support the Spanish banking sector directly without these loans gaining ‘seniority’. Thus, the support for banks by-passes the government so the Spanish government debt will not increase further, and the remaining Spanish government bonds in the hands of the private sector do not receive a ‘junior’ status. As a counter-demand, the weak countries have to agree with a common EU bank supervisor (probably the ECB): a first step toward a banking union
• As long as the ECB has not gained supervisory powers and the ESM cannot support banks directly, the emergency funds are able to buy the sovereign bonds of countries like Italy and Spain to reduce their financing costs. As this probably does not entail the involvement of the Troika (EC, ECB, and IMF), the conditionality attached to this form of financial support might become somewhat less strict: another relief for investors

 

Most interpretations have described Merkel and the other strong countries becoming hostage to the weak countries’ problems. This is not necessarily true, however. Germany indeed made some concessions, but only to prevent an escalation of the euro crisis. The agreement signed last week remains vague and must still be accepted by national governments. In addition, details have to be filled in, and direct support – through the ESM – to Spanish banks becomes possible not before the end of this year. This means that Germany retains the pressure on weak countries, and can impose strict requirements for extra help it provides.

 

Importantly, the agreement of the EU summit does not address the true underlying problems of too high debts and too low growth in the weak countries. Slightly lower interest rate costs for the weak countries do not help much in this regard, and so financial support from Germany remains vital.

 

Against this background, and with a weakening world economy, we anticipate equity indices rising by some percentage points (possibly also support by another interest rate cut by the ECB) before resuming their downtrends. With tensions in the Eurozone coming to the fore again soon, as German opposition to providing additional support to the weak countries appears stiffer than most currently hope for, euro weakness is in the cards.  Furthermore, it will only be a matter of time before the interest rates on government bonds of the weak euro countries start to rise again, lifting German bond yields alongside.