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7 June 2012 Eurozone Implosion Risks Overplayed, as US Sustains Modest Recovery

Ive been reading a history of the last days of the Third Reich, and the Berlin Philharmonics final performance before their evacuation as the Soviet army advanced on the city was of Brnnhildes immolation at the end of Wagners epic opera, which was the theme tune to Nazism. While the Germans have shown an unfortunate mystical predilection for a bit of Gtterdmmerung, bringing Europe to its knees twice in a century, their taste in music these days runs more to the guy from Baywatch and Austrian rappers than battles to the death between Norse gods and in that, perhaps we should all find hope. Back in the 1940s, before differential calculus and computers dominated macroeconomics, economies were modelled using elaborate perpetual motion systems of containers, pipes and feedback valves with water moving around them to reflect the flow of money in an economy. While that may seem quaint now, it remains a useful way to visualise the displacement effect of capital movements around the global financial system. Since 2008, it is as if the table this system rests on is violently tilted every few months, with all the liquidity flushing from the risk asset to safe haven side and (partially) back again rather than finding the sustainable equilibrium beloved of economists. The core problem is that too much liquidity is pouring into a system suffering a chronic shortage of creditworthy absorption capacity (and banks are suffering a shortage of collateral they can repo). The combined FX reserves of Asia and the oil exporters now approach $9trn.

Peripheral Deficits Funded By Germany

Source: ECB, University of Osnabruck

This money enters the global real economy via bonds, suppressing risk-free rates and fuelling asset bubbles, originally in US/Eurozone real estate and more recently in Asian property. Reserves top 100% of GDP in Hong Kong and Singapore, and 50% in China, Malaysia and Thailand. The BIS recently noted that reserve accumulation on this scale distorts the credit system. Bank credit is basically high-powered money supply; when it runs well ahead of nominal GDP growth and monetary liabilities in the form of bank balance sheets grow beyond
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the ability of the sovereign to absorb them, we end up in the current crisis. The only solution is to drain the system of excess private sector credit and debt to restore some form of equilibrium, with offsetting fiscal and monetary infusions to avoid depression. That is the task which the US is well on its way to achieving, Japan never quite achieved and Europe is struggling to even comprehend. The key to whether Europe escapes the Armageddon scenarios peddled to fund managers by commentators like Raoul Pal is Germanys perception of its national self-interest. The economics profession and financial pundits are largely tribal, with most adhering to a dogmatic world view from monetarism, the notion that the money supply is at least a leading indicator of aggregate demand (and probably deterministic) to the rather stern Austrian school of economics (think Marc Faber), and more specifically the rather dubious Austrian theory of the business cycle. Investing on the basis of what should happen by applying rigid intellectual preconceptions hasnt helped performance since 2008, given the key (and crucial) role of policy intervention. What has worked is taking an agnostic view of the incentives and constraints within that shifting policy framework.

German Trade Surplus Has Generated EMU Instability

Source: IMF

The one key tenet of economics that has survived the financial crisis unscathed is that of optimising outcomes within constraints, and whether looking at China or Germany, thats the right framework to help figure out policy options. By breaking down Eurosystem payment balances we can see just how much skin in the game Germany has in holding EMU together, with 650bn owed via peripheral national central banks from Athens to Madrid to the Bundesbank, a net payment position that was in broad balance pre-crisis. The LTROs essentially allowed core euro zone banks to exit peripheral sovereign debt holdings, which does have the advantage of making a Greek exit less traumatic (on the private sector at least, the ECBs balance sheet would be shot to pieces) than commonly feared. The most dangerous trend in the euro zone is that financial institutions are increasingly trying to match assets and liabilities by country, defeating the original purpose of EMU in fostering integrated and more efficient cross-border capital markets, while a rising share of cross-border risk is now assumed by the ECB and de facto by the Bundesbank. With over 40% of German exports exposed to the rest of Europe (and probably over 50% taking into account the indirect impact on sales of German machine tools and luxury cars in China etc. driven by European end demand), the vast vendor financing scheme within
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the euro zone which saw German banks fund peripheral construction booms and trade deficits over the last decade can only be switched off if German domestic demand, like Chinas, is boosted to compensate. Its even conceivable that they think tough love will work, and that the weaker countries will see nominal wages and costs fall so dramatically that they would move into large external surpluses with the rest of the world, thereby restoring economic activity. German economists often claim that radical structural reforms with a fire sale of assets would draw a wave of inward direct investment, financing the current-account deficit in the short run, and generate new economic activity in the longer run. That assumes crucially that those investors retain faith in EMUs sustainability, which is clearly no longer the case. Austerity in the context of private sector deleveraging exacerbates both economies and banks which in turn raises unemployment and the output gap and lowers government revenue, creating a vicious circle. Since 2007, the financial balance of the private sector shifted dramatically from deficit towards surplus across the euro zone periphery, by 16% of GDP in Spain for example. Meanwhile, Germanys economy is only 1% larger than it was four years ago and mediocre demand in the core reinforces economic weakness in the periphery (although there are some positive signs from Germany, in terms of property prices waking from their torpor and real wage rises accelerating). Very little that has transpired economically in the euro zone over the past couple of years is much of a surprise, although the fact we havent reached a denouement yet is. Back in the 10th May 2010 Weekly, I noted that: Even with a debt restructuring, Greece will be in deep trouble, forced to provoke a deep slump just to close the primary, non-interest deficitthe alternative is a devaluation, which means leaving the euro either by agreement or unilaterally, even though that would leave the country with net external liabilities of at least 70% of GDP which clearly implies immediate default. In fact, Ive long believed that a two tier euro zone was inevitable, split along the dangerous productivity fault line between north and south, with Germany leading a core fiscally integrated bloc that was economically coherent. Countries like Portugal and Greece have little to offer the world in the way of traded goods and services, and their best hope would be to attract tourists and capital from Northern Europe with a competitive exchange rate reflecting their low productivitythe IMF/EU austerity plan is a recipe for a deflationary death spiral (including up to a 10% nominal wage drop by 2012) without exchange rate flexibility. We have recently seen the political repercussions of that death spiral; its conceivable that the Germans are trying to make life so unbearable for some of the peripheral economies that they will leave EMU voluntarily, thereby reducing the euro zone to that coherent core I wrote of two years ago, but there is no real constituency in the country for a return to the Deutschemark or nationalism.

