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‘Debt, disunity, default, double dip, deflation and depression?’

I have lost count of the number of newspaper articles over recent weeks predicting the imminent break-up of the Euro, a default by at least Greece, maybe Portugal, Ireland and Spain as well, the collapse of the European banking system and as a result, a “double dip” economic recession from which there may be no obvious way out. Often accompanied by barely concealed glee, we are told that the “melt-down” in the Euro (to levels still slightly above where the currency launched in 1999 against the US dollar and still 20% above where it launched against UK sterling (See Fig 1: “The Euro meltdown”?) is the obvious result of embarking on an economic project that was fatally flawed from inception. Moreover, with the absence of unity amongst the Euro-zone’s politicians, electorates and even its central bankers, it is argued that there is little chance of any manageable solution to the crisis. A recent Bloomberg survey showed participants view a Greek default as almost certain and the break-up of the Euro-zone as probable. Debt and disunity will bring default, double dip, deflation and depression. Further debate it seems is unnecessary, but we will try.

Figure 1: The Euro meltdown?

It is often claimed that there is “too much debt” in Europe. It is always difficult to refute that there is “too much” of anything commonly considered to be a vice, just as it is difficult to argue that there is “not enough” of anything normally thought of as virtuous. Nevertheless, unsustainably high leverage would mean that debt interest payments have reached a level where as a proportion of the economy or government revenues they become difficult to service. Current yields on 10 year sovereign debt in the Euro-zone range from 2.56% in Germany to 8.16% in Greece (See Fig 2: Euro-zone 10 year government bond yields YTD). Germany accounts for 25% of all debt outstanding, Greece just 2.6% (Spain 11.7%, Portugal 1.8% and Ireland 1.8%). A weighted average yield on Euro-zone 10 year debt is currently just 3.55%. If all Euro-zone government debt (€7,063bn) were fixed at this weighted average yield over a 10 year duration then annual interest payments (€251bn) as a proportion of Euro-zone GDP (€8,963bn) would be just 2.8%. This is hardly an unsustainably high figure.

Figure 2: Euro-zone 10 year government bond yields YTD

It has been noticeable that many famous money managers and market commentators – often with little explanation for their Damascene conversion – now view the Euro as a toxic asset, having only 12 months previously viewed its main rival the US dollar with similar disdain. It is worth remembering the logic behind those now slightly embarrassing but seemingly easily forgotten consensus price targets for the Euro of $1.65, even though purchasing power parity suggested that fair value was never more than $1.20. Until recently the Euro-zone has been viewed as a comparatively lightly leveraged economy. There are good reasons for this. The fiscal deficit for the Euro-zone at 6% of GDP compares with the US at 10%, Japan at 11% and the UK at 12%. The structural (economic cycle adjusted) fiscal deficit in the Euro-zone of just 3.5%, compares to 10.5% in the UK and 8.5% in the US and Japan. Euro-zone debt outstanding equates to 79% of GDP (compared to similar leverage ratios of 73% in the UK, 83% in the US and 189% in Japan.) Personal savings rates in the Euro-zone have, in contrast to the US and the UK, been double digit for decades (See Fig 3: Euro-zone savings rates vs. US and UK). The Euro-zone has a balanced current account and has no need for countries outside the single currency to fund it. Whereas the Federal Reserve and the Bank of England had to “print money”, buying assets with no balance sheet sterilisation equivalent to 8% and 12% of their GDP respectively, the ECB contented itself with providing liquidity for assets held by the banking system. There are lots of Anglo-Saxon pots here calling the Euro-zone kettle black, albeit pots with overt fiscal and political union.

Figure 3: Euro-zone savings rates vs. US and UK

The current crisis in Euro-zone peripheral debt is in many ways more about Europe’s political structures than its economic solvency. The failure of the original “Maastricht criteria” on fiscal discipline (fiscal deficits no more than 3% of GDP; gross debt no more than 60% GDP) to be enforced and the absence of a fiscal policeman has allowed rogue members of the Euro to take advantage of low communal interest rates and rack up inappropriate debts without being subject until recently to the discipline of capital markets or a supra-national political entity able to enforce fiscal discipline. The problem has therefore been the absence of greater political and fiscal unity, not necessarily the concept of the monetary unity itself. The current situation is unsustainable, but monetary union accompanied by greater fiscal and political union is in fact the only credible way out.

Through the announcement of the bail-out package for Greece as well as the further monies made available for other countries in the European Stabilisation Fund, Europe now has de facto fiscal unity, with the stronger countries underwriting the solvency of weaker countries. The figures announced of €110bn for Greece, and €750bn in additional aid for distressed European sovereigns, of which two thirds is funded by EU governments, one third by the IMF, are significant. For example, the total debt outstanding of the peripheral sovereigns Spain (€560bn), Portugal (€126bn), Ireland (€105bn) and Greece (€273bn) in total is €1050bn (See Fig 4: Euro-zone government debt by country), and is therefore 82% covered by the total €860bn package announced. These potentially distressed sovereigns have funding needs of just €122bn for the next two years. Any new sovereign bonds issued will have access to this funding backstop, contingent on agreement with the EU/IMF on appropriate fiscal reforms. This makes assumptions of imminent sovereign default seem far-fetched. No one is going to run out of money any time soon.

