Year-End Review, pt. 2

While other events will certainly weigh on the markets, the single biggest variable in 2012 (from the view from 2011) is going to be Europe.  There are several possible catalysts that could trigger a full-blown crisis in Europe, so I'm analyzing three main areas: Economy and Reforms; Budgets and Austerity; and Liquidity.

• Economy and Reforms
• Back-looking data suggests Europe is on the edge of a recession, while PMI and IP data indicates that most of Europe has already entered a recession.
• The December PMI report suggests 2011 Q4 GDP to be about -1.5%, vs. around 0% figured by governments themselves.

• I don't have a study to back it up, but my theory of why the world economy seems so bad has to do with global overcapacity.  And as has been noted by others, there is a currency devaluation contest going on to make your country's products more competitive.  
• Which is why I wonder whether the lower value of the Euro - currently, and likely prospectively - will make this European recession a mild one.
• I think the key is confidence (and thus, a function of policy and policy-makers).  If it looks like positive changes are being made to Euro treaties; if it looks like budget-deficit targets will be enforced; if it looks like reforms to the current account problem (including changes in Germany) are recognized and addressed; if it looks like the ECB will print whatever is necessary to keep Spain and Italy solvent; then, I think confidence will be high enough to keep things from spiralling out of control until the exchange rate has a positive effect on the Euro economy.
• An important thing to note: "When will the economic contraction have an effect on tax receipts? And to what extent?  Enough to shake confidence?"

• Budget and Austerity     
• One of the problems as I see it, is that there are plans to reduce deficits, but not [unsustainable] debt.  
• Economic recession is compounding this problem, as the only "plan" in place is to increase "growth".
• But there are insufficient economic reforms/investment programs to complement/ counter the austerity measures.
• Spain announced Eur16bn in budget cuts and new taxes at the same time it announced it missed its 2011 deficit goal of 6% (now to be > 8%).  Add regional and municipal debt that is coming to the surface now that incumbent parties are being voted out of office, and plans heretofore seem less than confidence inspiring.
• This means that tax receipts (and the underlying economic activity to produce them) were overly-optimistic.  How 'bout that?  
• What does that indicate about their projections for 2012?
• Monti (Italy) reaffirmed his goal to balance the budget by 2013 when he announced the 3rd round of budget cuts and tax raises since June.
• This projection, of course, contemplates GDP at -.6% in 2011, and -.4% in 2012.
• France scrapped the idea for a 3rd round of austerity measures, wanting to instead focus on growth, and believing growth will pick up next year.  They are aiming to reach 3% deficit/GDP by 2013.
• Really?  Higher growth in 2012 than 2011 will do the trick?  They must already be resigned to losing their AAA...
• Liquidity
• Measures of imminent crisis, if they can be called that, have receded due to recent global CB action (swap lines, loosening monetary policy, etc).
• For example, EUR basis swap, 3 mo:
• While actions by the ECB, (e.g., SMP, LTRO, reduction in the interest rate, etc.) have provided liquidity to the banking system, certain measures still indicate that a systemic crisis has not yet been averted.  
• For example, 2 year EUR swap spreads are at levels not seen since Lehman:

• While there is liquidity available to fuel a rally in risk assets, heightened demand for money (self-preservation) may keep the escalator from going back up.
• U.S. M2 is back to rising at a normal rate, but remains elevated above its long-term average.


• Possible catalysts for systemic banking crisis?
• It's important to note that all below are confidence-dependent, so watch Euro economy, reform/austerity implementation, deficit/tax-revenue targets, and ECB willingness to print.
• Bank-run contagion (starting in Greece?) - watch Greek bank deposits (and Spanish and French).
• Negative bank-deleveraging feedback loops - watch U.S. M2, Euro M2/3, Feb. 2012 LTRO auction (banks using LTRO for carry trade?), ECB deposit facility.
• Insufficient liquidity (or willingness to use it) to roll over bank debt (wholesale lending has dried up) - watch EUR basis swap, 3 mo.,  2 year EUR swap spreads, USD FRA/OIS spread, 3 mo.