Austerity vs Growth

The focus in Europe is shifting from austerity towards a growth-led model. Central bank governors and fiscal authorities are more inclined to stimulate the economy. Even to the extent of allowing public debt to expand.

This changing mentality is caused by the following:

• Without higher growth rates, a vicious deflationary spiral can take hold.

• There are no signs that the period of low growth is about to end. Social and political tensions could continue to skyrocket. People have been promised “the earth” in the past, now they end up with empty hands.

• Baby boomers are due to retire. Ideally, younger workers should take over the baton. However, youth unemployment is shooting through the roofs. A “lost generation” can quickly lose many of the skills it has acquired and once growth finally recovers, we can expect severe bottlenecks.

No free lunch

In the past Europe could compensate for structural weaknesses by debt-fueled economic growth. First in the private sectors, later in the public sectors as well. Virtually everyone extrapolated high growth rates into the future. Not just private individuals and businesses took out credit on the basis of unrealistic expectations; social security systems were also built on assumptions that the boom would continue.

The credit crisis showed that it is impossible to accumulate huge amounts of debt with impunity. By now, many people do not want to borrow more. Especially as lower growth has caused asset prices to fall. Governments, too, have enormous budget deficits and national debts: they needed to bailout banks and in a climate of sluggish growth the tax take drops whereas more money needs to be spent on social benefits. To make matters worse, populations are graying. Consequently, public expenditure will continue to soar, a lower number of workers will have to support more and more jobless people and the elderly and will have to service outstanding debts.

To read the rest of this blog: http://www.huffingtonpost.co.uk/andy-langenkamp/ecb-cannot-save-euro-cisi_b_3278539.html

Virtually all over the world, the focus is shifting back towards a growth-led economic model. Policymakers are increasingly prepared to take the risks we listed earlier. Not just central bank governors but the fiscal authorities as well. Even to the extent of allowing public debt to expand – just as long as growth rates improve. This changing mentality should be viewed in the following context:

• There is growing awareness that, without higher growth rates, a vicious deflationary spiral can take hold. As we said before: if that happens, nobody has the answers.

• There are no signs that the period of low growth is about to end so social and political tensions could continue to skyrocket. Many people have been promised “the earth” in the past, now they end up with empty hands. This has all sorts of undesirable side-effects.

• Before long, many baby boomers are due to retire. Ideally, younger workers should take over the baton. However, youth unemployment is shooting through the roofs. Such a “lost generation” can quickly lose many of the skills it has acquired and once growth finally recovers, we can expect severe bottlenecks.

Favorable outlook

This does not automatically imply that the Fed will crank up the printing presses. US economic growth may be quite low at the moment but the outlook is not that bad:

• From Q2 onwards, the effects of the fiscal consolidation will gradually wear off.

• Housing prices are on the rise so homeowners are more prepared to borrow money (while credit is easing).

• A rapid increase in gas and oil production has provided the US with an economic impulse. On top of this, industrial production is increasingly moving back to the United States, from China and the other emerging economies. The combination of low energy prices, modest wage rises in recent years (in contrast with pay in China), and automation is making it more attractive to manufacture in the US.

• Easing inflation has enhanced consumer spending power.

It would not surprise if these developments boost US economic growth in the second half of the year, albeit gradually, to 2.5%-3% and to 3%-3.5% in 2014. If so, the Fed will not need to step down harder on the monetary gas pedal. On the contrary; in the fall, we can expect it to take steps towards unwinding the stimulus. In all likelihood, the Fed will also prioritize growth, so the central bank will only take its foot from the gas pedal if growth continues to be higher. Many think that, instead of abruptly unwinding QE, the Fed will take its time and do so over six months. (However, the markets will look ahead and may start to discount the end of quantitative easing before long.)

Italy formed a new government on April 27 after two months of political deadlock. Center-left leader Enrico Letta will be the new prime minister, presiding over a coalition cabinet of former Italian Prime Minister Silvio Berlusconi’s forces (People of Freedom party), center-left politicians and technocrats like formerly deputy governor of Italy’s central bank Saccomanni. Italy’s parliament is likely to approve the new cabinet Monday evening.

