The note below has been prepared in collaboration with our Head of Investment Strategy, Keith Poore. A PDF of this document can be found on the AMP Capital website, www.ampcapital.co.nz
> Europe is in the early stages of moving towards a better balance between fiscal consolidation and structural economic reform.
> Credibility of fiscal commitments and structural change will be important for markets.
> Our base case scenario is that Greece stays in the euro, largely because no one gains from its exit.
> Systemic risks are reduced thanks to continued building of the European firewall and the ECB’s commitment to unlimited banking sector liquidity.
Austerity vs. growth
In the aftermath of the Global Financial Crisis, large fiscal adjustments were required across many of the world’s major economies. In the early stages of that process, there was an opportunity for those adjustments to occur over the long term. That would have required governments to articulate credible long term plans around such issues as pension entitlements and the rising cost of healthcare at the same time as they tackled structural economic reform.
That proved too difficult for many politicians. Such an approach would, however, have allowed a more appropriate balance between fiscal consolidation and economic growth. Stronger economic growth remains the best solution to addressing high debt levels.
Failure to take a long term approach led to markets making their own assessments of individual country’s fiscal sustainability and some were found wanting. As a result of increased market concern, some governments in Europe have been forced to front load increasingly harsh fiscal austerity measures that have had considerable economic costs. The balance between fiscal consolidation and supporting economic growth has effectively been lost. Deep recessions and sharply higher unemployment rates are now seeing a popular backlash.
Striking a better balance
The new French president Francoise Hollande was elected with a mandate to seek a better balance between fiscal consolidation and economic growth. Inconclusive elections in Greece have raised the spectre of a reneging of the commitments made under the terms of two bailout agreements and the possibility of a messy exit from the euro.
Fiscal sustainability ultimately requires stronger economic growth. In many parts of Europe, higher economic growth requires structural reform. Front loaded austerity and deep recession have reduced the capacity for effective structural reform to be put in place that addresses loss of competitiveness, rigid labour markets and access to trade. In the absence of exchange rate adjustment, wages (or more precisely, unit labour costs) must fall.
For those structural reforms to be made, it will require the foot to be taken of the pedal of austerity. That means credibility and strength of commitment will be important. The institutional framework to be provided by the fiscal compact should help with that credibility. That would allow a more gradual fiscal adjustment to take place and allow a growth compact, heavy on structural reform, to be developed and implemented alongside.
Focus on Greece
Greece has made significant progress on deficit reduction. IMF data shows the Greek structural budget deficit peaked at 17% of GDP in 2009. That was reduced to a deficit of 6.8% in 2011 and is estimated to reduce further to 4.7% this year. Greece is committed to further reductions that the European Commission estimates requires further cuts of 3.8% of GDP.
However, the costs have been high. At the end of 2011, the Greek economy was 13% smaller than it was pre-GFC. It is estimated, again by the IMF, to contract a further 4.7% this year. The unemployment rate has risen from 7.2% in 2008 to 21% currently.
Without its own exchange rate to allow a competitiveness adjustment, wages are bearing the brunt of the adjustment. Unit labour costs have fallen around 5% over the last two years and are projected by the European Commission to fall a further 8% this year. That’s a significant adjustment that will assist the tradeable sector, but the impact versus Greece’s European neighbours is ameliorated by the fact that unit labour costs are falling across the continent.
The problem with Greece exiting right now is not so much the direct cost, but the indirect contagion through the assumption that if Greece exits, Portugal, Ireland and Spain would be likely to follow. That could lead to runs on banks in those countries.
The adjustment process for Greece should it leave the euro would be more harsh. A significant reduction in the exchange rate (presumably the Drachma) would be a boost to the external sector, but would come with massive inflation and a significant further reduction in purchasing power and living standards. And it would come with a significant boost to debt, as Greece’s debt is denominated in the euro, making default inevitable.
