The short-term direction of the market hinges on two things: 1) whether the U.S. is heading in to a recession; and 2) whether Europe can get its act together.
1) ECRI believes recession is a certainty. I'm not ready to put the nail in the coffin just yet, though. Overall numbers are down, but not bad, and yesterday's Chicago PMI surprised to the upside. Next week has alot of data coming out, notably the ISM and NFP figures (plus EU and Chinese PMI); I'm going to hold off on passing judgement.
2) Strangely, I'm now cautiously optimistic about the Europeans' ability to solve their debt crisis. Why? Is it because everyone else is so damn sure its all going to fall apart? I hope its not because I'm that contrarian...To me, a breakup of the Euro is not possible; maybe an exit by Greece, but even that seems unlikely. There is too much driving the member states together: in culture, in shared interests, in the belief that the whole is greater than the sum of its parts (i.e., ability to compete internationally, economies of scale. etc). And history: most of the member-states spent the last several hundred of years killing each other to gain control of Europe; they now realize that peaceful cohesion is cheaper than war.
The problem is one of solvency, which has now given way to a problem of liquidity. Until this year, most of the efforts were aimed at solving the liquidity problem. I believe this is changing, and the change will be enough to get them out of this mess.
Efforts addressing solvency
- While its yet to be seen whether constitutional amendments prescribing deficit limitations will push governments to use creative accounting / push items off their balance sheets, they do provide a way to balance the budget...but oversight is needed to make sure what the government says is accurate, which I'm pretty sure the markets will do. Germany doesn't have a constitutional amendment, but has enacted a law that requires the budget deficit to be < .35% of GDP by 2016 for the national government, and 2020 for the states. Spain just approved a constitutional amendment to have near-zero deficits by 2020. Italy proposed one at the same time as Spain, but it appears it is being pursued with less vigour. France seems to think that it doesn't need one.
- Germany has reduced its deficit to about 3% of GDP (Slide 63) and estimates are that it will be about the same next year. I don't think Germany will have a problem with fiscal prudence.
- France has proposed new taxes and spending cuts that aim to reduce its deficit from 5.7% of GDP in 2011 to 4.5% in 2012, shooting for 3% by 2013. These are based on growth rates of 1.75%, though, and are likely to be missed. Further, the Socialist party won the senate and may be able to delay or derail the proposed measures. France's Debt/GDP is about 85%, and their deficit/GDP in 2010 was 7%. I'd like to see more of a sense of urgency in France; S&P doesn't bluff.
- Spain has made great efforts towards balancing their budget, and they have alot more manoeuvring room than other Euro countries do. Their debt/GDP is only about 70% in 2011 (Slide 58). The deficit/GDP was over 9% in 2010 and expected to be about 6% in 2011; 4% in 2012 if trends continue (Slide 63).
- Italy passed €54 billion worth of cuts and taxes in August. Tax and spending reforms are loudly called for by both Italian business and now the Germans.
- Greece will be allowed to default when the new EFSF is up and running, and maybe only after at-risk banks are preemptively recapitalized.
- Finally, the new ESM will require changes to the Treaty of Lisbon, et. al., but once enacted, will have automatic monetary sanctions for countries that don't meet the deficit targets. It will be run by the EC, not the member-states. The European Parliament voted on 9/27/11 to enact the new sanctions rules and a budget-surveillance system.
Efforts addressing liquidity
- Europe has at its disposal: A) the new EFSF has a total capacity of €440 billion (once passed by Malta, Netherlands, and Slovakia - by 10/17/11), which can now buy the debt of countries in the secondary markets as well as recapitalize banks (through loans to the member-state) - all pre-emptively if need be (but is that a good idea?); B) the EFSM, with a capacity of €60 billion; and C) the IMF commitment, amounting to €250 billion. This totals €750 billion. Conservative estimates of Euro-banks' capital shortfall look to be around €250 billion. That's if Spain and Italy don't get caught by rising bond yields.
- Levering the EFSF through the ECB? Doesn't look like that one's going to work. Not only has S&P suggested it could result in a downgrade of France, but German CDS has been rising since the idea came up. Further, its not likely Germany would go along with this, either in the Bundestag or the constitutional court. However, there is discussion of a way to lever through an insurance company arrangement, but I don't know the details and am not sure exactly how that would work.
- Work towards the ESM continues, and there is talk of moving up its implementation, but I'm not too optimistic that Europe's leaders can do something both correctly and quickly.
- SMP program - bond purchases by ECB of member states (Slide 34) - unsterilized. Yes, with a Z. There is talk this is going to end soon, as dissatisfaction of monetization has resulted in German defections from the ECB.
- Federal Reserve, in conjunction with the ECB, BOJ, BOE, SNB, and Bank of Canada, extended the existing U.S. dollar liquidity swap arrangements through August 1, 2012.
- ECB - 3 and 6 month Long-term Refi Operations (LTRO's) being offered and extended as needed.
Counter-argument
- There is one thing my positive outlook doesn't take in to account: a possible renewed Eurozone recession. Deficit projections are all based on improving economic growth. PMI figures on Sunday night (Monday) will shed some light on the path...
1) ECRI believes recession is a certainty. I'm not ready to put the nail in the coffin just yet, though. Overall numbers are down, but not bad, and yesterday's Chicago PMI surprised to the upside. Next week has alot of data coming out, notably the ISM and NFP figures (plus EU and Chinese PMI); I'm going to hold off on passing judgement.
