Market Review 18 May 2010

Last week investment attention remained firmly fixed on the problems in Europe.  Chancellor Merkel suffered a significant defeat last weekend, which highlighted the lack of support from German voters for a Greek bail out.  There were various dissenting voices behind what has hitherto been determined official support for the euro.  One German law maker suggested that Trichet should step down because the ECB had bought Greek debt. 

President Sarkozy threatened at one point to pull out of the euro zone.  Deutsche Bank suggests that Greece might not be able to repay its debts and Paul Volker, in London, suggested that the euro zone might disintegrate.  There were riots in Greece and Ireland and strikes are now scheduled in Spain.  The unemployment rate in Greece in May will probably be around 13% and over 20% in Spain – and that is before the proposed fiscal drag is applied.  Both Spain and Portugal announced cuts in public expenditure.

The €750 billion EU/IMF rescue package a week ago was intended as a once-and-for-all method to solve the EU crisis. It was designed to prevent bond market defaults within the EU and dampen the massive interest rate risk spreads that had opened up for Mediterranean government bonds over recent months.  The problem, of course, is that the rescue package, although necessary in the short term, does not address the bigger, long term structural problems. 

Over the course of the last week, markets focussed on these longer-term structural problems.  The truth is that there has been massive divergence between EU budget deficits, unit labour costs, current account deficits, etc. The EU took only a first small step towards addressing those deeper fundamental problems last week when Spain and Portugal proposed 5% pay cuts for public sector workers.

The establishment of the euro zone in 1999 presupposed that the various countries linked together in monetary union would experience roughly similar fundamental trends.  However, that has not been the case.  In the last 11 years, fundamentals among EU member nations have diverged significantly, creating the pressures now apparent among the laggard deficit countries of Greece, Portugal and Spain.

The divergence can be seen between Germany at one end of the EU spectrum with its stronger unit labour cost trends, resulting in large current account surpluses, much of which is from rest of the EU.  While at the other end of the spectrum, the Mediterranean economies have had weaker unit labour cost trends and much larger budget and current account deficits than Germany. 

With 11 years of divergence, Mediterranean governments have backed themselves into unfinanceable deficits and are now forced into belated action.  Benefits and wages may have to be cut as much as 30% over the next few years.  The bailout out packages can only prevent default in the near term but in the longer run these countries require smaller budget and current account deficits.  They need to become more like Germany.

Private capital is now unwilling to fund those on-going Mediterranean budget deficits, and those economies, therefore, are faced with the necessity of bringing wages and benefits down swiftly in nominal terms, since they are unable in practice to raise their productivity sufficiently quickly to close the gap with Germany.  Perversely, of course, German industrialists have been the great beneficiaries of the euro.  Their southern European competition has become increasingly unable to compete with them, because they have not been able to benefit from regular, if disguised, devaluations against the Deutschemark.  Germany has been running an increasingly large trade surplus with the rest of Europe.

Much of Europe now risks having to go through a second recession to right the imbalances.  It is difficult to avoid the conclusion that the rest of Europe either has to compete with Germany within the euro or still go through similar austerity measures even if they leave the euro – truly an unattractive choice.  Northern European members of the Euro zone, of course, have concomitant obligation to pick up an enormous bill to maintain the euro and, meanwhile, allow the ‘quality’ of the ECB’s balance sheet to deteriorate.  In recent months, that fact has caused the euro exchange rate to trade more like a Greek euro than a German one.  A European recession would be a major negative for the world economy and trade cycle.

If this were all, the situation indeed would be gloomy.  The correct response, of course, is to stimulate growth not foster depression.  The ECB will remain under pressure to ease monetary policy both by cutting rates and increasing the size of its balance sheet – quantitative easing.  Germany should grow faster.  Indeed, it should be noted that the Euro zone economy has been recovering, interest rates in Europe are close to zero and are likely to remain so.  The euro has declined almost -20% in the last quarter and global growth is strong.

The world is growing elsewhere.  The US continues to grow as is much of the rest of the emerging world.  Indian imports in the year to date are up at an annualised rate of 79%.  French industrial production is up by 7.8% and ISI’s Truckers survey of commercial traffic in the US has risen a remarkable 39.9% from its recession low.  There are steady and incipient signs that US employment is in an up trend.  ISI’s Permanent Employment Companies survey increased again last week by 0.8% to 42.9%.  This is versus its recession low of 16.1%.  And the ISI Temporary Employment Companies survey remained at a strong 61.6%.

We have assumed that the tighter fiscal policy is, the looser monetary policy needs to be.  A policy mix of “tight fiscal and loose monetary” is generally positive for asset prices.  On a net basis, we have had nothing in Continental European equities for some weeks.  For US dollar based accounts, we have wholly hedged any non US dollar positions back into the US dollar. 

For sterling based and euro based accounts, we have increased our exposure to the US dollar.  We have raised our cash levels but we have not yet abandoned the view that a primary trend in equities is in tact.  However, we have to acknowledge the risk of political disruption and administrative incompetence.  Nowhere are these two possibilities more on show than in Europe.

Europe will have to resolve its problems.  Ultimately, we expect a fiscal union and possibly a two tier Euro zone.  Europe has never addressed the lack of a fiscal union effectively.  Without fiscal union, the core EMU countries are effectively giving a credit card to the weaker countries that lack discipline and are too eager for growth at any cost. 

Ultimately some countries will have to take a leave from monetary union.  Without the option of devaluing their “own” currency, there is no other option than outright default.  Therefore, an option that allows devaluation, combined possibly with austerity policies, may be a more realistic option.  From the perspective of bond holders, this is just default in disguise.  You lend people euros and get back something less.

The likely outcome is that the euro will survive but the fixing process will take time, which will also mean that relative to the US dollar and other regions of the world, Europe will be weak, which is what the market is reflecting.