US Data Soft But Broadly Resilient, as Inflation Expectations Rise Its intriguing that with a global equity selloff suggesting imminent deflation, 5-yr-5-yr forward implied US inflation expectations have risen in recent weeks to just under 2.8% (versus 2% during last autumns panic), while amid the Spanish solvency panic, euro zone 2-yr swap spreads are still just over 80bps (versus almost 120bps pre LTROs). On a 3-mth moving average basis, implied US 5-10 year inflation expectations in May were 2.5%, and to avoid any technical distortions from negative TIPS yields, the Fed household survey measure is also near its highest point of recent years, so we remain a long way from the deflation scares that have characterised previous bouts of risk-off behaviour. The major US data series released over the last week were weaker than expected (non-farm payrolls, unemployment, manufacturing, construction, factory orders and auto sales), but in line with my warning back in March of a likely loss of momentum, and the US economy remains quite a distance from a cliff edge. The May ISM Composite Index of industrial sector activity fell to 53.5 from an unrevised 54.8 in April. Most series fell including production, supplier deliveries and inventories. The employment component also fell to 56.9. However, the new orders component rose to its highest level since April 2011 driven by domestic demand, with the separate index of new export orders falling sharply to 53.5 on weakening
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BRIC demand. Exports are 14% of US GDP, and euro zone exports are only about $200bn a year, or the same as trade with Mexico. The price index fell sharply to 47.5, its lowest level in six months.

PMIs Suggest Sluggish Rather than Sliding Growth

Source: ISM Institute

The unemployment rate increased to 8.2% in May from 8.1% in April. Essentially, the jobless rate has held nearly steady during the last two months. The positive news is that the labour force increased in May, after posting declines in March and April, lifting the participation rate to 63.8% from 63.6% in April. In addition, employment advanced 422,000 following declines of 31,000 and 169,000 in March and April, respectively. At the same time, the broader measure of unemployment which includes marginally attached workers moved up one notch to 9.6%. The April and May payroll tally is on the soft side compared with the first quarter average monthly increase of 226,000 jobs. Private sector payrolls advanced 82,000 in May, nearly matching the 87,000 gain posted in April. The overall workweek was shorter in May (34.4 hours) compared with April (34.5 hours), while the factory workweek also dropped in May (40.5 hours vs. 40.8 hours) and factory overtime slipped slightly (3.2 hours vs. 3.3 hours in April).. Hourly earnings rose only 0.1% in May to $23.41, which puts the y/y increase at 1.7%, the smallest increase since November 2010.

Workforce Participation Rate Improved in May

Source: BLS

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US personal income increased 0.2% (2.8% y/y) in April, down from 0.4% March; that included a 0.2% rise (3.2% y/y) in wages and salaries. Among other income categories, rental income surged 1.0% (14.2% y/y), a tenth consecutive monthly gain of 1% or more. Dividend income remained strong, rising 1% in April and 6.5% from a year ago, exacerbating overall inequality trends given the concentration of equity ownership in the top income decile. Personal consumption expenditures picked up to a 0.3% increase in April or 4% y/y. Durable goods purchases rose 0.6%, resuming growth after a 1.4% decrease in March led by motor vehicles. The PCE chain price index was flat in April after a 0.2% increase in March; its up 1.8% y/y. The core PCE price index, watched closely by the Fed, was also a bit slower in April, with a 0.1% increase following Marchs 0.2%; it is 1.9% up y/y. The personal saving rate was 3.4% in April, down from Marchs 3.5%; a year ago, the savings rate was 4.8%. The overall picture is flat to falling real earned incomes, offset by a falling savings rate to sustain consumption. In fact, adjusted for inflation, per-capita disposable incomes are currently at about the level first seen in late 2006, although as Ive highlighted previously, the average hides a widening distribution as income inequality remains the key trend. The best hope near-term for a boost to US retail spending will come from sliding energy prices. Overall, were stuck in that on-going washboard recovery for both markets and the global economy, in which the psychological scars of 2008 remain raw for investors, terrified of being wrong footed by the next systemic meltdown. The best way to play it is to be tactically flexible, and tilt portfolio risk weightings regularly based on what have proved to be the pretty reliable macro signals. Wagners melodramatic opera lasts an excruciating 19 hours, but it does eventually come to an endand so ultimately will the binary risk on/off frenzy gripping global markets as post crisis deleveraging progresses fitfully. In the meantime, if the Germans can create a comeback for this guy, perhaps they can for risk appetite too

Author: SEAN MAHER Consultant Strategist Quam Securities s.maher@globalalliancepartners.com Tel: + 44.207.687 2213

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Weekly Insight

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