Wednesday, November 30, 2011

What's next in Europe?

Each time the debt situation has moved on in Europe the catalyst has been a sense of crisis. Here we are again. The only difference has been that each crisis has been more extreme than the one before.

At this point, while credit markets in Europe aren’t frozen, they are looking increasingly frosty. Sovereign bond yields have risen to unsustainable levels. There can be no room for doubt about the seriousness of the situation following the failure of a German bond tender last week. We are now at the tipping point.

Fortunately there is another European summit scheduled for December 9th. So there is still another opportunity to put in place the more enduring solution we thought we were getting in October. The good news is there is a solution in reach, it just needs taking.

We are not looking for anything we haven’t looked for before. We still want to see credible, implementable plans for fiscal consolidation in Europe; a firewall around Greece; a backstop for bond issuance in wider Europe and a plan for bank recapitalisation. We also want to have some understanding of the long-term plan for fiscal co-ordination in Europe and structural economic reform to boost medium-term growth prospects.

The most recent plethora of speculation has centred on the establishment of a framework for fiscal co-ordination in Europe, enshrined in Treaty. That’s good news, but it’s where the solution should have started two years ago. At that point such a move would have been sufficient to stem contagion. It seems unlikely that this alone will now be enough to save the Euro, especially given the time it will take to put in place, but it is an essential part of the long-term solution. In our view Euro bonds will be an inevitable part of that solution. It is unfortunate that the German Chancellor has backed herself into a corner on this issue.

The good news is that a firmer commitment to fiscal co-ordination could be enough to encourage the ECB to take another important step in the solution: larger scale bond purchases in Europe - most likely in conjunction with the EFSF and IMF. For all its reluctance to act as lender of last resort in Europe the ECB has purchased around €200b in sovereign debt since August. This has been as crisis points have been reached. Perhaps movement on fiscal co-ordination will get the ECB (most likely in conjunction with the EFSF and probably the IMF) over the line in terms of larger scale bond purchases.

It seems to us the ECB will inevitably buy more bonds. In the worst case scenario the ECB steps up its intervention, not as lender of last resort, but as defender of price stability and avoidance of a deeper European recession and deflation.

On the fiscal consolidation point, the move to technocrat governments in Italy and Greece is a positive development. The conventional wisdom is that Monti in Italy and Papademos in Greece will find it difficult to implement what is required in Italy and Greece. Of course it will be difficult but we think they have a better chance of implementing the necessary reforms than would have been the case for Berlusconi and Papandreou. We think it will be easier for technocrat leaders to implement what is required than it would be for the politicians the electorate blames for the crisis.

There is little doubt the situation in Europe is serious and has become more serious as time has moved on. The risk of a deep protracted recession in Europe, with flow-on implications for the global economy, is real. Most of the measures required will take time to implement and for the benefits to flow. The important factor now is that markets have confidence in the politicians commitment and ability to implement whatever it is they come up with on December 9th.

Tuesday, November 15, 2011

Mario Monti's Challenge

The likely new Italian Prime Minister Mario Monti has some serious challenges to meet. The fiscal challenges are well known. The bigger challenge will be to turn around long-term economic under-performance in one of the world’s largest economies.

Unlike Greece, which has a solvency problem, Italy’s fiscal crisis is one of liquidity. That being said, if a liquidity crisis is not dealt with effectively, it can become a solvency crisis.

Italy’s budget deficit this year is estimated to be around 4% of GDP. After accounting for interest payments, that’s a primary surplus of around 0.5% of GDP. Some commentators have argued recently that the primary surplus means Italy’s deficit is not as bad as it looks. Sorry, but a deficit is a deficit.

Italy has public debt of around 120% of GDP. The duration of that debt is quite long (7 years) by comparison with other countries, but there is approximately €350 billion in bonds that will have to be refinanced in 2012.