Letta and his team have their work cut out for them. The third-largest economy of the Eurozone is plagued by economic contraction, high unemployment and high public debt of almost 130% of GDP, which pushed it several times to unsustainable lending rates the last couple of years, prompting speculation on a bailout. Credit rating agency Moody’s this weekend warned that Italy would have to knock on the doors of the ECB in Frankfurt for help if Letta will not succeed in turning things around.

Markets hopeful

The financial markets have given an early thumbs-up to PM Letta. The Italian Treasury has sold its five and ten-year bonds at the lowest interest rates since October 2010. So Letta can focus on domestic problems unlike Mario Monti before him. The technocratic PM had to win back the confidence of the financial markets during his term in office. Letta has got the benefit of the doubt from the markets so far, so he can work on fixing the economy and reforming the political landscape.

But if Letta holds his alleged promise to Berlusconi’s PDL by abolishing and repaying an unpopular housing tax introduced by Monti, this would leave an €8bn hole in the public accounts. That will not be a very positive start for Letta.

Forced into a coalition with Berlusconi after the PD was unable to gather the numbers needed to govern alone after the elections, Letta has pledged to try to restore confidence in Italy’s tattered political institutions. Doubts remain over whether the three party coalition will last the full five years. However, Letta is expected to try to pass at least a couple of reforms quickly. Mainly political ones including a change to the much criticized electoral system and a cut in the number of parliamentarians.

Italy already doomed?

But many worry that political reforms alone will not be enough to fend off the markets. London School of Economics fellow Roberto Orso claims that the current crisis (2007-2013) is in many ways much worse than the 1929-1934 contraction and that Italy already went bankrupt in 2011. Only the ECB and Italian banks buying government debt have kept Italy on its feet. The situation is dangerously depressing as Orsi makes clear with numbers:

In the present crisis, investments have collapsed by 27.6% in the five year period, against 12.8% in the interwar depression. GDP has declined by 6.9% against 5.1%. Italy has lost about 24% of its industrial production, going back to the 1980s level…Every day 167 retail units are lost. The automotive sector has been constantly contracting: from about 2.5 million cars sold in 2007, sales in 2012 reached only the 1.4 million mark (the 1979 level). Construction, the other pillar of the national economy, is in rout: the 14% slump in 2012 is only the last in a series of difficult years. Home sales have dropped by 29% in 2012 to the 1985 level of 444,000 units. Unemployment is now at almost 12% and growing fast.

Experts divided

Letta must be a miracle worker to restore confidence and economic growth. Orsi didn’t have much faith in Italy a week ago: the only realistic scenario will be that of a debt restructuring or renegotiation according to him. Others like UBS and Robin Bew of the Economist Intelligence Unit are likeminded about the pessimistic fortunes of Italy. The Swiss bank is cautious about the durability and ability to deliver reforms of the new government. And according to Bew the splits within the coalition are so stark (more talk of repealing old policies than discussing new ones) that we can new polls within months.

Other analysts are more upbeat. Credit Suisse believes that the Letta government is better for the markets than most other alternatives and thinks that the risks of early elections in the next twelve months are extremely low. In other words, the other big Swiss financial institution considers a more lasting power for Letta’s coalition than generally acknowledged by observers.

Disconnect

One thing is for sure, market sentiment towards Italy is very positive compared with the last couple of years. The interest rate differential (or spread) between Italian benchmark bonds and German equivalent bonds, often seen as the main indicator of investor confidence, is way lower than during the highs of mid 2011 and at the start of 2012. Italian credit default swaps – to insure bonds against default and traders use them to speculate on credit quality – have come down. And the Italian MIB stock index has done very well in April.

But although market sentiment is good, the economic conditions have never been worse. This disconnect between financial markets and the real economy cannot continue forever. If Letta fails to have a good start, markets can quite quickly turn against Italy.

