Credit Strategy Highlights: Upcoming EU summit to agree on a permanent crisis mechanism?

More headlines regarding the European sovereign debt crisis and potential stabilization
mechanisms can be expected for this week, due to the upcoming EU summit on December
16-17. After two suggestions for an immediate crisis response (the introduction of E-bonds
and the increase of the capacity of the EFSF) were rejected by the German government,
another one is crystallizing. Instead of increasing the size of the EFSF, its scope could be
broadened, which means that it could buy government bonds in the market (and hence might
ease the pressure on the ECB, which is currently the only force that addresses the market
panic). Moreover, the EFSF could also provide a liquidity facility in case a government is
experiencing a short-term liquidity crunch, but where a full-fledged bailout (comparable to
Greece and Ireland) is not necessary. Furthermore, there could also be some provisions to
increase the lending power of the EUR 440bn fund, as the current rules of
overcollateralization and excess cash reserves to obtain a AAA rating for the fund limit its
lending capacity. A higher flexibility of the fund rules could help address in particular the fears
regarding Spain, as a program comparable to Ireland and Greece would – in the current
framework – overstretch the rescue mechanism. However, we argued before that the situation
in the different countries that are under scrutiny is in fact different and does not warrant a onesize-fits-all approach. In Spain, for example, it is foremost the banking system (and the
respective recapitalization and funding concerns) that is in the focus, while the sovereign
credit profile is not yet impacted by the banking crisis, as was the case for Ireland. Hence,
more flexible rules in the EFSF could allow for a mechanism where help can be directed
exactly where needed. In this respect, it is  also interesting to note that German Finance
Minister Wolfgang Schäuble indicated that he expects an EU agreement on the matter.

China macro data

This morning, Chinese stocks gained about 2% on economic data that were released over the
weekend. Industrial production climbed to 13.3% yoy in November from 13.1% the month
before, while a more moderate surge to 13.0% was expected. Also supportive for stock
markets was the fact that the authorities reacted moderately to the substantial rise in inflation
that was also reported on the weekend. CPI rose to 5.1% yoy from 4.4% (consensus
expectation was for a rise to 4.7%), while producer prices even climbed  to 6.1% from 5.0%.
The Chinese authorities are in a difficult situation. On the one hand, with the US being in
money printing mode and the EUR in a confidence crisis, rising rates would trigger more
money inflows and therefore would create more upward pressure for the Chinese yuan, which
would pose a risk for its export-oriented businesses. On the other hand, price inflation, in
particular food price inflation, which rose 11.7% yoy in November from 10.1%, starts to bite
the poorest, who are the majority of the population. If this were to continue, authorities would
risk social unrest. Hence, the chance that there will be more rate hikes at the beginning of
2011 are not minimal. This, in turn, could negatively impact European companies (in particular
Germany's car manufacturers) as with the Chinese central bank stepping on the brakes, the
risk of a downturn in the overheated Chinese housing market is high. This would clearly
impact the shopping spree of Chinese consumers.

This week's data releases

On the data side, there will be the ZEW index, eurozone industrial production, the UK RICS
house price balance index, US retail sales, PPI figures and the FOMC meeting (Tuesday), US
CPI figures and empire manufacturing (Wednesday), European PMI indices, eurozone CPI,
US housing starts, building permits and the Philly Fed index (Thursday), and the Ifo index,
Italian industrial order/sales and the conference board leading indicators (Friday).

EEMEA Credit Strategy Highlights
Later today, we will release our EEMEA credit outlook for 2011. The key points of the
corporate credit section are:
■ After an extraordinarily strong 2010, when Emerging European corporate credits generated
15% and sovereigns 11.7%, we doubt, however, that this performance can be sustained
into 2011. Higher UST yields are expected to cause some headwinds for Emerging
European sovereigns and the eurozone debt crisis presents a major source of volatility.
However, the "credit clock" still indicates good timing for long positioning in credits, as
corporate profits are growing faster than their leverage, suggesting a still favorable
environment for credits (as well as equities).
■ Credit fundamentals are on balance expected to improve both on sovereigns and corporates,
sustaining the positive rating momentum heading into 2011. On the sovereign side, Turkey,
Ukraine, Romania and the Baltics are expected to be upgraded. Downside risks are
imminent for Hungary and Poland. Regional corporate issuers should continue to improve
credit metrics on the back of firm commodity  prices, while corporate policy risks are not
severe. Although M&A activity and dividend policies should become more expansive next
year, they are unlikely to spoil credit metrics. Here we also expect a continuation of the
positive rating momentum, and default rates to decline further from 1% to 0.6% next year.
■ Strong inflows into EM funds on the back of a diverging development of macro
fundamentals between developed markets and EM remain a key technical support. In
corporates, strong coupon payments from regional corporates and ample global liquidity
should help to absorb new bond issuance, which we actually expect to decline from USD
41.2bn this year to USD 30bn in 2011, on the back of moderate redemptions and capex.
■ Recently, inflows into EM funds showed an increased dependency on developments in the
eurozone periphery. Thus, we recommend to hedge the exposure to regional credits at this
stage – in the case of Emerging European corporates, we advise to use the respective
sovereign CDS for hedging purposes.
■ Strategy-wise, we stick to high-quality quasi-sovereign (GAZPRU, TNEFT) and private
(TMENRU, TPSA, MOLHB, MOBTEL) credits. Nonetheless, we enter the new year with
long cash bond positions (proxy) hedged by sovereign CDS.

Full report: Credit Strategy Highlights: Upcoming EU summit to agree  on a permanent crisis  mechanism?