Wealth Management Research 2 September 2011

The debt crisisWaiting for payday

The spotlight has recently been shifting back and forth betweenthe debt problems faced by the US and those in Europe. Americanobservers are especially concerned about looming bankruptciesin Europe, while commentators in Europe are quick to pointout the even higher level of debt in the US and the country’slackluster efforts to consolidate it. In the final analysis, however,their problems are quite similar: The growth outlook is weakbecause both governments and private households urgently need toreduce their debt. This will deprive the economy of the credit-drivenmomentum it has enjoyed in the past, thus leaving governmentswalking a tightrope between consolidating their budgets andavoiding a recession. Their dilemma: Not saving enough couldprompt a further decline in credit quality, but so could saving toomuch.

The US has already lost its AAA rating from Standard & Poor’s dueto the debt ceiling debacle, while Moody’s may downgrade the US’stop credit rating by the end of 2012. If we were to weigh the creditratings of the Eurozone countries against their national incomes,they have warranted only a AA for a long time. And if the ratingagencies had to issue a joint rating for the entire Eurozone today, inspite of some plus points over the individual ratings, it would mostlikely not be AAA.

Euro crisis: Guidance must come from the European CentralBankSince the initial Greek rescue package in May 2010, the Europeandebt problem has spiraled into an enduring crisis for the Eurozoneand a real threat for the major economies. In an attempt to stemebbing confidence among lenders, financial interventions havereached dizzying heights. So far the Eurozone countries haveguaranteed direct loans of EUR 180 billion and credit guaranteesof over EUR 440 billion, while the European Central Bank (ECB)has purchased bonds issued by Eurozone countries in the amountof EUR 115 billion, and the International Monetary Fund (IMF) hasguaranteed credit packages exceeding EUR 78.5 billion. But the rootcauses of the current problems remain unresolved. Investors andrating agencies are having a difficult time believing governments’

Thomas Wacker, CFA, analyst, UBS AG

Claudia Sigl, analyst, UBS AG

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 5.

proffered commitments to fiscal consolidation measures, giventhe fact that they have done little to ensure solid government fi-nances in the past. Ultimately, the incentives for politicians to spendmore in the short term in order to secure re-election are significantlygreater than their concerns about the debt burden of future gener-ations. This approach may have appeared canny when interest rateswere low. However, European politicians are now finding it hard toaccept that they cannot force their creditors to offer them low in-terest rates and that rating agencies are not obliged by law to givehigh country ratings.

The debts racked up by the public and private sectors over thecourse of a decade cannot simply be eliminated overnight. But thisis exactly what nervous investors seem to require in order to restorecalm quickly and sustainably. Nevertheless, harsh spending cutbacksare not a cure-all for a debt crisis; rather, they are the prescriptionfor a painful and drawn-out recession, like those currently grippingGreece and Portugal. Other countries that have implemented far-reaching savings packages are also faced with the threat of slippingback into recession, and even the strongest countries are experienc-ing a significant slowdown. If a stagnating economy is the price oflower budget deficits, then the official debt ratio (ratio of debt togross domestic product) is unlikely to improve anytime soon.

Saving alone is not enoughDebt crises have never been solved through saving alone. Excessivedebt has more often been eliminated by inflation or financial repres-sion and – in hopeless cases – by state bankruptcies. In our view,there is nothing Greece can do now to avoid bankruptcy. It is on-ly a question of time before the country collapses under the mas-sive constraints placed on its budget or – with savings targets leftunmet – its financiers come to the realization that they will have tosupport ongoing savings measures by taking a haircut. The plannedvoluntary exchange of some bank-held bonds is a mere drop in theocean, and will probably work more to the benefit of banks, whichwill be able to exit their positions with relatively low losses. A statebankruptcy could become an inevitability as early as spring 2012, aspart of the third review of the new credit package by the IMF.

