Friday, April 13, 2012

Spain and US Jobs

Two bits of not-so-good news this week: the worse than expected US March month jobs report and a re-emergence of European sovereign debt angst. The latter is the more critical of the two.

March US payrolls data was worse than expected, but it comes after three months of generally better data. We don’t read too much into monthly data which can tend to be volatile from month-to-month. This result hasn’t changed our view of modest debt constrained growth in the US this year and a continued gradual decline in the unemployment rate.

However, it does reinforce our caution in not jumping to revise up our growth forecasts for this year on the back of recently better data. Rather, we are taking the view that the generally stronger data is providing a better balance of risks around our expectation of 2% GDP growth this year.

The other consideration for markets is the likelihood, or not, of further monetary accommodation from the Federal Reserve in the form of a third round of quantitative easing. The best way to describe the situation right now is that QE3 remains less likely than it was at the start of the year, but more likely than it was last week. The probability of the Fed going down that path will continue to wax and wane with the data, but we continue to hold the line that more QE is not the answer to more fundamental economic growth issues in the US.

In Europe, yields on Spanish (promise to not use analogies with “rain”, “drain” or “pain”) and Italian debt have moved higher over the last few days. While we didn’t think for a second that the recent period of relative calm would last forever, we had hoped for a few more months of respite before European sovereign debt angst re-emerged.

The catalyst has been Spain’s recent revision of its budget deficit target for 2012. This was originally set at -4.4%. The Government wanted to revise that down to -5.8% of GDP, but negotiations with “the troika” saw a compromise at -5.3% of GDP. The deficit target for 2013 remains at 3.0% of GDP.

Forecasts for Spain GDP growth in 2012 are now -1.7%. The concern from markets is that if the deficit target starts to slip again, there will be deeper cuts to spending, a deeper recession and a downward spiral that completely loses the necessary balance between fiscal consolidation and building stronger economic growth. We are not great believers in the concept of expansionary austerity.

Spain needs a credible long-term deficit reduction plan and structural reforms to address poor growth dynamics, especially with regard to the labour market and productivity. Spain’s unemployment rate is 23% and youth unemployment is 50%. The IMF estimates Spain’s output gap is 3%. That suggests the current unemployment rate isn’t significantly higher than the structural rate of unemployment. That suggests some urgency for structural reform.

What Spain needs most is the political will to institute credible reform and time for those reforms to take effect. The same is true of Italy. Both countries are suffering from a liquidity problem, rather than a solvency problem. But a liquidity problem can become a solvency problem if left unchecked.

The good news is that compared with 2011, systemic risks in Europe are lower than they were. The LTRO (tranches 1 and 2) means that the banking sector is better funded. At the same time, the firewall continues to be built but still isn’t sufficient to cover the possible needs of both Spain AND Italy. The ECB can also reinstitute the SMP if needed.

Also the global economy is in better shape than it was at this time last year. US data is, on balance, stronger than it has been. And while China is slowing, we think it is close, if not at, the bottom of the current cycle. Recent March month loans and money supply data support that story.