Europe: Critical Decisions and Dates

 

September 6: Spain and Italy are clinging to the Euro by an ECB-spun thread.  We don't yet know the conditions the ECB will demand in order to purchase bonds, and its possible they could be more than Spain and Italy could politically bear.  The market seems to have given Draghi the benefit of the doubt, but he will need to deliver acceptable details by the Sept ECB meeting, or the market will likely again call Europe's bluff.

What must Draghi address?

• The conditions that Spain and Italy will have to agree to for the ECB to purchase bonds
• Will acceptance by the EFSF/ESM program be sufficient?
• This would then require approval of all member countries, including Germany
• How much room for error do Spain and Italy have?  E.g., would Greece still get ECB purchases if the program applied to them today?

• How Draghi plans to deal with ECB seniority
• A simple waiver of seniority?
• What really happens in the case of a default (or PSI)?  Will the ECB be solvent if they have to take a haircut equal to the private sector?

• To what extent is the ECB willing to buy bonds?
• Draghi has stated, for example, that they will do whatever it takes, but no more.

September 12: The German Constitutional Court releases its opinion on the constitutionality of the ESM.  It is likely to be ruled constitutional, but if conditions are applied…well, we'll have to wait and see.  We likely already know the outcome, but the impact of anything other than an unqualified "Yes" makes this extremely important to watch.

End of September: The Troika will release its conclusion on whether to release the next bailout tranche to Greece.  Further measures by Greece to comply with the bailout conditions are a prerequisite to receiving more aid, but are not necessarily sufficient.

Other notable items may include:

• By Sept. 11: Details on a EU banking union.  As underwhelming as preliminary proposals from European leaders are, the bar is probably set pretty low.
• By end of September: Details of the Spanish banking stress tests.  However, these are a confidence-building measure and not an actual analysis, and as such, I have no confidence in their conclusions.
• By end of September: Moody's will have completed its review of Spain's rating.

When Will the Market Figure Out that New QE is Not Coming?

New QE?  Nope.

If for no other reason than to preserve its bureaucratic power.  A move is already building in the Republican party to audit, alter or even shut down the Fed.  The House of Representatives passed a measure to audit the Fed just 2 weeks ago; it passed 327-98.  Which, yes, means  the vote included many Democrats.  It doesn't even matter that its dead-on-arrival in the Senate; pressure is building, and if the Fed acts at all and fails, they will be seen as interfering in the election process, and will take all the blame for economic failure (no matter how much they actually possess).  They will also earn the hatred and disgust of Republicans, Independents, and maybe even some Democrats, and you will see a concerted effort to alter or abolish the Fed as a result (don't underestimate hysteria if the shit hits the fan).  "But, but, if they print and the markets go up in response, Obama will win the election, and your scenario won't play out."  Maybe Obama would win the election, and even if he did, the Republicans will be back in power in the not-too-distant future, at which point the as-we-know-it-Fed's days will be numbered.  Now, if Bernanke was inclined to meddle in politics to get Obama re-elected, his smartest play would be to give serious indications of New QE every time he speaks, from now till the election, never actually delivering until after the election.

Second, Bernanke has basically said the same thing for months of weakening data: the Fed will support the recovery if necessary.  Thanks, but we already knew that.  What he's trying to tell the heroin-addicted-market-that-only-hears-what-it-wants-to-hear, is that there is no need for QE, for the reason listed below.

Third, as Bridgewater notes (through Zerohedge), each successive round of stimulus has a smaller and smaller impact, and that reduced impact gets shorter with each use.  Another, even weaker QE program would only confirm this, and the Fed would appear to hold a gun, but with no bullets.  That scenario would be far more dangerous for markets than no New QE at all.

Finally, and further reinforcing my view above, there is no economic cover to intervene .  Yes economic data has pointed downward lately, but guess what?  It happens.  Downturns happen.  Recessions happen.  The Fed has little ability to affect employment and there is no possibility of deflation at the moment.  Grow up Peter Pan, Count Chocula.  Guess what? The recovery is doing just fine (given its origins), its weathered many euro-shocks, and its rocked 'em all (only an enlightened few will get that reference, lol).  There's no possible need for monetary policy intervention, at this time.

The following chart looks at the extension of bank credit and its trajectory, now vs. 2010/QE2:

The next two charts show current inflation as well as expected future inflation, both at Fed targets (via Calafia Beach Pundit):

Core PCE Consumption Deflator:

5Y/5Y forward inflation expectations:

When will the market price in no New QE3?

