France, the eurozone crisis recovery, and investing and economic timeframes

I have some interesting ideas on the eurozone regarding France, a housing decline and its divergence from the rest of Europe. But I am going to save that for a later post. Suffice it to say the German – French spread is widening; it is at 61 basis points for 10-year securities. And France was the only nation except Greece that saw a manufacturing PMI below 50 in the last month’s data for the eurozone. The Netherlands, which I contrasted to France last month, had the highest numbers. What is this telling us? It depends on what timeframe you are using. So I want this post to address two things: investing and economic timeframes and the eurozone.

The European private debt problem

First, I see the European sovereign debt crisis as mostly about private debt. The Economist gave us some good numbers on this in October in a series of pieces on European debt. Below is the chart I think best presents the picture.


What you see is a complex picture of corporate and household sector vulnerability. In most countries, pre-crisis the problem was not government debt at all. It was private debt. This chart from a post I wrote in 2012 makes the point best for Ireland and Spain.

(newsletter and RSS readers click on links to see charts)

And this chart includes Italy, Portugal and Greece, showing that only Italy and Greece had very elevated public debt, pre-crisis.

Private debt problem stabilization

My takeaway here is that the euro is an incredibly difficult bind because it has taken what was a private debt problem and made it both a private and public debt crisis in some countries. And that is the genesis of Europe’s under-performance economically. But when you see what is going on in Europe, you realize that almost all of the affected countries have stabilized or are stabilizing.

The private debt problem has not gone away but it has reached a point where it is no longer negatively affecting growth so much that these countries are in recession. House prices have fallen enough and are stabilizing. The Netherlands is most emblematic of this trend. On a cyclical basis at least, the deleveraging crisis is now over. And this owes mostly to the end of falling house prices.

On the other hand, France is now moving the other way. While the rest of the eurozone sees improving numbers, France sees declining numbers. Why? I believe housing is a big part of it. Take a look at this chart just released by the Economist on global house prices.


There are a few markets on this chart within the eurozone that have elevated house prices. But Ireland, Italy, and Spain are not any of them. In Greece, house prices have fallen by nearly 40%. I don’t have the numbers on Portugal but the situation is similar, if less dramatic. My point here is that the reason the downward trajectory in the periphery has been arrested is because the decline in house prices has been arrested, putting less stress on private balance sheets and ending the urgent need for large-scale deleveraging. Austerity only makes this worse, by the way. And pubic debt wasn’t the problem to begin with.

Of all the markets that are still elevated in price, France stands out as one where house prices are under assault with Finland (and perhaps Belgium). Finland has been in a recession. No one has noticed because the country is small and government debt is also small. But the recession is related to the assault on house prices. The same goes for France. But France is much bigger and has many of the structural deficiencies that other peripheral countries have. So what happens there matters. In a recent interview with Der Spiegel, ECB head Mario Draghi talks to this:

Draghi: Some countries need a programme that runs for three years, others take somewhat longer. In Greece, the position at the outset was particularly difficult, so now we have to be particularly patient with the country. That’s no surprise.

SPIEGEL: The reform process is slowing down in other countries as well. France, for example, is again making debts, and the planned reforms in the labour market or the tax system are not moving ahead. How concerned are you about developments in the euro area’s second-largest country?

Draghi: France is facing the same problems as other countries which need to get their budgets in order and to make structural reforms.. Many states have raised taxes and cut investments first. This is the easiest way, but both approaches weaken growth. A more promising avenue is to bring current government spending down and introduce structural reforms in the labour market.

I am quickly coming to the view that France is the country to watch in the eurozone in 2014 besides Greece.


This whole discussion begs the question of investing and economic timeframes. Draghi was asked whether the crisis was over and he said no. I don’t know what he meant. But I would suggest the answer has to do with timeframes.

When I think of economic events – and therefore investing timeframes – I think there is a large difference between very short, short, medium, long-term and very long-term horizons. As a former bond guy, I still think in those terms and the government bond markets conveniently replicates my timeframes. The very short term is overnight and completely dominated by central banks’ setting of  their target interest rate. Even the short-term is dominated by central bank policy. When central banks raise or lower interest rates, they immediately affect government bond rates out to six months to a year. That is a short-term time frame during which there is unlikely to be a reversal in policy and so the central bank sets policy and therefore dominates interest rates for credit in those time frames.