Within Germany there has been widespread resentment at the €148bn (6% GDP) and €22.4bn (1% GDP) its government has committed to the European Stabilisation Fund and the Greek bailout respectively. Various protests have been launched arguing that the EU treaty contains a no bail-out clause that prevents members from providing financial assistance to other EU countries. Although the German constitutional court has thrown out emergency injunctions against both aid measures, it is still examining the underlying cases.

Figure 4: Euro-zone government debt by country

It could theoretically throw a spanner in the works. However, the court has already ruled that financial aid is acceptable if economic circumstances imperil the currency union as a whole rather than a specific country and if the intervention has been presented as one-off rather than a permanent intervention, hence the need for Chancellor Merkel’s “Euro in crisis” rhetoric. The European Stabilisation Fund is therefore unlikely to be sunk by the German constitutional court.

De facto fiscal union without political control however risks increasing tensions between the core and the periphery. Over the coming months we are therefore likely to see an evolution of EU institutions to ensure that the donor countries have greater political controls over the recipient countries and that fiscal discipline is enforced in the peripheral countries. The peripheral countries have no credible option but to accept these terms. Leaving the Euro would overnight devalue all of a country’s assets and leave the value of their liabilities unchanged, hence wholesale bankruptcy of a nation. Despite widespread scepticism amongst investors, there have been clear signs over recent weeks of the commitment of troubled sovereign governments to fiscal discipline and in Spain to labour and banking reform and of acceptance of austerity amongst their populations, with dwindling participation at protests and strikes in Spain and Greece. Soon only those for whom attending demonstrations is a hobby or a career choice will be left. This diminution of civil strife rarely gets reported.

Delivery of reform in the periphery will also be crucial to keeping the electorates of the core onside. The only credible outcome in which the Euro-zone breaks up is if the stronger sovereign credits exasperated by the failure of peripheral governments to deliver fiscal reform left to establish a new currency, an idea given recent publicity in the German press. This would of course entail a complete U-turn on 65 years of post-war German foreign policy, and as things stand would also involve simultaneously leaving the EU with any other countries persuaded by the idea. Relations between European countries would have to deteriorate significantly for such an option to be given consideration by mainstream political opinion. Greater political union to ensure compliance with the rules along with de facto fiscal union would therefore probably be an acceptable outcome to both the core and the periphery.

There is a widespread assumption that Greece and perhaps other peripheral countries will have to default or restructure their debt and that this will cause a second European banking crisis. We highlighted earlier in the year that Greece was technically insolvent. This does not necessarily lead automatically to default. First, it is by no means certain that austerity measures will have a negative effect on economic growth rates. Studies of previous fiscal austerity regimes in Europe in Denmark (1982-1986), Belgium (1984-1998), Greece (1989-2001), Ireland (1986-1996), Finland (1993-2000) and Sweden (1983-1988 and 1993-1998), have in fact shown that in most cases economic growth actually accelerated in the five years following the introduction of fiscal austerity^. Second, in a worst case economic scenario – assuming Greece complies with the EU/IMF plan – the owners of government debt will not be the European banking sector, but other European governments, the IMF and the ECB. It is however difficult to imagine a more benign creditor, perhaps willing to postpone interest payments in the desire to secure the return of original capital. If there is to be a second wave credit crunch, then there would need to be significant additional losses on assets in the banking sector. It is by no means certain that if there are write-downs to the value of government debt that banks will end up bearing the losses.

Although the European Stabilisation Fund is intended to act as a “buyer of last resort” for any troubled sovereigns in the primary market, that role is already being carried out by the ECB in buying peripheral sovereign bonds in the secondary market and in providing unlimited short duration liquidity to the European banking sector. To date the ECB has bought €45bn of peripheral bonds, and is now thought to own 10% of all Greek, Portuguese and Irish bonds outstanding. Sovereign yields have contracted significantly as a result. These purchases so far equate to 0.5% of Euro-zone GDP, suggesting significantly further firepower (€720bn – €1075bn) should the size of the ECB’s interventions eventually match those of their UK or US counterparts. Importantly, the ECB has indicated that it will continue to buy peripheral bonds in the secondary market even after the European Stabilisation Fund is active and provide unlimited three month duration liquidity facilities for the European banking system. These liquidity facilities also encourage European banks to continue to participate in government debt auctions, as any assets bought could in theory be immediately used as collateral with the ECB in return for liquidity. With its narrow mandate for price stability and its desire to maintain its inflation fighting credentials, the ECB will no doubt continue to be deliberately vague about its interventions which may continue to frustrate financial markets. Getting the balance right will be crucial. This is not guaranteed.

