Eurozone
The Eurozone economy is going through a critical period. While the recovery gains traction in many countries, the underlying fiscal problems are here to stay for some time. The wind of austerity which is currently blowing over the Eurozone is likely to weigh on domestic demand, particularly in the Eurozone periphery. Core Eurozone countries should be able to support the recovery for the Eurozone as a whole but growth will likely remain below potential for some time, forcing the ECB to keep its monetary policy easy for longer than it intended. The Greek debt crisis has turned into a severe sovereign debt problem for many Eurozone countries and into an almost existential crisis for the monetary union. It took the announcement of the massive €750bn eurozone solidarity fund and the ECB’s decision to buy government debt on the secondary market to begin stabilizing financial markets.
The recent financial market turmoil on the back of deteriorating public finances in several European countries is a reminder of the recovery’s vulnerability. With banks holding large amounts of sovereign bonds, the CDS premium on European banks has reached the highest level since Q1 2009, implicitly raising the funding cost for the European banking sector. Moreover, concerns that government austerity will stifle economic growth and hurt private sector borrowers markets and not all potential losses from the credit crisis have yet been divulged remain an unknown. In that regard, the Spanish banking sector has been under increasing scrutiny. In a push to restore confidence in the financial system European governments announced they will publish detailed results of the stress tests of big European banks in the second half of July. However, it is still uncertain whether this will alleviate tensions, as doubts will likely linger regarding the scope and methodology.
Meanwhile, the ECB’s government debt buying programme is intended to lower peripheral yields. The increase in government bond yields threatened to tighten monetary conditions further in the weakest countries of the Eurozone. The ECB has reversed its exit strategy by reintroducing new liquidity, guaranteeing commercial banks abundant liquidity until the end of this year. I expect the ECB to continue even longer with this policy as banks in the weaker countries are still relying heavily on the ECB’s liquidity lifeline. The record amount of funds placed on the ECB’s deposit facility is symptomatic of a dysfunctioning money market.
As broad money growth remains stagnant, I expect inflation to be muted this and next year. Deflationary pressures are still present. The annual rate of growth in negotiated wages in the euro area declined to the lowest since 1991. Core inflation in the Erozone remained at 0.8% in May, the lowest level since the start of the monetary union.
President Obama’s plea to stimulate economic growth now and cut deficits later received a mixed response from European leaders at the G20 summit in Toronto. European leaders are determined to push ahead with fiscal austerity measures: A tough budget of fiscal tightening was announced in the UK, fiscal consolidation plans in France, austerity measures in Germany and Italy, captured headlines across Europe. Yet, announced cuts in Germany for 2011 account for only about 0.2% of its GDP. Germany’s €18bn in tax cuts this year should limit the impact of overall euro-zone fiscal tightening, further supporting a strong German recovery. For other European countries, austerity measures prompt uneasy recollections of the premature US fiscal tightening which killed the recovery after the Great Depression.
Current economic indicators signal a slowdown of the recovery, after what looks like a strong second quarter. Both the PMI and the European Commission’s sentiment indicators still paint a reassuring picture. The figures confirm the image of an export-led recovery, with inventory replenishment also contributing to growth. Stronger production numbers were reinforced by readings from the labor markets, which, while weak, showed stabilization in job losses across the Euro-zone. Still, with the inventory cycle leveling off, industrial production may lose momentum in the second half of the year. At the same time, revised GDP data for Q1 also confirmed that domestic demand throughout Europe remains weak at this stage of the recovery (attributable to lackluster labor markets across the Euro-zone) and that inventories and external demand continue to be the predominant drivers of growth.
Downside risks to the growth outlook remain. The market is currently pricing in a 50% chance of a 50% haircut on Greek sovereign debt in the coming years. With no resolution program yet in place the European bank sector remains vulnerable. The negative implication of delaying a possible restructuring is that the coming quarters will remain vulnerable to flurries of market turmoil, which is in itself a growth-restraining factor.
Being one of the crisis beneficiaries, the German economy will continue to ride on the export wave, while fiscal consolidation and a less competitive export sector should suppress growth in France and Italy. Spain could be seen as the lynchpin for the Eurozone recovery, with the housing market and the banking sector remaining shaky. In both the Netherlands and Belgium fiscal consolidation will be the top priority for the new governments.
United States
Risk appetite decreased sharply in the second quarter as disappointing economic data coupled with sovereign concerns overshadowed a strong earnings season. The S&P declined 11.4%, the VIX volatility index nearly doubled and the 10 year treasury rate fell to 2.9%, a level not seen since April 2008.
Economic data point to a slowing recovery: real GDP was marked down for the first quarter – to 2.7% QoQ at an annual rate from 3.0% in the first revision and represents a halving of the 5.6% pace posted in Q4 that helped riskier assets to fresh recovery highs in the opening months of this year. Fiscal stimulus (including its multiplier effects) and stabilization in inventories account for most, if not all of the increase in real GDP for the first year of the recovery from the 2009 bottom. Real final sales (GDP excluding inventories) came in at an 0.8% annual rate. Over the past four quarters, real final sales have registered a total growth of 1.2% at an average annual rate marking it the weakest post-recession recovery on record, according to Goldman Sachs. To put this 1.2% pace in perspective, this is less than one-third of the 4½% bounce in real final sales that is typical of a post-WWII recovery.
