Despite a sharp rebound on Thursday, most equity markets have moved sideways for the week, except for Spain, Italy and some Asian markets that remain in negative territory. German bonds suffered profit taking and saw yields increase. Italian and Spanish yields eased after Mr. Draghi’s statements. Gold is trading above USD1615/oz, and crude oil is challenging the USD90/bbl level.
The UK economy is contracting faster than expected, with GDP falling at the most rapid pace in three years. GDP declined by 0.7% in Q2 from Q1, compared with estimates for a 0.2% fall.
This is the third straight quarter of decline in the UK economy. The outlook for the third quarter may not look as bad as Q2, but expect further contraction in the months ahead. The UK recession seems to be deeper than expected.
Moody’s Investors Service changed the outlook on three of Europe’s strongest Aaa countries – Germany, the Netherlands and Luxembourg – to negative, but affirmed Finland’s stable outlook. The agency sees the risks of a Greek default, a euro exit and/or the costs related to trying to keep the country in the euro as mounting. All three countries’ economies remain strong and wealthy, but future policy action could compromise this stability. Finland avoided a negative outlook because its economy and banking system are less dependent on the euro area.
The rising uncertainty regarding the outcome of the euro area debt crisis given the current policy framework has now “officially” impacted the Aaa-rated euro area sovereigns whose balance sheets are expected to bear the main financial burden of support, be it because of the need to expand the European Stability Mechanism (ESM) or the need to develop more ad-hoc forms of liquidity support.
Moody’s also lowered the outlook on the European bailout fund’s debt to negative from stable. It affirmed the EFSF’s Aaa rating, but changed its outlook for potential downgrade following the assignment of a negative outlook earlier this week on the Aaa debt ratings of three of the EFSF’s guarantors: Germany (which holds a 29.1% share in the guarantor pool), the Netherlands and Luxembourg. A further deterioration in the creditworthiness of the participating euro area member states might trigger a downgrade of the EFSF’s rating, especially if the ratings of Aaa countries with large EFSF contribution keys are negatively affected.
Note that a weakening of the commitment to the EFSF among euro area member states could have negative rating implications.
The euro area’s economic downturn seems to be worsening, as indicated by the eurozone Flash PMI survey for July. The composite purchasing managers’ index was unchanged at 46.4, which represents the sixth straight month in contraction territory, i.e. below 50. The manufacturing component of the index was particularly ugly, falling at the steepest rate since May 2009. The flash PMI for July suggests the euro area downturn showed no signs of easing at the start of the third quarter. In fact, it is consistent with GDP falling at a quarterly rate of around 0.6%, which is similar to the rate of decline we expect to see for the second quarter.
It seems increasingly clear that eurozone GDP will contract by -0.5% to -1% this year, which will be a drag on the speed of fiscal consolidation in the region and might lead to a further intensification of the debt crisis.
German business conditions deteriorated more than expected, falling for the third consecutive month to the lowest level in over two years, according to data published by the Ifo institute in Munich. The July business confidence index fell to 103.3 from 105.3 a month earlier. The Ifo’s gauge of the current situation also declined, to 111.6 from 113.9, and a measure of executives’ expectations fell to 95.6 from 97.2, declining to the lowest level since June 2009.
The Ifo business climate report came just one day after disappointing Markit Flash PMI numbers showed that Germany’s manufacturing and service sectors are contracting. Expect the eurozone crisis to further dampen the outlook for economic growth and company earnings.
The Spanish recession deepened in the second quarter, with the economy contracting by 0.4%, according to the Bank of Spain. Domestic demand fell more sharply than in the prior quarter, while exports recovered slightly. The economy marked the third straight quarter of decline, as the toughest budget cuts in Spain’s democratic history worsened the economic contraction. The austerity plan through 2014 now amounts to more than 10% of the country’s annual GDP.
Confidence in the euro area’s fourth-largest economy is continuing to suffer. Yields on Spain’s 10-year benchmark bond surged above 7.5% this week, breaching a level that forced Ireland, Portugal and Greece to seek external aid. Keep in mind that a Spanish sovereign bailout would leave little to provide assistance to other eurozone members.
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