Monday, November 29, 2010

Ireland bailout...

Ireland has successfully negotiated an 85 billion Euro bailout with Euro-area Governments, the EU and the IMF. The funds are made up from a contribution of 17.5 billion Euro from Ireland itself (from cash reserves and national pension fund), 22.5 billion from the European Financial Stability Mechanism, 22.5 billion from the European Financial Stability Fund and bilaterals from the UK, Sweden and Denmark, and 22.5 billion from the IMF.

The support is for a 7-year period. This is a far more realistic period than the original 3-years negotiated in the Greece package in May – which has now been extended by a further 4.5 years to match the Ireland term. This will reduce, although in our view not entirely eliminate, the risk that Greece eventually restructures its debt.

EU finance ministers have also approved the broad outline of a permanent crisis-resolution mechanism to be called the European Stability Mechanism. Private bondholders could be made to share the burden of restructuring of a euro zone country's sovereign debt bought after 2013, subject to a case-by case evaluation. This will also help market sentiment since it significantly waters down a proposal from Germany and France for investors to be forced to take losses to share the costs with taxpayers. More on this later.

The immediate question now is whether the Ireland deal is sufficient to stem the contagion. Only time will tell. The good news is that the likely next cabs off the rank are Portugal and Spain, where economic fundamentals are weak, but better than either Ireland or Greece. A Portugal bailout could be easily managed within the existing EU/IMF facilities in place, but possibly not enough to cover Spain, raising the prospect that the existing facilities need to be expanded.

Of course if Spain needs a bailout, it could also be the case that the issue becomes more than Europe can handle itself and that the bailout mechanism becomes a more global effort, with the likes of the US, China and other brought in, under IMF auspices.

For about two years now we have been arguing the importance of governments articulating credible plans for consolidating their fiscal positions back to some semblance of sustainability. That seemed a tad silly in the depths of the recession, but we also pointed out that the risk of not doing so would be that bond markets, which generally dislike uncertainty, would seek answers to tough fiscal questions.

Bond markets are looking for certainty, and will continue to pick off one country at a time until that certainty is resolved, or at least as best it can be. Governments all over the developed world need to get in front of the problem and articulate meaningful fiscal consolidation plans.

Thursday, November 25, 2010

Ireland bites the bullet

The Irish government has announced big spending cuts and increased taxes to trim (sorry - slash) the budget deficit to 3% of GDP by 2014. The deficit is projected to be 12% of GDP this year, or 32% if you include the bank bailout. Measures include welfare cuts of 2.8 billion euros and 1.9 billion euros in income tax increases, an increase in sales taxes, a 10% pay reduction for new entrants to the state workforce and a decrease in the minimum wage. the underlying macro-economic forecasts include average GDP growth of 2.7% per annum over the next four years. That sounds a tad optimistic.

The GFC and its aftermath was largely about bringing living standards back within incomes. This has been playing out in households around the developed world as households reduce consumption and focus on retiring debt. Governments need to do the same thing. As we said at the time of the launch of the European Financial Stability Mechhanism in May, the EFSM was not a solution to the problem, but allowed some time to Governments to get there act together and reveal credible plans for medium-term fiscal consolidation. This would inevitably be politcally fraught, as the Irish government is finding out. Other Government's, and not just in Europe, need to similarly bite the bullet before bond markets seek more urgent gratification.

US: still muddling through...

Our view that the US would do little better than "muddle through" over the latter part of 2010 and the early part of 2011 was reinforced with the release of a plethora of partial activity data overnight.

First the good news. Consumer spending rose 0.4% m/m in October, up from an upwardly revised 0.3% in September. Households are starting to spend again with the early signs being that consumption may put in a similar contribution to Q4 GDP as it did to Q3. Incomes were up 0.5% and the savings rate blipped up to 5.7%, showing households are still working hard to repair their balance sheets. This does bode well for future consumption, once balance sheets are back in order. That will take some time.