This weakness took place despite a 10% deficit-to-GDP ratio, a debt-to-GDP ratio rapidly heading to 100%, a near zero Fed funds rate, record low mortgage rates, unprecedented stimulus efforts that have tripled the size of the Fed balance sheet, shifting accounting rules to help rejuvenate profit growth in the financial sector, record low mortgage rates and government pressure on banks to modify defaulted loans. The latest ISM index readings point to the inventory cycle either reaching or already having reached its peak
Support from fiscal stimulus and impact of inventory stabilization are dissipating in the second half of the year. A continuation of the recovery thus depends more heavily on the private sector, which faces several headwinds. Among them: (a) weakness in labor income, reflecting the impact of high unemployment on wages and employers’ reluctance to rehire meaningfully, (b) fiscal drag from the state and local sector, (c) large overhangs of vacant homes and unused industrial capacity, which limit the potential for major improvements in private sector investment, (d) limited credit availability from a financial sector that is still on the mend, and (e) a hit of uncertain size from the European crisis. As a result, I expect growth to be significantly lower in the second half of 2010. While I expect reacceleration in 2011, risks tilt to the downside.
The Fed recently revised down its inflation outlook to rates well below its assumed goal and hinted that it will keep interest rates close to zero for an extended period of time. The long downward slide in inflation will give the Fed sufficient time to observe economic developments and if/how the European sovereign crisis affects domestic banks and businesses. Deflationary pressures have surfaced: excess supply continues to dominate demand, creating downward pressure on wages and prices in many areas of the economy. In particular, rent, the biggest component of the core CPI, is forecast to continue declining as house prices fall for at least another year due to the large inventory of unsold homes and new home foreclosures.
I believe the most recent recession is different from the eight post WWII recessions: the most recent recession wasn’t just a blip or correction in GDP due to a manufacturing inventory-led recession. This was a traumatic asset price deflation and credit contraction of historical proportions. In essence, this was — or still is — a balance sheet recession that has no commonality with the experience of the post-war business cycle when recessions were temporary dips in GDP in the context of a secular credit expansion. And, this was not solely a U.S recession and debt-deleveraging cycle — it was global in nature. In a low growth, low inflation environment capital appreciation strategies will take a back seat to income-oriented strategies (safety and income at reasonable prices). This secular shift is evidenced by fund flows: US equity funds have continued to see significant outflows this year, most of which is invested in fixed income funds according to Investor’s Business Daily.
Credit
The second quarter of 2010 proved much more volatile than the first due to the sovereign debt crisis which took its toll on financial markets worldwide. The cash credit market was not immune to the rising risk aversion but at least spreads showed resilience in the face of great volatility. Credit spreads gave up ground gained since the start of the year and liquidity dried up as cautious investors sold some inventory. However, large-scale fund redemptions have not occurred. In fact, there hasn’t been any panic selling and cash credit was one of the best performers among the major asset classes.
Throughout this period I have remained fairly optimistic about the prospects of the cash credit markets. After all, fundamentals remain strong: credit metrics keep improving, default rates are falling, rating upgrades are increasing versus downgrades, and corporates have very high levels of cash on their balance sheets. These defensive cash positions will prop them up in the event of any further market disruption/dislocations or a downturn in the economy. Earnings results have been strong and free cashflows/net incomes are on the rise. Corporates’ ability to service their debts remains intact or is improving. Additionally, the economic recovery has continued and cash credit is offering a higher yield than safe-haven government bonds for a small increase in default risk, and remains much more stable and secure than equities. Within credit, spreads have put up a mixed performance. Non-financials are well inside pre-Lehman levels while financials are much wider than they were back then.
Non-financial spreads have been much more resilient through the past crisis than their financial counterparts. The sovereign debt issues have generally raised concerns about potential writedowns for banks, and this is also affecting their ability to fund themselves in the primary markets. This is reflected in the new issue volumes of European bank paper which started the year strongly (€67bn of senior bank debt issued in Q1) but dried up in the past couple of months (€19bn in Q2 - including only €650m in May). Banks have restarted new issues very recently, but the pressures and concerns remain.
Nevertheless, investors have enough cash to put to work given their initial move to hoard it in case of fund redemptions. Coupon payments and bond redemptions have helped to boost their cash balances. For the most part, investors are waiting for new issues before getting involved given the poor liquidity in the secondary markets. However, recent new issue activity has not been enough to satisfy the strong appetite for credit. When calm returns to the markets, liquidity may not improve and I expect investors will have to look to the secondary markets to meet their investment targets. Hence, in my base case scenario I expect spreads to improve slightly through the summer but that tightening should accelerate after the typical August-lull into year-end. As governments withdraw fiscal stimulus in the second half of the year I expect slower top-line growth to be partially compensated by higher margins. I continue to monitor risks that pose a downside risk to the growth outlook such as budgetary developments in Greece, lingering uncertainty over bank stress tests and deflationary pressures.
