As the summer begins, we are reminded of a bad memory: last year’s market collapse. 

 In August 2011, European stock indices declined by around 20 percent. The spectre’s name was “Private Sector Involvement” (“PSI”). It quickly became clear that many sovereign bonds were losing their reputation as safe investments over the discussions about the PSI. A year later, the talk about PSI has subsided, but sovereigns continue to be rattled by the crisis. 

Many market observers believe that a hard default in Greece followed by the ensuing chain reaction would cause an extreme emergency and the probability is high that the country eventually becomes insolvent.



Citing sources from inside the troika, newspaper articles reveal what Greece did last summer - hire new officials.

 Instead of laying off a six-figure number of civil servants, the authorities hired roughly 70,000 new employees in 2010 and 2011, who expect to be paid on a regular basis. But the coffers are empty, and the feared hard default could follow without international support. 

Indeed heads of state and central bankers see the financial industry as the weak spot and are discussing a number of measures to address this.

So will we see the introduction of non-recourse repos in autumn? Unlikely! In light of the substantial provisions and write-downs, we believe that the effects of a Greek default for the rest of Europe would be limited. It is more down to the forced austerity plans in Italy and Spain that the domestic economies are suffering.

The macro picture (even without a Greek default) looks bad – even worse than in the scary summer of 2011. Also in the US, company profits (ex-financials) declined for the first time in ten quarters and the job market recovery is still sluggish.

In addition, China’s growth figures for the second quarter also offer little tailwind. We therefore cut our 2012 growth expectations for Europe from -0.5 percent to -0.7 percent for this quarter.

This summer the spectre has swapped its Greek toga for a bespoke Italian suit. In Q1 of 2012, no economy in the European Monetary Union shrank as much as Italy’s; the economy contracted by 0.8 percent compared with the previous quarter. For 2012, a decline of 1.5 to 2 percent would not surprise us since there was no noticeable improvement in unit labour costs, and several reforms proposed by Prime Minister Mario Monti have come to a standstill.

But for a surprise like in the summer of 2011 to materialise, we need to see more than mere trouble from the economic front. After all, it’s not all bad news: the trade deficit is shrinking rapidly. It would be more dangerous if Monti (who is governing without the backing of the political majority) were to lose popular support.

 The latest austerity program, which intends to slash the national budget by additional €29bn until the end of 2014, goes hand in hand with layoffs and cuts in wages and pensions which is bad timing as the next elections are scheduled for April 2013 and additionally, some media outlets invoke the name of Silvio Berlusconi who is playing the anti-euro card and may incite political instability. 

 Spectre no. 2 is clad in Spanish attire. First and foremost it’s the country’s banks that are in trouble. While private deposits in Italy have been stable in the past six months (from December to May); Spanish savers pulled 90.3 billion Euros from their accounts. Meanwhile, banks increased their holdings of ailing government bonds by  €78.1bn. 

 Furthermore, a divergence in business rates within the eurozone is emerging. Companies from the periphery now need to pay far more for fresh money than businesses in countries like Germany and France. Therefore, the issue of a credit crunch in Spain is more pressing than ever. The monetary transmission mechanism does not work anymore; the policy of cheap money is failing just where it is needed most and may explain why heads of state and central bankers see the financial industry as the weak spot. 

Standard & Poor's is confident that the euro crisis is reaching a turning point once the resolutions adopted by the latest Euro summit are implemented. But beware: The European nations won’t be so quick to hand over large parts of their sovereignty, maybe even without consulting the voters. 

Indeed, the passage of a roadmap to a fiscal union in Europe should be a game changer in the markets; however, we don’t expect the implementation of such a mega plan in the third quarter.