Letta and his PD will do everything to make the new government a success, because Berlusconi’s PDL leads in the polls and Grillo’s M5S is still doing quite well. Berlusconi, caught up in a legal battle over tax fraud and charges of paying for sex with a minor, is not in the cabinet. But he will have a powerful influence and could bring the government down if he chooses. PDL secretary and Berlusconi confident Angelino Alfano will be the new deputy prime minister and interior minister. If Berlusconi succeeds in warding off all his legal troubles with some help of Alfano, he could prove to be more of a supporter of the Letta cabinet than most think.

New elections before year-end?

The consensus among experts is that Italians will head back to the voting booths somewhere between October and early next year after Letta has revamped the electoral institutions and procedures. We believe the markets will give Letta some time to bring reforms to home base, but they could become nervous if there’s still a social-economic stalemate within the coalition as the year end nears. Our financial analysts expect Eurozone tensions to flare again at the close of 2013, but we are not entirely sure if this will mean a premature end to the Letta-government.

Three things should be closely watched in the coming months:

1) Will Berlusconi restrict himself to a role behind the scenes or will he not be able to resist his urge to display some showmanship and derail a very vulnerable coalition that way?

2) Will the leader of the other wing within the PD – Matteo Renzi – be loyal to Letta or will he start undermining the PM?

3) Will Grillo keep bumping into the electoral ceiling of 25% of the votes in recent polls, because people are getting tired of his rants and unwillingness to compromise? Or will he profit from the impression that the political, corrupt establishment still runs the show?

It’s too early to answer all of the above questions, but we will closely monitor the political and economic developments in Italy and report on these in coming Global Political Analyses.

Presently, many economic forecasts are revised down; not least because growth has declined in recent months. In the US this is because of the fiscal tightening measures, in China it is due to deteriorating exports and restrictions on lending, while growth in Europe has slowed on the back of deficit reduction and sluggish credit supply. For the moment, Japan is the only area where things are looking up, as a result of massive fiscal and monetary stimulus. In such a climate, doubts whether it is even possible to boost growth are understandable.

 Gold fuels doubts about economic growth 

The recent pullbacks in the gold and commodity markets have added to these doubts. Everyone thought that money creation would drive up prices. Now the opposite is happening. This points towards substantial skepsis regarding the economic prospects. No wonder that the IMF is shifting its focus towards less austerity; some commentators say that central banks should step up monetary easing, particularly in Europe.  Meanwhile, economic growth is slowing in Germany – among others on the back of the yen pullback, which has undermined German competitiveness. Therefore the country is under a lot of pressure to apply fiscal stimulation. Also because Berlin’s public finances are more or less under control (if we disregard the implications of the aging population).

Yet, history teaches us that one can be wide of the mark if growth projections pay too much heed to recent economic developments. To give an example:  so far, stock prices have been almost impervious to the recent growth slowdown. This is because many investors expect central banks to keep the money faucets open. Should stock prices drop in the coming period – on the back of worsening data – in all likelihood this period of weakness would last no longer than a few months and prices would not drop sharply.

Fed to end QE?

A far more worrying scenario – for the financial markets – is that economic growth in the US will pick up from Q3 onwards. This will fuel speculation that the Fed will unwind its program of quantitative easing. Our expectation of higher growth in the United States, later this year, is based on the following:

•             The fiscal drag will decrease from the third quarter.

•             Credit is easing on the back of low interest rates and higher asset prices.

•             Automation, lower energy prices (because of strongly expanding oil and natural exploration in the US), and low wage increases have made US manufacturing more competitive. In fact, we are seeing something of an “industrial renaissance”.

•             A lack of workers with just the right skills is putting slight upward pressure on wage increases.

Owing to these factors, US economic growth could accelerate to around 3% at the end of the year and even more so at the start of 2014. However, due to the enormous liquidity creation of the past years, this will probably trigger inflation expectations and cause long-term interest rates to soar.

To keep the situation under control, the Fed will need to start winding down QE sooner rather than later. There is a chance that this will coincide with much better growth data in Japan where growth could speed up to 3%-4% on the back of the stimulus measures and a cheaper domestic currency.