So we still don't see consumption being a key driver of this US recovery. Jobless claims fell 34,000 to 407,000, but this and other labour market data has us believeing jobs growth will track along the +150k mark over the next few months, which will see the unemployment rate remain stubbornly high at around 9.5%.

The not so good news is that purchases of new homes dropped 8.1% in October, showing the housing market will continue to be a drag on the recovery. In particular, this will see households remain reluctant to open their wallets too much further.

Durable good orders fell 3.3% in the month. That was, however, after an upwardly revised 5.0% in September. This data is very volatile. If you look at the 3m/3m annual rate its consistent with about 3.0% growth, which fits in with all the other data that indicates the US econony is still growing, albeit not at the pace it was earlier in the recovery.

So muddling through remains the order of the day. We agree with the Fed's downward revision to US GDP growth in yesterdays FOMC minutes. As previously discussed, while good work is going on in households to repair their financial positions, we are not as optimistic as the Fed on the contribution consumption will make to GDP growth in 2011. We still look to net exports to be the key contributor to this US recovery, and that's going to take some time.

Monday, November 22, 2010

Standard & Poor's: Right message, odd timing...

After nearly 25 years working in financial markets, I’ve long given up trying to predict the actions and motivations of credit rating agencies. I’m certainly not going to start today. The key point for today is that Standard and Poor’s action of lowering its foreign currency sovereign credit rating outlook for New Zealand from stable to negative highlights the challenges still facing the New Zealand economy.

Not the least of these is that New Zealand is, once again, living with twin deficits. The current account deficit is deteriorating again and the Government is running fiscal (operating balance) deficits. But this is not new news. After improving to around 3% of GDP, the current account deficit will head back towards 6% of GDP over the next year or two. And as we noted at the time of the May Budget, the Government’s projections for economic growth and the forecast track of the operating balance (and therefore cash positions and debt levels) would prove too optimistic.

While the Government did a good job over the last two Budget’s of turning a deteriorating fiscal position around, they could have done more by recognising the structural nature of the problem and dealing with the structural fiscal issues, especially around expenditure (in particular, entitlements). This is essential if we are to return to a position of structural surpluses and prepare the New Zealand economy for the next global crisis (whatever that may be).

On a more positive note, we believe that some domestic economic rebalancing is occurring. Households are changing their behaviour by spending less and getting their balance sheets in order. This is why New Zealand is experiencing a tepid, non-traditional (i.e. one not driven by domestic consumption and residential construction) recovery. It remains to be seen whether this is a temporary of more permanent phenomenon.

The forecasts underpinning today’s decision are a tad odd. Over the last two years we have been happy being at the bottom end of market expectations for economic growth. Over the last 12-months the many forecasters have lowered their forecasts to be more in line with ours. However, S&P’s expectations of 1.6% GDP growth in calendar 2011 seems too pessimistic.

The good news in today’s developments is that it will bring new attention onto New Zealand’s economic challenges, in particular our external imbalances. We believe the New Zealand dollar is significantly overvalued and will, in time fall. Our portfolios remain positioned for that eventuality. Renewed attention from credit rating agencies may be part of that process.

Ireland seeks IMF/EU help

Sanity has prevailed in Dublin as the Ireland government has formally requested assistance from the IMF and the EU. Details at this stage are light, but the expectation appears to be that the package will be perhaps a bit less than 100 billion Euro. This compares with a similar deal for Greece where a 110 billion Euro rescue package was negotiated earlier this year.

The funding will come from a combination of the European Financial Stability Mechanism (EFSM) and the European Financial Stability Facility (EFSF). The IMF will also chip in with a multi-year loan of up to 50% of what Europe provides. Bilateral loans could also form part of the package , with Britain and Sweden aleady indicating they could assist.

This is exactly what the European Financial Stability Facility was established for. As we discussed at the time it was established in May this year, it would not solve debt problems in Europe, but it would provide stability while fiscal austerity and financial restructuring of banks played out where necessary.

Ireland has been battling with large fiscal deficits, largely brought on by the bailout of banking sector, which have already seen 50 billion Euro. The process of putting the economy back onto a sustainable fiscal path will still be a significant challenge, but it can now play out in an orderly fashion.