At issue is the level of interest rates Italy has to pay to finance that debt. Ten-year bonds at 6.5% (and higher again last week) make Italy’s debt dynamics unsustainable. Achievement of a balanced budget (or primary budget surplus), or at least a credible plan to get there, is essential to bring interest rates down. Measures passed last week before the resignation of Prime Minister Berlusconi look likely to achieve that goal, but not before 2014.

The bigger problem, which in our view must be sorted with the same level of urgency, is Italy’s poor economic growth performance. As we’ve commented before, the long-term answer to reducing Europe’s debt burden is stronger economic growth. That’s why we have always argued there needs to be an appropriate balance between achieving fiscal sustainability and supporting economic growth.

Italy’s economic track record is woeful. Trend GDP growth is probably no better than 1% per annum. The challenge is best exemplified by its recent performance on productivity. According to OECD data, Italy is the productivity laggard of Europe with a performance well behind that of Germany, the United States, and Europe as a whole. In fact productivity in Italy has gone no-where in a decade.


Therein lies Mario Monti’s biggest challenge - instituting structural reform that grapples with an inflexible labour market and a stifling bureaucracy. These are just as critical to Italy’s long-term health as dealing with the more immediate challenge of achieving fiscal sustainability. The other challenge is that by their very nature, structural changes take time to have an impact, and the near-term impact can be negative for both employment and economic growth.

Friday, November 11, 2011

US fiscal "super committee"

While attention is firmly focussed on the ongoing debt crisis machinations in Europe, there is another critical fiscal deadline looming, this time in America.

On November 23rd the US fiscal “super committee” is scheduled to forward its recommendations to the US House of Representatives and Senate on how to cut $1.2 trillion from the US budget deficit over the next 10 years. This committee was established out of the Budget Control Act, the same legislation that raised the debt ceiling in August.

There doesn’t appear to be much progress being made. With six of the twelve committee members Democrat and the other six Republican the debate has, not surprisingly, been somewhat partisan. The Republicans are reluctant to raise taxes and the Democrats are protective of domestic social programs. To be fair, the Democrats have moved further on spending than the Republicans have on taxes.

Failure of the committee to reach agreement would be negative for market sentiment. $1.2 trillion is a mere drop in the bucket in terms of what needs to be achieved over the next few years in budget consolidation, but failure now would not bode well for the bigger job ahead.

However, should the committee not reach agreement, automatic spending cuts or “sequestration” of $1.2 trillion would kick in from January 2013. While that’s not the best outcome, it would be better than no deficit reduction at all. Should it get to that point, half of the spending cuts will come from defence while the other half will be spread across other domestic programs.

So failure of the committee to reach agreement would still result in budget cuts of the same magnitude they are currently looking to agree on. This would soothe market (and rating agency) concerns to some extent, but the politicians would be doing nothing to help their public image that was severely tarnished during the debt ceiling debate. Perhaps given the backlash in August there is some hope they will still reach an agreement?

Thursday, November 10, 2011

Italy and the ECB

Two weeks into the job and what will most likely prove to the defining moment of the tenure of new ECB President Mario Draghi is already upon him.

The ECB has been receiving a bit of flak lately – for not being sufficiently decisive or bold in its actions. It was under some duress that the Bank moved to purchase Italian and Spanish bonds in August.

We’ve been prepared to cut them a bit of slack. On one level, the Bank has been reluctant to solve the problems of political intransigence. The European debt crisis is essentially of a political making, and it has taken a sense of crisis from time-to-time to keep moving the politicians forward.

On another level the Bank has been reluctant to move into what it deems to be the realm of fiscal policy. There also appears to be a number of folk at the ECB who were students of post- World War I German hyperinflation that was the genesis of the anti-inflationary zeal of the Bundesbank. Hence the reluctance to expand the monetary base (the earlier purchases of Italian and Spanish bonds were sterilised).