Unless I'm missing something, the next time Bernanke speaks will be at Jackson Hole on 8/31/12.  I can't say for certain he won't try and tease the market, but I just don't see him laying out a plan for New QE either.  My baseline scenario is for him to note the ongoing economic weakness , the issues related to Europe, and to basically say what he's been saying for months: the Fed stands ready to act, if necessary.

Now, the market could very well take whatever he says and believe what it wants to.  In which case, we may have to wait for the FOMC decision 9/13/12 for the market to finally get it.

China: Review

China's economic trajectory is heading south:

Yet policy responses have been limited to a few administrative tweaks, a few tax cuts, a couple RRR cuts, etc.  This appears to me to be a wait-and-see approach by Chinese authorities.  A major economic slump is not yet a foregone conclusion, and they still have a real estate bubble and now food price inflation to worry about.  Measures will probably be taken, such as more RRR cuts, etc., but a repeat of the lending binge and fiscal stimulus of 2009 seems extremely unlikely, at least for the foreseeable future.

Also Sprach Analyst sums up the limitations on Chinese monetary policy well: "The consensus invariably believes that China “has a lot of room to stimulate the economy”, “has a lot of tools at its disposal”, etc. This could not be further from the truth.  The latest data actually confirm the point. Loan growth is not really picking up after interest rate cuts, and deposit growth remains weak. Meanwhile, prices pressure continues to subside, with PPI falling 2.9% yoy. This actually fits into our debt deflation call surprisingly well.  Meanwhile, we noted that China has record rather consistent capital outflow since late last year, and this picture has been confirmed in the balance of payments, which showed that China had the first BoP deficit since 1998. As explained in more detail in our guide to China’s monetary policy, central bank creates money to prevent Chinese Yuan from appreciating during the period of inflows and massive trade surplus, thus creating more liquidity in the banking system. The opposite will happen: central bank withdraw money from the foreign exchange market to prop up Chinese Yuan (as they have been doing recently), thus tightening monetary condition. It is true that the central bank can cut reserve requirement ratio (as they have done for a few times) to offset, but cutting RRR is not real easing, and there is only so much the PBOC can cut (i.e. about 20% or so).  In theory, the government can run much higher deficit (and run up larger debt) for the sake of creating growth with a fiat currency. But with a peg like it is now, with smaller trade surplus and capital outflow, that severely limit the central bank’s ability to ease credit. Although government directed lending (i.e. government forcing state-owned banks to lend) is a key tool within China’s monetary policy toolbox, Chinese exchange rate regime (as it currently stands) limit the ability for banks to extend credit when the country is facing shrinking trade surplus and capital outflow, even if the government wants them to."

Also, from UBS, via Zerohedge: "When might the government roll out another stimulus? Have local governments already announced major stimulus? Will the economy grow at a much slower pace than targeted by the government if no new stimulus is adopted soon? Could the country/industries/companies survive without another stimulus? These are some of the recent more frequently asked questions.

UBS: Don’t Hold Your Breath for another Stimulus in China

Indeed some market participants seem to be eagerly anticipating or hoping for another stimulus in China, and each day that has passed without a big policy announcement seems to have depressed the market further. While the Chinese government has been very concerned about the economic slowdown and has taken policies to support growth, we would not be holding our breath for another big stimulus. The previous stimulus in 2008-09 did lift growth much higher than otherwise would have been, but the excessive credit expansion also worsened the imbalance in the economy and left serious negative consequences which are still been dealt with today. Chinese government has clearly recognized this and is keen to avoid making a similar mistake this time. Of course, the slowdown in export and in the overall economy is also much milder compared with 2008-09. Importantly, the lack of labour market distress so far has made it less urgent to come up with any big stimulus.

This is not to say that the government has done little or will do little to support growth. Indeed macro policies have changed to supportive of growth since early this year and this has intensified since mid-May. The policies taken so far include fiscal (tax cuts for small businesses, subsidies for some appliances, pension increase, and more spending on social housing), monetary (increase of base money supply through RRR cuts and reverse repos, increase of banks’ lending quota, and 2 interest rate cuts), and credit and quasi-fiscal (easing of lending to the property sector, local government platforms and some sectors, approval and launch of more government investment projects). Among all these, we continue to believe that the measures to increase public investment, to be financed largely by bank credit, will be the most important ones in the near term.