Investors are understandably nervous that the volatility in financial markets will begin to impact the real economy with the recent example of the summer of 2008 still fresh in their minds. Leading economic indicators have, however, been surprisingly resilient so far particularly in view of their elevated levels. The recent widening of spreads in the corporate credit market albeit from very low levels if continued and low levels of recent corporate bond issuance if sustained could potentially be a negative transmission mechanism. Unlike in 2008, however, no defaults in the troubled asset class have yet occurred and may not occur, banks are not as leveraged, corporate Europe has already refinanced its debt at attractive rates of borrowing and policy makers are already proactive. In addition economic growth is rebounding from low levels and according to purchasing managers’ indices, inventories in the real economy are still very low and have yet to be rebuilt. The German IFO survey, for example, has suggested that inventory levels are still being drawn down, over a year into the recovery in the overall index. Experiencing a robust recovery in real demand, it would be a brave decision to further cut back on already run down levels of stock through cancelling orders or closing factories.

One of the consequences of the crisis is that policy makers are now much more focused on risks to economic growth. Even in countries such as China needing to exit stimulus, the path of policy is now unclear. In other countries any thought of fighting inflation has given way to fighting deflation. The cost of debt linked to sovereign bonds has diminished. Measures of US housing affordability are at record highs since data series began in 1970. Mortgage rates on new lending are at record lows in the US and UK. Most governments have saved significant amounts from interest payments: benchmark 10 year bund yields contracting 86bps year to date has, for example, saved the German government a theoretical €16bn a year on its €1.8 trillion of debt. The weaker Euro is also a god-send. According to the OECD a 10% fall in the Euro against the dollar adds roughly 1.5% to nominal GDP growth, split equally between economic growth and inflation. It is possible that financial markets are over-estimating the negative impact of the sovereign crisis on the real economy and under-estimating the positive impacts of lower interest rates for longer and a weak Euro stimulus on the real economy.

Figure 5: Euro-zone GDP by country

We know that fiscal austerity measures in isolation will probably have an immediate negative effect on growth, certainly in 2010 and 2011, but Spain, Portugal, Ireland and Greece account for just 16% of Eurozone GDP (See Fig 5: Euro-zone GDP by country). Without default, they are small enough not to impact the path of the growth of the wider European and global economies. They will also be reliant on growth elsewhere to pull them out of their own economic abyss. Economic growth is the biggest variable in ascertaining how solvent the peripheral countries will be over the next few years. Leading indicators currently suggest surprisingly strong growth in parts of core Europe, particularly in export led industries. With manufacturing orders in Germany (25% of Euro-zone GDP) currently running at +40% YoY (See Fig 6: Germany is booming), and the German IFO survey still running at over 100, economic growth in Europe’s largest economy is currently consistent with 3-4% economic growth, well above the 1.5% most economists are forecasting. Although extrapolating current conditions clearly is fraught with danger, we can at least say that if nothing changes estimates of economic growth in the Euro-zone (currently 1.2%) are too low rather than too high.

Figure 6: Germany is booming

So what does this all mean for European equities? Clearly the situation is more binary than usual. A near-term sovereign default and a break-up of the Euro would be a very negative event. It is however, despite it apparently being consensus amongst investors, an improbable event, albeit one which it is logical for investors to hedge against. Record skew in the options market (puts are very expensive versus calls) suggests that they have done just this. It is therefore perhaps not surprising that market valuations seem very attractive with the forward earnings P/E ratio now in single digit and the P/E ratio using historic and 10 year average earnings estimates down to multi-decade lows (See Fig 7: MSCI Europe valuations (P/E)). On the other hand, if the crisis proves manageable then on top of cheap valuations, earnings estimates may be too low rather than too high, particularly given the weaker Euro and potential benefits from lower interest rates if passed through to credit markets. It is worth remembering the previous level of peak earnings for European markets in 2008 was an aggregate level 60% above 2010 estimated levels of profitability and this level was achieved at a currency rate against the US and the Asian dollar bloc of $1.50. Whilst higher tax rates and lower leverage will make it unlikely that European banks rapidly regain their 2008 earnings power even in a benign macro outcome, there are large parts of the European stock market that have been under-earning for a decade owing to a currency headwind. These will be the winners of the new stock market cycle.

Figure 7: MSCI Europe valuations (P/E)

In our view there is a logical plan in place to deal with the crisis in peripheral government debt, albeit one with high execution risk, dependent on the actions of the three main protagonists: the political leadership of the peripheral countries delivering fiscal austerity and political reform; the political leadership of the core countries and in particularly Germany delivering de facto fiscal unity and the ECB delivering unlimited liquidity to the European banking system and if necessary engaging in large scale purchases of sovereign bonds on a scale similar to that seen by the BOE and the Fed. The Euro-zone life-boat floats, we shall see in the weeks ahead whether her crew can sail.

Barry Norris
Partner, Argonaut Capital

^See BCA Research “Is there any way out?” April 29, 2010 and Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects. Alesina and Perotti, NBER Working Paper 5730, 1996

The opinions expressed here represent the views of the fund manager at the time of preparation and should not be interpreted as investment advice.

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