However, with Italian bond yields surging higher it’s time for the ECB to step up and act decisively by significantly expanding its purchases of Italian sovereign bonds. Only the ECB has the ability to take this step. The expanded EFSF will not be ready in time – we still don’t know how it is going to be scaled-up let alone then going through the process of getting broad political agreement. The various Euro zone parliaments have only just finished ratifying the July 21 proposal for the EFSF to lend up to its full face-value of €440 billion, which will prove to be woefully inadequate for the job ahead.

The ECB will be concerned that given the scale of the job needed, they will have no option other than to monetize their bond purchases. They will fret about the likely inflationary consequences, but no one will doubt their zeal in dealing with that problem when the time comes.

Friday, November 4, 2011

Deconstructing the "wall of worry"

“Wall of worry” has become the euphemism for all the things financial markets have been fretting about recently. The wall has many components, let’s call them “bricks”, including recession concerns in Europe and America, and whether China looks set for a hard or soft landing. To continue the wall analogy: while the mortar around some of these bricks is loosening, the foundation stone of the European debt crisis remains firmly in place.

In America the economy is not in recession, but remains in a fragile, debt-constrained recovery. Third quarter GDP growth of 2.5% was bang on market expectations, higher than we were expecting, but unlikely to be repeated soon. In particular consumption was the surprise upside factor in this result, but we don’t expect that strength to continue given it was largely funded out of a decline in the savings rate. The good news was the strength in the parts of the economy we have looked to drive the recovery: exports and business investment.


Looking ahead we expect growth to be lower in the fourth quarter at an annual rate of around 1.5%. The October ISM manufacturing index declined although the make-up was positive, especially the rise in the new orders index. The medium-term outlook will continue to be constrained by the weak housing market, still slow improvement in the labour market (jobs and wages), household deleveraging and fiscal consolidation.

Indeed the politics of fiscal policy will remain front-and-centre in America. The passage of President Obama’s stimulus plan looks uncertain and the development of a medium-term fiscal consolidation plan will be politically fraught, let alone the implementation of a plan that must deal with the unsustainability of some key US social programs.

China still appears to be heading for a soft landing. Property prices and activity have been slowing this year, driven by aggressive tightening measures by the authorities. There is some concern this slowing could turn to a collapse, but we don’t see this as likely. The China October PMI manufacturing index came in just over the 50 benchmark. This was weaker than expected, but in areas that were unsurprising (exports). GDP growth has slowed to 9.1% in the third quarter and we believe growth will come in around 9% for the full year. We’ve got 8.5% pencilled in for next year as the impact of the recent tightening in monetary policy continues to flow through the real economy.

The good news is that China has room to move on both monetary and fiscal policy. Inflation is at 6.1% for the year and appears to have passed its peak. We expect China to start loosening monetary settings in the first half of next year, but that could be brought forward if growth looks to be weaker. Authorities have proven agile on switching policy settings when required.

Europe is most likely already in recession. While we expect third quarter GDP to come in mildly positive, partial indicators are pointing to a mild contraction in the fourth quarter. We expect this weakness to be largely centred in the industrial sector. Business confidence and economic activity are being impacted by the uncertainty created by the debt crisis. Low confidence means hiring and investment gets delayed. Today’s cut in interest rates, and a likely further reduction in December, is a positive development, but uncertainty is likely to continue until the debt fear subsides.

Which brings me to the big one – the foundation stone of the wall. We were moderately happy with last week’s Europe debt plan. While it lacked detail, we were pleased that what we believed are essential elements of a sustainable plan were finally part of the conversation: a bigger haircut for Greek bond-holders, bank recapitalisation and a scaling up of the European Financial Stability Fund (EFSF). Seems to us policymakers are now having the right conversation.

But as we said last week, we still need to be wary of the politics. This week’s referendum distraction is an early reminder of that. The fact is there still needs to be a high degree of political will for effective implementation of the program. Italian bond markets were already pricing in a “lack of detail” premium, even before Papandreou announced his intentions for a referendum. At the end of the week markets are breathing a sigh of relief as the referendum appears to be off. But this is unlikely to be the final political twist we will have to endure.