Why the European sovereign debt crisis is not over
Earlier today, I had an interesting back and forth on Twitter with Edward Hugh, Claus Vistesen and Matthew Lynn about Europe and the ECB. I think we all believe there is more pain to come for Europe and likely there will be writedowns. But I think a lot of the problem has to do with the flawed institutional architecture and self-defeating economic policy in Europe. In my view, this means earnings growth problems for European equities and ultimately will mean a resurge of yields in the European periphery.
The present period of optimism is built upon two factors. First, when push came to shove and Italy and Spain were faced with default, the ECB stepped into the breach. Periphery bonds outside of Greece are perceived to have a backstop from the ECB that will limit downside for investors. Yields have plunged as a result. Second, the front-loaded austerity paradigm has become increasingly relaxed and this has given breathing space that has aided the basing effect already beginning in the periphery. The result, therefore has been even lower yields due to investors starved for yield, piling into periphery sovereign debt. And this drop in yields has aided financial sector balance sheets and the real economy at the same time, adding to the bounce off a low economic base.
Now, not only do we have these facts as an optimistic background, we also have Jean-Claude Juncker making noises about investment stimulus to the tune of 300 billion euros. On the surface this could be a bullish picture.
But, I don’t believe this is the stuff of sustainable recoveries. Rather, I see a renewed crisis developing once this particular cycle turns down. And I am concerned that the fragile European recovery has stalled. Yesterday, I noted the weakness in industrial production throughout the Eurozone. But not only is the real economy decelerating, equities are also suffering, with European shares at 2-month lows last week on the back of banking sector jitters in Portugal.
Juncker, despite the investment program news, has not given up the ghost on austerity. Nor has Eurogroup leader Jeroen Dijjselbloem. Austerity is still the mantra, but it is now set out on a weaker and less onerous basis in order to prevent the economy from lapsing into recession. Even so, we see the potential for deflation and debt deflation right throughout the periphery. Italian inflation is at the lowest level since 2009, for example.
Moreover, despite the bright spot in capital markets concerning periphery yields, this has been more of a sovereign phenomenon due to the implicit ECB backstop. And while that recoupling has passed through to large corporates, it has not passed through to small- and medium-sized business. Before Mario Draghi’s July 2012 ‘whatever it takes’ speech, yields on BBB-rated Spanish and Italian corporate bonds were 340 basis points higher than German ones, according to Deutsche Bank. Now the spread is only 20 basis points. But, according to Goldman Sachs’ interest rate divergence indicator, we are still at a divergence level on business loans across the Eurozone of 252, down from a high of 331 in May 2013. ECB policy is not going to change this substantially. We can hope that it does but the reality is that the real economic data are showing weakness right across Europe.
So where is this heading? What I am seeing in terms of the real economy in the periphery is mostly a basing effect outside of Spain and Ireland. And that means that these economies remain vulnerable to crisis after another downturn. Government debt levels, unemployment and financial fragility remain high in Italy, Portugal and Greece. In a recessionary environment, government debt would rise, government bond yields would rise, financial sector balance sheets would weaken, credit would contract, and unemployment would rise.
If we see renewed weakness before any sort of investment stimulus comes online, we would have to contend with this within the framework of Eurozone states as not having currency sovereignty, which means austerity and to the degree liquidity decreases, QE from the ECB. Bundesbank officials have already said they are unwilling to allow the ECB to buy sovereign bonds to thwart this threat. So the ECB will have to be creative in constructing a new liquidity program, perhaps on a pro-rata basis according to GDP, meaning German bonds would be bought the most. Or they would have to buy private sector assets. Whatever happens, the ECB has a limited and reactive mandate. They are not going to move preemptively. Combined with the fiscal constraints, that guarantees serious problems in the real economy in the event of a downturn any time in the next couple of years.
I see France as part of the periphery here. And to the degree France, Spain or Italy have exigent problems, I would expect an aggressive response. That leaves Ireland, Spain, Greece and Portugal. Spain and Ireland are going to do relatively better and will not be on the hot seat. Greece and Portugal are where the rubber hits the road for another crisis.
Bottom line: we should consider restructuring or default serious possibilities in Greece and Portugal for the next cyclical downturn in Europe. Despite recoupling, the real economies, financial sector and employment markets of Greece and Portugal remain weak. With sovereign debt levels high, another downturn would call their government solvency into question and restructuring will become an issue. This is a medium-term issue. Over the near-term, if the weakness in the real economy continues, expect equities in Europe to underperform relative to the US and Britain. To the degree European policy-makers find a way to relax their economic framework despite the lack of sovereign fiscal space, we can avoid worst case scenarios. However, I do not expect Portugal and Greece to benefit. Only if larger economies are threatened existentially will the Eurozone change tack.