The government has also been trying to encourage private investment in energy, utility, transport and service sectors including by promising easier entry and access to credit, but we think it may take some time before such investment can take off. Most recently, the State Council announced on July 30 that the government will support industrial upgrading including by providing interest subsidies for enterprises to invest in new technology and techniques, more advanced equipment, energy saving process and materials, and advanced information and automation systems. Banks are also encouraged to increase lending to such investment projects.

What about the many “regional stimuli”, including in Changsha and Guizhou? Should we tally up the regional investment plans and count these as stimulus? Not really. While the central government is clearly trying to support growth and investment in the inland regions, we think the many regional stimuli are largely wishful thinking of local governments. The realization of such ambitious investment plans depends crucially on sufficient financing, but banks have been more cautious this time and the overall credit policy is still closely managed by the central government. In addition, the central government’s insistence on not relaxing the property policies wholesale has put limited local governments’ ability to use land/property to finance ambitious investment projects.

Nevertheless, with the continued implementation of the existing pro-growth measures we think GDP growth can still be close to 8% in 2012. In the coming months, we should see bank lending to expand at a steady pace, with the share of medium and long term loans rising gradually, which should help support a modest and investment-led recovery in Q3 and Q4 2012. Industrial profits are down and may continue to be depressed for 1-2 quarters with the ongoing decline in some prices and inventory adjustments, and some companies may not survive this cycle, but we do not foresee major macro risks because of this. Some adjustment and industry consolidation in an economic downturn may not be bad, and many listed companies may emerge from this cycle stronger and more efficient. The ride, of course, may not be pretty."

United States: Review

On balance, the positives are all in the present.  The negatives are all in the new orders.  But I keep hearing "Q2 has been underwhelming, but we feel things will pick up in Q3 and Q4."  Wouldn't that show up in New Orders data?  In fact, we have seen the exact opposite in new orders data. 

This post borrows heavily from sources such as Calafia Beach Pundit, Zerohedge, et. al.  I didn't see a need to describe/chart public data if someone else has already done it, or summarize it, or reinvent the wheel, if someone else already has.


Positives
Employment
As Scott Grannis/Calafia Beach Pundit writes: "There is no way we are even close to a recession when the number of people working in the private sector grows at a 1.75% annual pace—or about 160K per month—and that is exactly what we have seen so far this year, according to the establishment survey. The increase in new jobs is disappointingly slow, to be sure, but it is not something that can be dismissed as meager or recessionary."



Housing
It looks like the worst is over in housing and most of the country will normalize.  In fact, what is happening is a re-localization of housing prices based on local markets.  The credit bubble drove prices up and down nationally; without artificial means of increasing/decreasing prices, supply and demand have again come in to play.  "But what about all the unsold inventory?  And the shadow inventory?"  First, a lot of the "inventory" is localized to a few areas, like Phoenix, Michigan, Florida, etc.  Second, a lot of the "inventory" will have to be razed  due to deterioration (mortgage companies do a piss-poor job of maintaining properties, especially the ones they can't sell), so it isn't inventory at all.  Finally, strong local markets - like Texas, the SF Bay area, etc. - are doing economically well, and people are migrating to these areas, so housing growth continues and will continue.  The housing bust is over for the country, except for the most overbuilt areas during the boom.




Commercial and Industrial Lending
Again, Grannis sums it up well: "Commercial & Industrial Loans outstanding continue to rise at double-digit rates. Banks are relaxing lending standards, and companies are willing to borrow, a good sign of rising confidence, and a clear sign that credit conditions, which have been very restrictive, are improving."


Consumer Loan Delinquencies
 
























Financial Conditions







Negatives
Inventory/Sales Ratio
Via Zerohedge: "With the first drop MoM since September 2011 and dramatically missing expectations, inventories dropped 0.2% and perhaps more worryingly - given the drop in inventories - is the critical inventory-to-sales ratio has now risen two months in a row as clearly sales are dropping faster than companies were expecting."


