Danske: Even A 100% Debt-To-GDP Ratio In 10 Years Time Could Prove Difficult For Several Countries

Sovereign debt problem has come to the forefront of mainstream media, even to new heights of default discussions. While some saw this coming as early as last summer, there is unstoppable belief that countries will sacrifice their credit in the name of corporate earnings growth?

Well, it looks like the credit markets have been caught by the virus too, as Suki Mann, the credit strategist at Societe Generale, notes today:

It's been an incredibly upbeat start to the year supported by better-than-expected economic data streams, with everybody's favourite risk measure – equities – now hopeful of a V-shape recovery. We think that’s unlikely and the stock rally is not sustainable at the current pace - there will be many bad days/periods where the data will leave much to be desired. We're wary of (but welcome) the good news currently and we’ll need to be pragmatic also when the tide goes out. For credit specifically, cash activity is limited (market better bid though), and so the focus is on the indices. They are ratcheting lower and at such a pace that it is already likely that we will need to revisit the targets we set for 2010. The X-Over index for example (target 340bp), traded with a 3-handle today having been in the 500bp area for much of Q4 (610bp in October). X-Over is also outperforming Main with the ratio at 5.7x now vs 5.9x at the end of 2009. The ratio was as low as 3.9x(624bp/159bp in March 2008) and as high as 10.5x (242bp/23bp in November 2006). Elsewhere, for now, the ills of sovereign indebtedness are forgotten as their CDS levels also head a little lower as hopes rise of a sustainable (“stimuless”) economic recovery. Even Greece is benefiting with its 5-year CDS at 257/262bp (-23bp today), compared with a recent high of 291bp.

However, those, who still can see further than 3 months ahead, may be interested in the latest note by Danske Bank on the sovereign debt that has taken "a dangerous path". Here are some key findings:

Euro area debt levels are rising faster than at any peacetime rate in the aftermath of the ongoing crisis. Further, as a result of the crisis government bond yield spreads between different euro area member states have exploded.

We take a closer look at debt sustainability for various euro area member states. The approach chosen is to make mechanical projections until 2020 for each country and analyse the projected path for future debt levels.

We conclude that debt levels will rise to unsustainable levels for some countries if member states do not tighten their primary balances significantly.

It is not too late to avoid default. If plans put forward by Greece and Ireland are strictly adhered to, it will stop the debt-to-GDP ratio from skyrocketing. Significant spread tightening in addition to fiscal tightening could stabilize the debt ratio.

The Maastricht Treaty’s debt-to-GDP criterion of 60% seems unrealistic within the next 10 years for many EMU countries. Even a 100% debt-to-GDP ratio in 10 years time could prove difficult for several countries.

Well, while some bulls simply cannot change their New Year's costume yet, there are some early cyclical bulls turning cautious? Jeff Saut, the admired strategist at Raymond James, issued a following weekly call yesterday:

Last Monday we wrote, “As we enter the New Year, we are once again turning cautious because the Treasury market is breaking down (higher rates) and the U.S. dollar is rallying. . . . Therefore, we think it prudent to ‘bank’ some trading profits and hedge some investment positions as we approach the new year.” Moreover, one of the lessons we have learned is that the beginning of a new year is often punctuated with head fakes, both on the upside as well as the downside. One of the greatest upside head fakes was in January 1973 when in the first two weeks of that year the DJIA rallied to a new all-time high of 1051.70 before sliding ~20%. While we are clearly not predicting that, what we have indeed experienced since the March “lows” is the second greatest percentage rally (69%), adjusted for time (nine months), since the 1933 rally. Following that 1933 explosion of 116% in just five months came a pretty decent downside correction. Since we tend to be “odds players,” prudence suggests some caution is again warranted.

Prudence? For some time already, as clowns were hiding in the homes for too long...