There is still hope for the national budgets of the other Eurozonecountries, however. Portugal and Ireland are just at the beginning ofa very long and difficult consolidation process, but a credit defaultis unlikely in the next few years, in our opinion. Due to the relative-ly small size of these two economies, the Eurozone community willbe able to help the governments of Portugal and Ireland with assis-tance loans until the initiated reforms start to bear fruit. The con-tinuation of these credit packages should also help mitigate marketturbulence following a Greek bankruptcy.

The crisis has reached the coreUncertainty has now hit Spain, Italy and France – three of theEurozone’s largest economies – and not only sovereign bonds butalso bank equities and bonds have come under pressure. It has thusbecome increasingly clear that neither promises by the affectedcountries to tighten their belts nor the efforts made by the ineffec-tually small and inflexible European Financial Stability Facility (EFSF)

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will be able to provide any long-term relief. The ECB is currently pre-venting a critical rise in Spanish and Italian interest rates by buyingup bonds, albeit unwillingly.

Soon, an improved EFSF should be able to take over this task, al-though we are doubtful that this will work in practice. In the firstweek after embarking on its most recent bond purchase program,the ECB acquired bonds totaling EUR 22 billion. The EFSF, for itspart, would have first had to sell new bonds amounting to EUR25 billion, which hardly seems possible at such short notice. In ourview, the EFSF is not a suitable vehicle for large-volume support pur-chases such as these. Therefore, the ECB is likely to have to con-tinue in this task for longer than some of its members might like.Even if major bond purchases with newly printed money (as per theUS model) are not currently on the agenda for the ECB, the centralbank will probably be forced to take on a larger role as a lender oflast resort in the near future.

Do Eurobonds offer a solution?Calls for jointly guaranteed Eurobonds have become louder andlouder in recent weeks. In an analysis published in May, we demon-strated that there is an economically viable model for joint debt se-curities, but this will require far-reaching changes to the Eurozone.Our fear is that many countries will resist the necessary partial relin-quishment of fiscal sovereignty, and that they will continue to cir-cumvent the existing stability pact as far as possible or even break itbefore it is able to have the desired effect.

Low-interest Eurobonds would take considerable pressure off ofweaker countries over the coming years, but would also dramatical-ly weaken the incentives for a restrictive budgetary policy currentlyemanating from the bond markets. Promises of fiscal consolidationwould quickly disappear from the political agenda due to demo-graphic challenges. This would result in a much more acute debt cri-sis – one which would cripple the economies of countries that havethus far boasted solid finances. Whereas today every hint that thecrisis is about to resurge prompts a fall in interest rates for Germangovernment bonds, thus giving the country financial leeway to im-plement rescue measures, Eurobonds would make Germany part ofthe problem.

We still think that Eurobonds should be introduced; however, thisshould only happen when the euro as a whole is on the verge ofcollapse and even those who are opposed to the bonds do not seeany viable alternative. We believe Germany would give in to pressurein order to keep the euro. On the other hand, we can also envisioncountries such as Finland or Slovakia preferring to exit the Eurozone.

Adverse environment for European banksWe have advised against bank bonds since end-2010, and even fol-lowing the most recent setbacks we remain tentative about re-en-tering this sector. Given the raft of unresolved problems in Europeand the US, conservative investors should still shy away from hold-ing too many bank stocks, and instead focus on markets with betterprospects such as Canada and Australia.

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Bad, but not hopelessWe have maintained a pessimistic outlook for over a year and werequick to rein in the optimism that began to burgeon after eachnew rescue package. However, in recent weeks the financial mar-kets have entered a phase in which risks are massively overestimat-ed, at least on a temporary basis, and suddenly we find ourselvesback among the optimists who do not believe that Europe is on thebrink of imminent collapse. We recommend adopting a conserva-tive stance and in the event of sharp drops in prices we would fo-cus on solid equity and bond positions with an investment horizonof several years. We cannot say when the crisis will reach its peakand when the necessary steps to ease the situation will be taken.What we can say is that the peak is still to come – but the collectivebankruptcy of Europe as a whole is not in the cards.

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