Persisting fears about sovereign and related debt from Greece to Dubai will keep investors occupied into 2010 after they enjoyed one of the best years for world stocks in the past two decades.
Greek assets have taken a hammering after two credit ratings agencies downgraded the euro zone member this month on concerns about its fiscal health, blowing out spreads between Greek bonds and safer German alternatives to their widest since early April.
Standard & Poor's also cut Mexico's credit ratings this week by one notch on fiscal concerns, while worries about Britain's fiscal and economic health are nagging investors after sterling hit two-month lows against the dollar this week.
Such fiscal fears could easily chill sentiment for world stocks as the benchmark MSCI world equity index wraps up one of the best annual performances in its 20-year history — up nearly 29 percent. In December however the index has barely made gains.
"Government spending has been the major driver of global growth in 2009 and the capital markets' challenge to this is a concern," said Rob Burnett, head of European equities and fund manager at Neptune Investment Management.
"In Europe, Greece is the standout country but the UK, Spain, Portugal and Italy are all experiencing a similar problem. We need to see a calming in fears in relation to government debt for markets to sustainably advance."
In Dubai, state-owned Dubai World must get creditors of debt worth billions of dollars to reach an agreement to avoid bankruptcy, even though this week's surprise $10 billion bailout from Abu Dhabi averted a default on bonds held by its property arm Nakheel. Creditors are due to meet on Monday.
Going into the holiday season, investors must be mindful of possible credit rating downgrades and their impact on asset prices as thin liquidity tends to aggravate market moves.
Standard & Poor's downgraded Greece by one notch to BBB+ this week, saying a further downgrade was possible if the government fails to gain political support for a fiscal consolidation program. The move came just days after Fitch cut the country to BB-plus, the lowest sovereign rating in the euro zone.
Moody's, the third big rating agency, has placed Greece's A1 rating on review for a possible cut.
"It is clear that Moody's is the least negative on Greece of the main three rating agencies. However, this should by no means be interpreted as a signal that a downgrade is not imminent. The main question is whether the downgrade will be of one or two notches and, of course, the timing will be crucial too," Ioannis Sokos, strategist at BNP Paribas, said in a note.
Sokos says it is only Moody's rating that will allow Greek government debt to be eligible as collateral at the European Central Bank in 2011, when the extraordinary liquidity measures by the central bank would expire.
In order to have Greek government bonds under the potential threshold of A- in 2011 by all ratings agencies, downgrades totaling three notches are needed by Moody's.
Analysts warn that it may also be just a matter of time before the UK loses its triple-A rating with its public debt heading toward 100 percent of gross domestic product.
"The direct impact of the crisis on the UK economy looks well discounted in a weak pound. However, secondary deterioration in the UK's fiscal stance looks likely to translate to a structurally lower exchange rate," Michael Hart, strategist at Citi, noted.
"A ratings downgrade for the UK now is increasingly likely. This may translate to a higher risk premium in the form of rising interest rates... If yields exceed a certain threshold they are more likely to be interpreted as a sign of distress than as a buying opportunity."
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