China "ups the ante" in inflation fight

The Peoples Bank of China has announced a further increase of 50bps in the Reserve Requirments Ratio (RRR). This increase, the second in two weeks, takes the average RRR to 17.5%. This move signals the Bank is taking inflation risks seriously - which is to be applauded. As we have said on many occasions, the most serious risk to emerging market prosperity is any lack of commitment to tackle inflation head-on. Given our positive view on commodities and the fact that commodities make up a greater share of CPI baskets in emerging markets, inflation represents a clear and present danger. We expect further RRR increases in the months ahead and another increase in benchmark interest rates before the end of the year. This will certainly have an impact on growth in China, but that's not necessarily a bad thing. We'd rather see lower, stable growth rather than something stronger but ultimately unsustainable.

Thursday, November 18, 2010

US Inflation

US core inflation hit 0.6% in the year to October 2010, its smallest increase in data stretching back to 1957. That’s the result of its third consecutive monthly “no change” in seasonally adjusted terms. Headline inflation posted a 0.2% s.a. increase, lower than the market expectation of 0.3%. The annual headline rate rose to 1.2% in October, up from 1.1% in September.

A couple of points are worth noting. As we have discussed before, it is not surprising that core US inflation continues to drift lower. The US recovery is in a soft patch: the inventory cycle has run its course and the momentum provided to growth from stimulus measures is on the wane, but final private demand is not yet sufficiently strong to fill the gap. Households are still deleveraging (which bodes well for future growth) and the structural rebalancing (non-tradeable to tradeable) required in the US will take time. The US is the “mature” economy we are most optimistic about achieving the necessary structural rebalancing and avoiding a period of debilitating deflation. The same can’t be said of some European countries.

The other point to note is that that we have, for a long time now, been optimistic about the outlook for commodities. This has been a function of our view of how the post-GFC recovery would unfold i.e. productive sector/emerging market led. This is one of the key areas of divergence in view between ourselves and the likes of the IMF who have a somewhat more sanguine view of the outlook for commodities and future inflation from that source. We are therefore not surprised to see a gap opening up again betwwen headline and core inflation, the difference being food and energy (commodity) prices.

This result today will be a fillip for the QEII supporters. Our view remains that QEII will do little to expedite the necessary rebalancing in the US economy. It’s just going to take time!! In the meantime, disinflation will remain the order of the day.

Tuesday, November 16, 2010

Greece: closing the gap just got harder

Eurostat has revised Greece’s 2009 budget deficit to 15.4% of GDP, up from 13.6% of GDP previously. Public debt was revised up to 126.8% of GDP and is now expected to reach 144% of GDP this year. The revisions were largely due to the inclusion of items that had previously been excluded from the Government’s accounts. The Greek Finance Ministry has revised this year’s deficit to 9.4% of GDP, up from 8.1% forecast in May.

The Government’s pledge to deliver a budget deficit within the EU’s ceiling of 3% of GDP by 2014 just got more difficult. In its May Budget, the Government had committed to a deficit of 7% of GDP for 2011, slightly below the 7.6% agreed as part of the 110 billion Euro EU-led rescue package negotiated in May.

The Finance Minister will submit his final 2011 Budget on November 18, including revised targets. As of yesterday, the Finance Ministry was still committing to the 2014 target.

Meanwhile in Ireland, the Government will in the next month be announcing details of its four year plan to reduce its budget deficit. The Government seems determined at this point to avoid asking for financial assistance. The budget will reveal how realistic that is.

US October Retail Sales

Retail sales were stronger that expected in October, rising a seasonally adjusted 1.2% over the month. The stronger than expected result was driven by a large increase in automotive sales of 5% over the month. This seems a tad strong - indeed there is some suggestion that given the end of the "cash for clunkers" program exactly a year ago, the seasonal adjustment process may be a tad unreliable. Seems like a reasonable assertion to me. Stripping out the automotive component, sales were up 0.4% in the month. That is more on line with our expectation of continued subdued spending from the household sector for some time to come.