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Why Portugal Downgrade Didn't Slam Stocks

Investors do not see Portugal's rating downgrade by Moody's as an event that will shake the markets, but it confirms the fact that the outlook for some economies in the euro zone is still cloudy, economists and market analysts told CNBC Tuesday.

Portugal
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Portugal

Moody's slashed Portugal's credit rating by two notches to A1, citing a deterioration of the country's debt ratios and weak growth prospects.

Portugal's debt-to-GDP and debt-to-revenue ratios have risen rapidly in the past two years, Anthony Thomas, vice president and senior analyst in Moody's Sovereign Risk Group, said in a statement.

The euro fell after the announcement and the spread between Portuguese and German 10-year government bonds widened by 4 basis points to 290 points.

"The bond markets response hasn't been dramatic," Martin van Vliet, euro-zone economist at ING Bank, told CNBC.com.

The downgrade came a little before a Greek auction to sell 6-month T-bills, the first since a bailout package agreed by the European Union and the International Monetary Fund in May.

Greece sold 1.625 billion euros ($2.03 billion) of 6-month instruments at a yield of 4.65 percent, up from 4.55 percent in a similar auction on April 13, according to Reuters.

"The markets will probably reason that the risk of default in six months is small," van Vliet said.

European stocks rose, shrugging off the downgrade with investors optimistic after Alcoa's positive start of the US earnings season. US stock index futures were also up.

"It's a blow to Portugal but it’s not a major shock," Ken Wattret, chief euro-zone economist at BNP Paribas told CNBC.

Portugal has a "chronic lack of competitiveness" with a "highly indebted private sector," Wattret added.

Growth Is Key

Economic growth in Europe's peripheral countries will be crucial to bring back investor confidence but more and more analysts fear a slowdown in the second quarter everywhere in the world.

"The outlook for Portugal is not particularly optimistic," David Tinsley, economist at National Bank of Australia, said. "It is in a very slow growth trajectory and therefore all its fiscal retrenchment has got to come from public spending cuts."

Other analysts agree.

"Despite the better-than-expected performance of the economy during the first quarter of 2010, we share the view that growth is likely to be muted over the medium term," IHS Global Insight senior economist Diego Iscaro said in a market note.

Over the longer term, investors are still afraid of the risk of default and European Central Bank President Jean-Claude Trichet hinted that the need to intervene by buying bonds is not that strong any longer, according to van Vliet.

"My guess is that they will have to continue buying bonds," he said. "It all depends on whether the economy will start growing in Greece."

The risk of default by one of the southern European countries was the main fear in the markets earlier this year, when ratings downgrades sparked massive selloffs in stocks as well as bonds and investors were taking refuge in US Treasurys, gold and cash.

"The process of credit downgrades reinforcing confidence erosion, I think that's a bit over," van Vliet said.

Default Risk Is Gone

Investors will slowly realize that the risk of default by European nations on their debt is gone, and they will push up stock prices and the euro, according to economist Warren Mosler, founder and principal of broker/dealer AVM.

In June, Mosler told CNBC.com the euro was likely to rise to between $1.50 and $1.60 because of the austerity measures in Europe.

He reaffirmed his stance, saying that there had been a "mad rush for the exits" by Europeans, who bought dollars and gold, pushing the euro down, when the default risk was high.

But the ECB's decision to buy Greek bonds showed the bank was ready to spend money to defend countries in the euro zone and "there is no limit to what the ECB can spend," Mosler told CNBC.com.

The ECB has put itself in a top position by doing this, as it can impose terms and conditions on any country that sells it its bonds, he explained.

"What that did is it shifted power from fiscal policy to the ECB," Mosler said. "I would say they will not buy these bonds unless they can impose their terms and conditions."

"It allows them to cut out one member selectively, without the whole system collapsing," he said.

- Simon Dedman in London contributed to this story

Contact Europe: Economy

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