Is France under threat?

22 November 2011

France faces the prospect of losing its triple-A credit rating after Moody’s warned that the higher borrowing costs for France plus slowing economic growth could cost the country its highest-possible credit rating.

Investors already seem to be pricing French government yields as though the country has lost its triple-A status. Yields on 10-year French bonds yesterday were 3.4%, about 154 basis points above their German equivalents. This spread reached 200 basis points on November 17, the biggest gap since 1990.

Moody’s said that any lasting increase in French borrowing costs would exacerbate France’s economic challenges with “negative credit implications”.

France’s triple-A sovereign debt rating enables it to manage its public debt (due to peak at above 87% of GDP next year). President Nicolas Sarkozy has introduced two rounds of budget cuts since August to try reduce the government’s deficit from 5.7% of GDP this year to 4.5% next year and 3% in 2013. Another worry for France is that it has several large banks exposed to eurozone debts.

Any French downgrade would impact the European Financial Stabilisation Facility, Europe’s 440 billion euro (A$600 billion) bailout fund. If France loses it triple-A status, it would put the bailout fund’s triple-A rating at risk – indebted eurozone members rely on the rescue fund to access funding at much lower triple-A rates and France is the second-largest contributor.

Recently released GDP results for France and Germany showed that the eurozone core grew modestly in the third quarter. But concerns are high that economic growth has turned negative since October when the eurozone crisis intensified. The latest economic data on Europe points to a looming recession there.

Crunch time for the ECB

Dominic Rossi, Fidelity’s Chief Investment Officer for Equities, says the shift in focus of bond investors from the periphery to the core countries such as France means we are entering into the turbulent final phase of this crisis.

“Given we are talking about triple-A sovereign nations now becoming involved, this has to be the final phase of the crisis, simply because there is nowhere else for contagion to spread,” he says.

So far, the European Central Bank has bought bonds of troubled countries on a sterilised basis, meaning there is no increase in the money supply – the bank has been counteracting its bond purchase by selling shorter-dated securities. With the need to support an enlarged group of sovereigns, the ECB may be forced to consider increasing the money supply to allow it to make unsterilised purchases of bonds. This policy change to quantitative easing has significant political barriers to overcome, however, principally in the form of German opposition.

“The evolution of the crisis path now suggests a tipping point at which quantitative easing by the ECB becomes palatable to Germany as the only option that avoids a eurozone break up,” Dominic says. “The path between the inconceivable and the inevitable has now become very short.”

What can investors do?

Managing European equity exposures will be vital during these testing times as certain financials may still have large exposures to these troubled regions. Despite the promise of unlimited liquidity from the ECB, interbank lending and funding costs could cause further pain for banks.

Within equities, recessionary concerns about Europe may hamper the performance of cyclical stocks by a greater magnitude than defensive names, so it makes sense for investors to take a more defensive stance during these uncertain times; especially for higher-yielding companies with reliable earnings streams that are growing their dividends.

Dominic says that equity investors should focus on high-quality, defensive companies with stable and reliable earnings streams, which pay high and sustainable dividends. “For the last 20 years, investors have bought equity markets for capital growth, but now is the time to buy equities for income.”

He says that we are very much in a ‘two-speed world’ in terms of economic growth as the long-term case for emerging markets remains intact.

“Emerging markets will not offer near-term respite from the problems in the eurozone as equity correlations are likely to converge once again when volatility becomes heightened,” he says. “However, when you consider their superior fundamental economic ability to recover, and the likely speed at which they can recover from a crisis centred on Europe, and the fact that their issues are cyclical in nature rather than structural, then the case for investment in emerging markets is robust on a medium to long-term view.”

Financial information comes from Bloomberg unless otherwise stated.

Parting ways – France and Germany

Bloomberg. 16 November 2011