In the second half of the year, the US and Japan could simultaneously start to unwind QE. For Japan this seems at odds with the effort the Bank of Japan has shown to stimulate the economy. However, it is not helpful to Japan if the yen depreciates much further. This would not just bode ill for many asset prices but also for Europe as a whole.

Eurocrisis back in vogue later this year?

The yield spread between government bonds in the weak Eurozone countries and Germany has narrowed in the past months. Mainly because large-scale money creation has fueled a massive search for yield. In addition, investors are increasingly prepared to take high risks in order to obtain returns. This has greatly helped the peripheral Eurozone countries to find funding. However, the situation will change as soon as Japan and the US start to close the money taps. In theory, the ECB could take over the baton but the chance of this is low, as Germany will probably veto such a policy. Subsequently, Eurozone tensions can flare later this year. Equally important, numerous investors assume that Berlin will ensure that Europe stays fairly quiet until after the German elections at the end of September. Once these are over, the problems could resurface with a vengeance.

• After a weak second quarter, the US economy could pick up during Q3. If so, the Fed will start to wind down its stimulus program, causing the dollar to appreciate, including against the yen. As to Japan, once USD/JPY rises above 110 the drawbacks will outweigh the advantages. Among others, it will force the Bank of Japan to restrict the capital flows away from Japan. To this end, it could lessen QE activity or impose capital export controls.

• Precisely massive liquidity creation in the US and Japan is prompting global investors to search for higher yields. So far, this has enabled countries such as Italy and Spain to borrow money fairly easily as Italian and Spanish government bond yields are comparatively high. Yet, as soon as Japan and the US turn off the money taps – or restrict the outflow of capital – bond yields will shoot up in Italy and Spain.

• Higher bond yields in Italy and Spain would be “lethal” to these economies – especially to the public finances. This will force the member states to seek an ESM bailout.

• The strong EMU countries are rapidly losing their appetite for pumping unlimited amounts of money into the European periphery. Jeroen Dijsselbloem, chairman of the meeting of Eurozone finance ministers, has already outlined the future course of action if a bailout is required. The IMF will calculate the amount of debt that the applicant can repay; the latter will not get a cent more out of the ESM. In all likelihood, this sum will fall far short of what is needed to salvage that country’s economy.

• There is a high chance that Germany will not permit the ECB to make up the difference and/or purchase distressed government bonds on a massive scale. This would result in a full-blown crisis.

Money creation buys limited amount of time

Our main concern is that people should not embrace false security. The situation appears under control because money is created on an unprecedented scale, all over the world. This cannot continue much longer. However, until central banks change tack, risks will be mispriced and capital misallocated.

Once created, the extra liquidity needs to go somewhere. At the moment, risky assets are the only investments that yield reasonable returns and they attract a lot of capital. This has inflated risky asset prices far beyond their underlying values. As the monetary stimulus dwindles, prices will fall back and the world will be a different place. This could even occur if investors start to focus on the discrepancy between actual prices and “real values” as money creation continues on a large scale. Two examples:

• Japan has been in a credit crisis since 1990 and has tried several times to find a way out through liquidity creation. Nevertheless, Japanese stock and housing prices continued to head south.

• From 2007 onwards, everyone was convinced that printing money on a massive scale – to defuse the crisis – would eventually push up inflation. This is why gold has surged. However, in the past 18 months – as more and more liquidity was being pumped into the system – the gold price has continued to fall.

By the same token, we think it would be unwise to be “taken in” by the fact that bond yields in the weak Eurozone countries are relatively low. (Also because this makes politicians more complacent so they are inclined to delay the structural reforms that are needed to overcome the crisis.)

In our view, it is not realistic to expect the ECB to act as a “rescuer of last resort”. If so, the strong EMU countries would still have to foot the bill, albeit in a roundabout way. In any case, they are becoming less willing to pay for the privilege. Not so much because the politicians in charge think this is a bad idea but because voters are against it.