On Friday, January 13th, S&P lowered its credit ratings on nine Euro-zone countries. Credit ratings on Cyprus, Italy, Portugal, and Spain, were all lowered two levels while those of Austria, France, Malta, Slovakia, and Slovenia were lowered one level. Cyprus and Portugal lost their investment grade standing as their ratings were cut from BBB and BBB-, respectively, to BB+ and BB, respectively. All the other downgraded nations remained investment grade, with Ireland and Italy having the lowest ratings among them at BBB+. The credit ratings of Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands were all affirmed at their current levels. For the most part, the downgrades had already been reflected in the market. Certainly yields on Italian and Spanish debt already reflected their downgrades and spreads of French debt over German bunds clearly indicated that France was expected to lose its AAA rating.
The most important of these downgrades are those to France, Italy, Spain, and Austria, respectively, the 2nd, 3rd, 4th, and 8th largest economies in the Euro-zone. As such, they are also the 2nd, 3rd, 4th, and 8th largest underwriters of the European Financial Stability Facility (EFSF). Not surprisingly, subsequent to these downgrades, S&P lowered its rating on the EFSF from AAA to AA+. In our opinion a downgrade to AA or even AA- would have been warranted given the percentage of guarantees backing the fund that are coming from countries rated A+ or worse.
S&P took all the nations off CreditWatch, but the outlook for 14 of the countries reviewed remains negative while the outlooks for Germany and Slovakia are stable. According to S&P, a negative outlook indicates a 1-in-3 chance of an additional downgrade within a year for junk rated debt or over the next two years for investment grade debt (We note that Standard and Poor’s outlook for the US remained negative as well after last summer’s downgrade).
Frankly, this may constitute a modest positive surprise as neither Belgium nor Ireland was downgraded. However, as noted above, the outlook for both remains negative. Additionally, Standard and Poor’s notes that a more significant economic downturn than they expect could result in further deterioration of the situation and additional downgrades. We anticipate a deeper recession in Europe than that which is reflected in consensus estimates and believe that additional downgrades are likely before year-end.