Consumer Comfort/Confidence/Outlook
Via Zerohedge:
Bloomberg Consumer Comfort:


Bloomberg index of outlook for the economy:


New Orders: Manufacturing/Cap-Ex/Exports
Via Zerohedge:


Via Zerohedge:


Via Zerohedge:


Via Zerohedge:
Global PMI - this is a trend has steadily deteriorated over the last several months


Earnings Outlook
Zerohedge, via Goldman Sachs: "Our model estimates that FX boosted the top line of a typical multi-national company by nearly 2.5% in 2011, but that the yoy changes should result in close to a 2.6% headwind this year – a total expected yoy drag of more than 5%.  We emphasize the continuation of the FX drag as we enter 3Q, where we model relative 7% yoy deterioration due to FX, based on current spot rates.  During the on-going 2Q reporting season several multi-national companies have cited FX as a considerable headwind."
YOY changes assuming current spot rates of 1.23 USD/EUR, 1.56 USD/GBP and JPY/USD 78.60 hold through the rest of the year
Via Zerohedge:











Via Scott Grannis/Calafia Beach Pundit:

Scott, time for a reversion to the mean?

Europe: Review

Liquidity Risk

The ECB has removed liquidity risk; this should continue as long as the ECB eventually commits to money printing (which they will inevitably have to do).  2 LTRO's and the specter for more, relaxed collateral requirements for repos, and emergency lending to "solvent" banks has removed liquidity risk for sovereigns and their banks, but has come at the increased the risk of loss on the ECB and creditor nations (e.g., Germany) under TARGET2. 

Now, the ECB seems willing to buy 2 year and shorter debt of Italy and Spain, provided they accept an MOU.  Anyways, the decision to pile on the risk of loss in case of an exit/breakup would not have been made lightly; there has been incredible resistance from Germany, in particular the Bundesbank, so the doubling down shows Germany's resolve to maintain the Euro as a whole (if they do what they say). 

2 year Euro Swap Spread

3 month Euro basis swap

One question that must be asked is: if the ECB could - without exceeding its mandate - buy the short end of the yield curve to maintain the monetary policy transmission mechanism, then why didn't they do this with Greece, Ireland or Portugal?  And if they're concerned about the transmission mechanism for monetary policy, what does acceptance of an MOU under the EFSF/ESM have to do with anything?  Is this solely (as Draghi hinted) about removing the risk of a euro breakup?  Does that mean the ECB sees itself as a de facto lender of last resort to sovereigns?

So, Europe will have the EFSF/ESM buying bonds in the primary market, and the ECB buying them in the secondary.  I don't see how this is anything other than a sneaky way to monetize peripheral debt: the EFSF/ESM buys the bonds at auction, then sells them to the ECB in the secondary market (or are they going to sterilize, as under the SMP?).  That  may not be a technical violation of the ECB's mandate, but its effect surely is beyond the scope of its legal authority.  Under the SMP, the ECB had cover to buy peripheral debt because they sterilized their purchases.  Should Italy and Spain need a bailout, the sums would be too great to sterilize; the ECB will have to monetize (outside of its mandate) or will have to capitulate.

Its hard to imagine that a Spanish bailout won't require Italy to get one as well.  As such, it will fall on the ECB to monetize debt in order to keep Spain and Italy afloat; the EFSF/ESM doesn't have enough for both, even with the involvement of the IMF.  Oh, and of course Spain and Italy have said they will not need to take any bailout funds, just like Greece, Ireland, Portugal, and Spain (bank recap) said just before they did.  Further, its been reported that Spain has stated it will never take a bailout that includes more conditions than the ones imposed by bank recap package.

Finally, its possible the ECB would have to buy enormous amounts of Spanish and Italian debt once they start.  The Economist asks, "how, precisely, Mr. Draghi proposes to make good his commitment to address investors’ fear that a big intervention by the ECB would downgrade the bonds held by others. Experience shows that, when Greece’s debt was restructured earlier this year, the ECB insisted on its bonds being treated as senior. The ECB took no losses, while private bondholders took a 70% hit. "  

Solvency Risk

The real issue that has not gone away (nor will by monetary policy alone) is solvency risk, of both sovereigns and banks.  I'm going to focus mostly on Spain and Italy, as their fate will determine that of the euro.  They both face high debts and high deficits, with little prospect for economic growth in the near term.  The market is concerned that they are in a debt trap and will eventually have to write down most of their debt, which could then cause solvency problems for their domestic banks (and foreign ones).  The problem is mostly the trend - things are bad, but they're also heading in the wrong direction.  Europe is running out of time to convince markets it can balance budgets and create economic growth.

