Contagion Redux: Moody's Downgrades Portugal Too Late

Moody’s downgraded  Portugal’s government bond ratings two notches to A1 from Aa2. The outlook for the debt was listed as stable.

Oddly enough, the stock indexes in the region did not react to the news at all, a sign that the capital markets believe that the situation in Europe has stabilized and that the ratings agencies, as usual, are late in their evaluation of the situation. That may be true. Its actions on Greece and Spain came well after its was clear to institutional investors that their’ deficits and sovereign debt were troublesome. Fitch and S&P have downgraded the debt of the three countries as well

Europe’s markets moved slightly higher after the announcement. The euro was down a small fraction to $1.2534. That is still well above its 52-week low of $1.1875Moody’s said in its note about the downgrade that:

1.) The Portuguese government’s financial strength will continue to weaken over the medium term, as evidenced by ongoing deterioration in the country’s debt metrics, such as debt to GDP and debt to revenues; and

2.) The Portuguese economy’s growth prospects are likely to remain relatively weak unless recent structural reforms bear fruit over the medium to longer term.

The rating is a guess, as all rating are, but in Portugal’s case the bet may be misplaced. The country, along with several others in Europe and Japan, have decided that austerity is the best way to improve their economic fortunes, at least long-term. Citizens in these nations will have to suffer higher taxes and a loss or diminution of key social services. A number of public employees may lose their jobs. But there is some chance that balanced budgets, or budgets in the process or being balanced, will improve the picture of the debt of these countries which bring their borrowing costs down. Over time, the champions of austerity reason, these nations will not have to borrow at all.

Portugal’s economy is one of the weakest in Europe, but the downgrade did not cause a sell off in European banks, which have hundreds of billions of euros in capital invested is the sovereign debt of countries in the region. Bonds issued by the treasuries of these nations did not sell down either.

It appears that the fear of contagion in the debt of European countries has weakened substantially. The $1 trillion facility in place to help the weakest countries is now viewed as adequate. There is hope that bank stress tests for financial firms in the region will show that most large financial firms have adequate capital to carry them through harsh economic times. The ECB may also extended a lifeline to banks that become troubled. And the largest economies in the region are regaining health.  France and Germany are recovering well from the recession.

The markets did not react to the Portugal downgrade because investors and analysts have already moved passed the notion that governments in the region will suffer economic collapses. Greece may need to restructure its debt, but that is already built into most assumptions about the future prospects of the region.

Europe is in trouble, but it is trouble it can get out of.

Douglas A. McIntyre