Under the terms of the second Memorandum of Understanding between Greece and the troika of the European Union, the International Monetary Fund and the European Central Bank (ECB), the plan was for Greece’s debt to GDP ratio to reduce to 120.5% of GDP by the end of the current decade. We continue to think that’s a stretch.
It seems to us that any renegotiation of deficit/debt targets as a pragmatic solution to the way forward would have to include a further write-off of Greek debt obligations. With private sector debt only 25% of outstanding debt following the initial private sector write down, any further write down must involve the public sector, including the ECB. In that case some recapitalisation of the ECB would be inevitable.
Elsewhere in Europe
Spain is the primary concern. The new government recently renegotiated the 2012 Budget deficit target to 5.3% of GDP from 4.5%. In its most recent forecasts the European Commission believe Spain will miss that revised target and have a higher deficit in 2013 than the projected 3%. That’s largely due to the depth of the recession with GDP growth of -1.8% this year and -0.3% in 2013. Furthermore, the banking sector remains vulnerable to further house price falls. In that respect an extension to the deficit reduction target should be allowed, rather than forcing more extreme budget cuts.
In Portugal the government is putting in place deficit reduction measures of around 5% of GDP, mostly through expenditure reduction. The European Commission estimates the structural budget deficit will reduce from -6.2% of GDP in 2011 to -3.0% this year. On the back of that adjustment the recession will deepen with GDP forecast to contract 3.3% in 2012 and the unemployment rate will rise to over 15%. Portugal would also clearly benefit from an extended period of time to meet its deficit targets.
Italy is less of a concern right now. Sound progress is being made on its deficit reduction targets: the structural budget balance will reduce from -3.6% of GDP in 2011 to -0.7% this year. GDP is expected to contract 1.4% this year.
March quarter Europe GDP came in at a better than expected zero for the quarter, thanks largely to a better than expected result in Germany. That followed a contraction of 0.3% in the December quarter. Despite the better than expected March quarter result, we are leaving our Europe calendar GDP forecast at -0.5%, with risks skewed to the downside.
The firewall and the ECB
Despite the recent renewed turmoil in markets, systemic risk indicators remain at lower levels than that seen late last year.
Work has continued on building the European firewall, with around €700 billion available through the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM). The International Monetary Fund has also been building its resources with recent commitments from all around the world totalling €430 billion.
The ECB has stepped up as ‘lender of last resort’ to banks with two tranches of Long Term Refinancing Operations providing €1 trillion of cheap liquidity. We would expect the ECB to continue its commitment to providing unlimited liquidity to the banking sector.
However, to ease current nervousness the ECB may need to become the lender of last resort to sovereigns too. That could be through a resumption of direct sovereign debt purchases through its Securities Market Program or the granting of a banking license to the ESM which would then have unlimited capacity to purchase sovereign debt. A euro wide retail deposit guarantee scheme might also be necessary to limit deposit flight. Our own index of Europe-wide finance system risk has risen in the last few weeks but it remains below levels reached in 2008 and late 2011. The main reason being interbank and dollar funding pressures are less acute thanks to ECB lending facilities.
* Derived from average of Italian and Spanish 10-year spreads to German bunds, 3-month change in the Euro Stoxx bank index , 3-month Euribor-Eonia spread and 3-month USD/EUR currency basis swap; Source: AMP Capital.
At this stage, our diversified portfolios remain overweight growth assets but the presence of systemic risk means the overweight is lower than a strict valuation-based approach would suggest. Taking a medium term view, with global and domestic bond yields at historic lows, equities look very attractive relative to bonds. Picking each market wave is extremely difficult, but given the recent decline in equity markets and the authorities’ commitment to do all that is necessary to support the euro zone, we think a bounce is more likely than a further decline. What we can be sure of is the tide looks a long way out on bonds.
Meanwhile, with the New Zealand (NZD) dollar falling recently the portfolios’ overweight to foreign currency is limiting some of the equity market losses. At 76 cents, the NZD/USD remains above our medium term fair value estimate and any escalation of euro zone risks would likely see it fall further.