Reminder of crisis in euro zone

A RATINGS downgrade of nine European economies including France and Italy is set to to drag the Australian market lower at the open today, reinforcing fears that the crisis in the euro zone is "alive and well".

By InvestSMART · 16 Jan 2012

By InvestSMART ·
16 Jan 2012

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But the fall on the local market is expected to be moderated by the fact that Standard & Poor's decision to downgrade the countries of their credit ratings on Friday had been largely anticipated by investors.

Futures markets yesterday picked the

ASX/S&P 200 Index to fall 17 points to 4163 in early trading today, although some observers believe the market could drop 40 points.

Wall Street sustained a mild fall on Friday on speculation of S&P's reappraisal of the European economies' creditworthiness. In downgrading nine countries, S&P warned there was a 40 per cent chance of a recession in the crisis-hit euro zone, which could shrink by 1.5 per cent this year.

The ratings downgrades in Europe have also reinforced Australia's relative health, given it is one of just a handful of countries, including Germany, to retain a AAA credit rating. That means investors will continue to see Australian bonds as a haven.

Prime Minister Julia Gillard used the downgrades as a chance to call for European leaders to "swiftly undertake structural reforms to boost their economic potential and lift growth".

While Europe had avoided a full-blown meltdown of the magnitude of the 2008 global financial crisis, AMP Capital Investors chief economist Shane Oliver said the debt-laden euro zone would "just continue to muddle along" and be a "brake on the local Australian economy for the next year or so".

"It should be largely anticipated [by Australian investors], but that said, we should still be a bit weaker at the open," he said yesterday. "It is telling us that the European crisis is alive and well. The fiscal austerity leads to economic deterioration and budget deficits blown out. It has the effect of worsening the economic outlook."

Australians investors are taking some optimism from the US economy looking stronger than it was three to six months ago, and indications that China will face only a soft landing.

However, investors are likely to be rattled by renewed concerns about Greece after a breakdown in talks between the Greek government and creditor banks on Friday over the size of losses investors face.

Will Seddon, a portfolio manager at White Funds Management, said the ratings downgrades had been largely anticipated but investors were concerned about the longevity of mild improvements in the US.

"People will be wanting to wait and see and not go in too hard in any direction. You don't want to go too short because if the US keeps on improving there is a chance of a big rally, but at the same time you don't want to back the long side too heavily," he said yesterday.

"There is also the China wildcard. It is hard to see some sectors [in China] landing softly."

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Frequently Asked Questions about this Article…

What did S&P’s ratings downgrade of nine European economies mean for the ASX and Australian markets?

The S&P downgrade of nine European economies, including France and Italy, was expected to push the Australian market lower at the open. Futures had the ASX/S&P 200 Index easing about 17 points to 4,163 (with some observers warning of a possible 40-point drop), and Wall Street had already seen a mild fall ahead of the local open as investors priced in the reappraisal of European creditworthiness.

How could the euro zone crisis affect everyday Australian investors and the local economy?

Analysts said the debt-laden euro zone is likely to ‘muddle along’ and act as a drag on the Australian economy for the next year or so, with fiscal austerity worsening economic outlooks. For investors that can mean increased market volatility and a more cautious investment backdrop, even though some effects may already be priced in.

Why are Australian bonds being seen as a safe haven after the European downgrades?

Australia retained its AAA credit rating (along with only a handful of countries such as Germany), so investors view Australian bonds as comparatively safer. That relative credit strength makes Aussie bonds attractive as a haven when Europe’s sovereign creditworthiness is under pressure.

Should I change my trading approach on the ASX because of the S&P downgrade?

Many portfolio managers recommended caution: the downgrades were largely anticipated, so a modest downside at the open was expected, and investors were advised to ‘wait and see’. The guidance in the article was to avoid going too heavily long or too aggressively short—balance risk exposure while monitoring US and China signals that could trigger rebounds.

What specific European risks should investors watch after the downgrade?

Investors should watch the risk of a euro zone recession (S&P warned about a roughly 40% chance and a possible 1.5% contraction) and renewed concerns about Greece after a breakdown in talks between the Greek government and creditor banks over the size of investor losses. Those developments can drive market swings and contagion fears.

How are US and China economic signs influencing Australian investor sentiment amid the euro crisis?

Australian investors were taking some comfort from a stronger US economy compared with three to six months earlier and from indications that China might have only a ‘soft landing’. However, the article also noted China remains a wildcard and could still create sector-specific shocks, so investors remain cautious.

What did Australian policymakers say in response to the European downgrades?

Prime Minister Julia Gillard urged European leaders to ‘swiftly undertake structural reforms to boost their economic potential and lift growth,’ using the downgrades as a prompt for policy action to restore confidence and growth prospects.

What practical steps can everyday investors take when global credit ratings shift and markets wobble?

Based on the commentary in the article, investors should avoid knee-jerk moves: expect some weakness but recognise it may be priced in, consider defensive assets such as high-quality bonds, keep diversified exposure, and monitor key indicators (European sovereign talks, US economic momentum, and China’s outlook) before making large directional bets.