2) Strangely, I'm now cautiously optimistic about the Europeans' ability to solve their debt crisis. Why? Is it because everyone else is so damn sure its all going to fall apart? I hope its not because I'm that contrarian...To me, a breakup of the Euro is not possible; maybe an exit by Greece, but even that seems unlikely. There is too much driving the member states together: in culture, in shared interests, in the belief that the whole is greater than the sum of its parts (i.e., ability to compete internationally, economies of scale. etc). And history: most of the member-states spent the last several hundred of years killing each other to gain control of Europe; they now realize that peaceful cohesion is cheaper than war.
The problem is one of solvency, which has now given way to a problem of liquidity. Until this year, most of the efforts were aimed at solving the liquidity problem. I believe this is changing, and the change will be enough to get them out of this mess.
Efforts addressing solvency
- While its yet to be seen whether constitutional amendments prescribing deficit limitations will push governments to use creative accounting / push items off their balance sheets, they do provide a way to balance the budget...but oversight is needed to make sure what the government says is accurate, which I'm pretty sure the markets will do. Germany doesn't have a constitutional amendment, but has enacted a law that requires the budget deficit to be < .35% of GDP by 2016 for the national government, and 2020 for the states. Spain just approved a constitutional amendment to have near-zero deficits by 2020. Italy proposed one at the same time as Spain, but it appears it is being pursued with less vigour. France seems to think that it doesn't need one.
- Germany has reduced its deficit to about 3% of GDP (Slide 63) and estimates are that it will be about the same next year. I don't think Germany will have a problem with fiscal prudence.
- France has proposed new taxes and spending cuts that aim to reduce its deficit from 5.7% of GDP in 2011 to 4.5% in 2012, shooting for 3% by 2013. These are based on growth rates of 1.75%, though, and are likely to be missed. Further, the Socialist party won the senate and may be able to delay or derail the proposed measures. France's Debt/GDP is about 85%, and their deficit/GDP in 2010 was 7%. I'd like to see more of a sense of urgency in France; S&P doesn't bluff.
- Spain has made great efforts towards balancing their budget, and they have alot more manoeuvring room than other Euro countries do. Their debt/GDP is only about 70% in 2011 (Slide 58). The deficit/GDP was over 9% in 2010 and expected to be about 6% in 2011; 4% in 2012 if trends continue (Slide 63).
- Italy passed €54 billion worth of cuts and taxes in August. Tax and spending reforms are loudly called for by both Italian business and now the Germans.
- Greece will be allowed to default when the new EFSF is up and running, and maybe only after at-risk banks are preemptively recapitalized.
- Finally, the new ESM will require changes to the Treaty of Lisbon, et. al., but once enacted, will have automatic monetary sanctions for countries that don't meet the deficit targets. It will be run by the EC, not the member-states. The European Parliament voted on 9/27/11 to enact the new sanctions rules and a budget-surveillance system.
Efforts addressing liquidity
- Europe has at its disposal: A) the new EFSF has a total capacity of €440 billion (once passed by Malta, Netherlands, and Slovakia - by 10/17/11), which can now buy the debt of countries in the secondary markets as well as recapitalize banks (through loans to the member-state) - all pre-emptively if need be (but is that a good idea?); B) the EFSM, with a capacity of €60 billion; and C) the IMF commitment, amounting to €250 billion. This totals €750 billion. Conservative estimates of Euro-banks' capital shortfall look to be around €250 billion. That's if Spain and Italy don't get caught by rising bond yields.
- Levering the EFSF through the ECB? Doesn't look like that one's going to work. Not only has S&P suggested it could result in a downgrade of France, but German CDS has been rising since the idea came up. Further, its not likely Germany would go along with this, either in the Bundestag or the constitutional court. However, there is discussion of a way to lever through an insurance company arrangement, but I don't know the details and am not sure exactly how that would work.
- Work towards the ESM continues, and there is talk of moving up its implementation, but I'm not too optimistic that Europe's leaders can do something both correctly and quickly.
- SMP program - bond purchases by ECB of member states (Slide 34) - unsterilized. Yes, with a Z. There is talk this is going to end soon, as dissatisfaction of monetization has resulted in German defections from the ECB.
- Federal Reserve, in conjunction with the ECB, BOJ, BOE, SNB, and Bank of Canada, extended the existing U.S. dollar liquidity swap arrangements through August 1, 2012.
- ECB - 3 and 6 month Long-term Refi Operations (LTRO's) being offered and extended as needed.
Counter-argument
- There is one thing my positive outlook doesn't take in to account: a possible renewed Eurozone recession. Deficit projections are all based on improving economic growth. PMI figures on Sunday night (Monday) will shed some light on the path...
Nomura has an interesting way to utilize the new EFSF: to indemnify the ECB's SMP program. See slide 2 http://www.scribd.com/doc/67232710/NMA-EFSF
ReplyDeleteDoing some more thinking...the next few months are do or die for the Euro. I still don't think the Euro will go away, but things could get really ugly - unfortunately, "leaders" in Europe may not move until its too late. Spain and Ireland have done what they need to do to balance their budget, and now need to worry about growth. But Italy and France still think they are above the fray; they still appear not to have a sense of urgency. Without that, and soon, my bullish view will turn bearish - I have a hair-trigger on this outlook.
ReplyDelete