But economic events that are meaningful occur over the medium to very long term. And this is why Draghi’s answer to the problems in Europe should be no. The same goes for problems in the United States.

One thing that is evident to me from having witnessed several economic cycles after I received an Economics degree is that the central bank really dominates the short term in such a way that cyclical forces gather steam and create economic momentum that is hard to overcome. A case in point is the 1990-91 recession int he United States. When we look back today, it is little discussed but I remember it vividly. Last week I was discussing it over lunch with a hedge fund friend and his wife and I told them that I remember New York City as going through a very difficult time. I lived on the Upper West side in a townhouse that had its rent price slashed by 30%. This was the end of the junk bond bull, the beginning of the savings and loan crisis and the near failure of Citicorp. I remember coming back to New York in 1995 and 2000 to live again and flipping through the book of Manhattan buildings for rentals and noticing immediately that none of them were built after 1990 or after 1982 for long, long stretches. My memory was that no large rental properties were built between 1982-1987 and 1990-1995 because of the disastrous climate for credit. Looking back, I remember 1990-91 as a very dark period in which people were frightened, having escaped the double dip of 1980-82.

But the Fed engineered a recovery that was so robust that it started hiking within three years. 1994 was a disastrous bond market, the worst until 2013. Yet, the economy had enough cyclical momentum to ride this out to the point where we started hearing Greenspan’s thoughts of irrational exuberance in 1996 . The period ended in an epic bubble. My point? Once the cyclical forces kick in, they work in powerful ways. People might not remember the 1990s as a difficult period because of the stock bubble. But its beginnings, with a banking crisis, bank runs, a collapse in high yield bonds and a general and severe credit tightening was very hard.

Was 2009 any different? Is it entirely possible, even probable that we are now seeing the same cyclical forces at work that could lead us in the same direction – not just in the US but in Europe as well? 

Forward guidance is an attempt by central banks to extend their reach from the very-short and short-term time horizons into the medium-term in much more forceful way. The ECB is now telling investors that it will keep policy accommodation on over a medium-term horizon, what I define as the belly of the yield curve beginning at 2 years and extending out to five years. This is much more aggressive than traditional policy in the sense that it is an explicit message that 1994 will not happen again (even though I would argue it just did in the US because of tapering). SO where I think Europe is headed is up and that’s because cyclical forces of business investment, hiring and releveraging will come together and make this happen on the back of credible promises by the ECB that you can take risk out to two years without getting burned.

The problem, of course, is the long-term to the very long-term. Over the long-term i.e. 7 to 10 years, the business cycle takes full form and so we should fully expect another downturn. From an investing perspective, the question is what very-long term forces are at play which will exacerbate or diminish the severity of a particular downturn. For example, in 1990-91, I would contend that the real economy and credit-based cyclical problems were much bigger than they were in 2000-2001. Yet, the market vaulted higher after the Fed eased in 1990-91 whereas 2000 or even 1998 marked the beginning of a secular bear market. The difference is secular i.e. declining interest rates, policy space, private debt.

To sum up, Europe is in what I believe is the beginning of a cyclical recovery that will continue because the ECB has guaranteed no interest-rate risk into the medium-term. Cyclical forces will gather steam on the back of this. Nevertheless, policy space in Europe is extremely limited by the level of interest rates and the level of government debt. At the same time, private debt remains elevated despite the decline in house prices in the periphery. In many European economies, house prices remain at dangerous levels. France is one of those economies. My expectation, therefore is that Europe will grow over the medium-term and to the degree this growth continues long enough, it could win back some policy space via diminished private and public debt and higher rates that allow for cutting interest rates at the next downturn. However, the risk in Europe – as in the US – is that when the next downturn hits the secular forces at play will not be favorable, and this is especially true in the US given the elevated level of stock prices. If those secular forces limit policy space, the downturn in both the real economy and equity markets will be pronounced and crisis will return to Europe full bore.

For now, the path is up. If debt levels are reduced and the ECB gets time to reload by raising rates during that time, crisis could be avoided. Otherwise, I expect it when the next global downturn occurs within two to five years.

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