Negative reaction

Economist
December 6, 2011

If traders were planning to spend December in a drunken round of parties, they will have to think again. Yesterday saw the outline of a Merkel-Sarkozy plan to stabilise the euro, and it also saw S&P, the rating agency threatened by EU reforms, defiantly put the whole zone on negative credit watch.

The S&P move is interesting, to say the least. One could imagine two outcomes over the next few months. Option A would be a plan for the creditor nations to subsidise the latter, in which case one might expect creditor downgrades and debtor upgrades. Option B would involve a break-up of the whole region, in which case Germany and the Netherlands would keep their rating but some of the others would follow Greece into junk status.

S&P's reasoning seems to be based more on the short-term economic outlook. It cites five factors.

(1) Tightening credit conditions across the eurozone;
(2) Markedly higher risk premiums on a growing number of eurozone sovereigns, including some that are currently rated 'AAA';
(3) Continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members;
(4) High levels of government and household indebtedness across a large area of the eurozone; and
(5) The rising risk of economic recession in the eurozone as a whole in 2012. Currently, we expect output to decline next year in countries such as Spain,Portugal and Greece, but we now assign a 40% probability of a fall in output
for the eurozone as a whole.

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