Spain

• Debt:
• Spain's official debt to GDP at the end of 2011 was 68.5%.  Add 2012's deficit (currently projected at 6.3%, which is too optimistic), then subtract the 2012 economic contraction (1.7% by the IMF's projection, again, likely too optimistic), and you get a Debt/GDP ratio for Spain of at least 77%.  Then add the €100 bn to recapitalize the banks, and you get 86%.  This does not include debt of the provinces (such as Valencia) that the national government may likely have to take on, and there is no end in sight to recession and deficits.  Further, because debt is reaching 100% of GDP, debt/GDP will continue to grow even during economic growth if the interest paid by Spain is higher than its GDP growth.  (See also, Mark Grant via Zerohedge.com, calculating Spain's Debt/GDP at 146%).
• Deficits:
• Will likely be 7% in 2012 and not too far from it in 2013, without further budget cuts and tax increases or economic growth (despite the hopetomistic view of Spain, et. al., growth next year won't be much better than this).  No end in sight to mid single-digit deficits.
• From The Economist: "The Spanish government must borrow €385 billion until the end of 2014 to cover its budget deficit and other needs such as bond redemptions, according to economists at Credit Suisse. Even if the IMF chips in a third as in previous bail-outs, European lenders would have to find €250 billion or so. They have already committed €100 billion to rescuing Spanish banks, so for other emergencies they would have only €150 billion of the €500 billion now in their rescue kitties."
• Budget:
• I'm going to save most of the writing talking about Italy's hilarious expenditures.  Given their similarity, I'm assuming Spain has the same nonsense they could cut, but won't.
• Economic Growth:
• The trend is still downward.
• Ongoing deleveraging by Spain, the regions, the banks, and the public
• Complicated by capital flight
• From The Economist: "Spain ran hefty current-account deficits in the first decade of the euro. As a result, its liabilities to foreign investors exceeded the assets that its residents own abroad by 92% of GDP last year, among the highest in the euro area. The problem for Spain is that foreign capital has been fleeing over the past year. That has weakened the banks and the economy and left the Spanish government shunned by foreign investors for its own financing needs."
• From Reuters:  "Capital flight from Spain gathered pace in May and the central government deficit rose further above target in June, taking the country two steps closer to the full-scale bailout it is desperate to avoid.  Outflows rose to 41.3 billion euros ($50.6 billion) as the government's rescue of one its biggest banks hit already fragile investor confidence and triggered a plea for European aid worth up to 100 billion euros for the country's lenders.  In all, 163 billion euros - or around 16 percent of economic output - left Spain between January and May, with domestic banks sending money abroad, foreign lenders pulling out cash and mostly non-resident investors dumping domestic assets.  Over the last 11 months, funds equivalent to 26 percent of GDP exited the country, Tuesday's data from the Bank of Spain showed."Labor/employment rigidity
• Bureaucracy
• Lack of competitiveness
• Real estate market decline
• Largest loss of companies in Spain are real estate-related (as much as 15% fewer in 2011 alone): "Number of firms operating in Spain hits 5-year low"
• Unemployment
• About 25% and rising.  Is work being done off the books?  Its hard to imagine their economy being as stable as it is (it should be imploding) if unemployment was really that high.  Even if that's the case, it still means no income tax revenue for the state.

Italy

• Debt:
• Italy's official debt/GDP at the end of 2011 was 120%.   Add 2012's deficit (currently projected at 2.4%, which is too optimistic), then subtract the 2012 economic contraction (1.2% by the IMF's projection, again, likely too optimistic; 2.4% according to business lobby group Confindustria), and you get a Debt/GDP ratio for Spain of at least 125%.  Again, with debt so high, you have to have growth above the interest paid by Italy to keep the ratio from increasing, let alone reducing it.
• Deficits:
• Supposed to be 1.7% of GDP in 2012 and .5% in 2013, but again, those are rosy assumptions.
• Budget:
• Gems like these are why the market worries that nothing will change:
• Italy pays more than any other country to Olympics medal winners.  $182,400 for a gold.
• The average Italian politician's salary is the highest in Europe, at  €180,000 a year.
• Italian politicians also enjoy numerous expensive perks: total spending on private cars and chauffeurs alone is about €4 billion per year.
• I don't feel like looking more up, these were the easiest to find, but you get the idea
• Economic Growth
• The trend is still downward.
• Deleveraging, capital flight, similar to Spain - See WSJ
• The rest is the same as Spain, except northern Italy is doing ok (industry is located there), so overall Italian unemployment is "only" at 10.8%.