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November 15, 2011

The Italian job – ECB bond buying will relieve crisis, says Russell

• Europe steals world's attention but recovery hopes exist for U.S. on eventual housing revival

SYDNEY, November 15, 2011 - Italy has taken centre stage in the latest act of the European debt saga and investors have called on the European Central Bank (ECB) to purchase Italy's rising debt. But will the ECB act before the crisis escalates further?

As a complement to Russell Investments' November 2011 Market Commentary, a forward looking snapshot of the global investment landscape, chief investment strategist, Andrew Pease, has provided the following insights on what he believes the key players need to do to prevent a deeper crisis from evolving.

Enter the Draghi

According to Pease, only the ECB and its new president, Mario Draghi, can prevent a deeper crisis from engulfing Europe. This would involve the ECB committing to the purchase of a virtually unlimited amount of Italian government bonds, which it has so far been reluctant to do. An unconditional promise to purchase Italian debt, effectively quantitative easing, Pease says, is needed to reassure markets there is a buyer of last resort for Italian debt.

If the ECB does not commit to large scale Italian bond purchases the self-spiralling crisis of rising Italian bond yields is likely to continue.

"Rising bond yields make investors worried about Italy's ability to repay its near €2 trillion of outstanding debt. As a result investors demand higher interest rates on Italian bonds, making them even more concerned about Italy's ability to repay," Pease said.

The pressure for the ECB to step in and take on Italy's debt stems from the distinction between Italy's crisis and that faced by Greece. For Italy the problem is mainly one of liquidity rather than solvency.

"This is a crucial distinction as a liquidity crisis can be calmed by the ECB, a problem of solvency (such as in Greece) can only be fixed by a debt restructuring or default. While Italy has a debt to GDP ratio of 120%, its primary fiscal position indicates revenues are almost equal to spending. Italy could sustain its current debt levels at a bond yield of around 4.5% - its average bond yield over the past 10 years. However if yields continue to rise beyond 7%, Italy is effectively insolvent."

Pease says the big question now is whether the ECB will come to the rescue. He believes eventually, they will have to but cautions the ECB's reluctance to buy bonds is stopping it from acting until absolutely forced to.

"If the ECB sits on this (the decision to purchase Italian debt) the crisis may escalate until there's no other option than to act as the bond buyer of last resort. This is a moment that could change the dynamics of the euro-zone crisis. While it won't mean the end of Europe's problems by any stretch – it will mean that the risk of an uncontrolled illiquidity driven crisis is effectively over," he said.

Housing revival to pull U.S. out of its slump, eventually

According to Russell, the U.S. outlook isn't dire but isn't rosy either. The biggest risk facing the U.S. is Europe's woes pulling its banking sector down, but Pease says an eventual housing revival although unlikely before 2013 is a strong growth prospect.

"We think the housing market could eventually be the trigger for a sustained economic revival, stimulating demand for whitegoods, furnishings and infrastructure in the form of roads and utilities. While this won't be immediate, a housing rebound will provide the kick start to the rest of the economy," Mr Pease said.

How low can you go? Support mounting for further RBA cuts

Locally, there is a growing rationale for lower interest rates by the RBA, however Russell cautions it's not as strong as the market believes.

"We probably sit in the middle between those who believe the slowdown in the economy is temporary and will rebound in 2012, and the markets which have priced in about 100 bps of further easing over the next 12 months. We'd expect another cut if employment continues to trend lower post the slowdown in GDP growth we witnessed in the first half of this year," Pease concluded.

Read the November 2011 Market Commentary - The United States of Europe?