The European banks’ stress tests are over and the benign results appear
to have stabilised the market. Combined
with good results from the latest round of European bank reporting and upbeat economic
forecasts from the Eurozone, financial stocks and the Euro have rallied in
tandem. Amidst the euphoria the
concerns about the Mediterranean countries’ sovereign debt crisis have reduced
with the two-year yield gap between German and Greek, Portuguese and Italian
bonds narrowing. Stories about the
relative risk of a Eurozone default have stopped for now, but is this a false
dawn?
Reports that net outflows from Italian and Portuguese debt continue
unabated and that Greece
is still suffering, albeit at a reduced rate, coupled with the continuing
inflows to the German safe haven suggest the market is not as easily
mollified. At the same time the
prognosis for the U.S.
is increasingly contradictory with the bond markets suggesting that quantitative
easing will have to restart in order to boost the economy whilst stocks rally
on anticipated better earnings expectations.
In the UK
we have had very positive growth figures and talk has returned to the hoary old
chestnut of the relative merits of private equity, venture finance and the
returns both generate for their investors and the benefits to the wider
economy. Fuel is added to the
naysayers’ fire by the numbers of second, third and even fourth round buyouts
with increasingly high price-to-earnings multiples which, in deals over €100mn,
now approach the 18x hit in the boom days. Commodity prices are generally on
the up with cocoa, coffee and wheat at or near record highs and stocks
worldwide are rallying strongly. All is
clearly well with the world economy and the risk of a double dip recession and
a deflationary environment is behind us. Our countries may be bust, but we’re all going to be ok.
This dislocation between the sovereign economic outlook and that of the
wider economy continues in the U.S. The recent state budgets have a reported
$84bn shortfall (Source: The National Conference of State Legislatures) which,
given the state obligation to balance budgets, is a somewhat alarming prognosis
for 2011 especially if budgets are missed. Admittedly the
shortfall is tiny in the context of the overall municipal bond market of
$2,800bn but, with the withdrawal of federal support and increasing
unemployment leading to reduced tax takes, these deficits could well be
significantly worse. It seems that in
both the Eurozone and the U.S.
the next stage of the financial crisis is in danger of moving away from the
“real” economy to European sovereign and U.S. quasi-sovereign state
debt.
Historic statistics for both
General Obligation Bond defaults in the U.S.
and Sovereign defaults in Western Europe make
a default scenario unlikely; however, there are broad similarities between the
problems faced by both sets of entities.
Both have a strong central currency over which they have no control and
no ability to devalue. Both have a central or reserve bank responsible for
setting interest rates and neither can increase the money supply in an attempt
unilaterally to inflate their way out of debt. Both sets of entities are
therefore faced with the unappealing options of tax hikes, spending cuts or
increased debt issuance as the only resolutions for their monetary issues. This
begs the question why, when the risk of a break-up of the Euro is on most
agendas, there has been no similar talk of a threat to the dollar?
The Greek bailout by the European Central Bank was seen by the markets
as a half-hearted attempt to stabilise the region with many analysts predicting
that this signalled the end of the Euro.
At the end of the day Greece
has been saved, but now faces an uphill battle to reduce its deficit through
spending cuts and tax rises at the most unwelcome point in the economic cycle
and in the face of widespread public opposition.
For U.S. General Obligation Bond issuance the situation is less clear.
President Ford’s refusal to bail out New York City in 1975 and the infamous
headline the following day: “Ford to City: Drop Dead” in the New York Daily News, set the scene for
Ford’s loss in NYC in ’76, this in spite of a subsequent u-turn and approval of
federal loans. It therefore seems more
likely that the current regime, in spite of the bailout fatigue gripping the
electorate, would back support for federal lending to troubled states.
As was demonstrated with the difficult passage of the Greek bailout
through the German Parliament, buy-in from the key economies in Western Europe for proposals affecting the wider Eurozone
can no longer be taken for granted. This
has led to many financial commentators predicting that the financial crisis
will also signal the death knell for the Euro.
Historically this seems probable as political monetary unions such as
the Euro have not succeeded in the past with both the Scandinavian and Latin
monetary unions failing as a result of the political turmoil of the First World
War.
Crucially for the Euro and the EU, the disparity in the cost of both
labour and goods across the Eurozone is in stark contrast to the broad
similarity of the same in the U.S. This issue will be greatly exacerbated upon
the admission of the Eastern European states, where the cost of labour and the
comparative cost of goods is significantly lower than in the more developed
economies of Western Europe. In addition, the language barriers in the
Eurozone make mobility of labour significantly more challenging than in the U.S. and the absence of fiscal federalism, which
in large part helps to smooth these differentials across the U.S., also
create hurdles for the EU. Although the
EU has adopted some fiscal federalism in an attempt to overcome this barrier,
it remains insignificant when compared to that in the United States and, moreover, is the subject of
much political discord across the region, unsurprisingly worse among the
electorates of countries such as Germany which perceive themselves
as net givers to the Euro family.
At its heart the issue will be one of whether the political will exists
to create a United States of Europe.
Currently this seems improbable with the political unification of the
member states being widely opposed by the common man in spite of the evident
wish to achieve this objective amongst the political elite. Historically, European states have never
achieved political unity and it seems unlikely that this can be achieved
through an economic back door. The future for the Euro hangs in the balance and
the recent European Bank stress tests, with Portugal’s sovereign debt given an
assumed 12.1% discount to par and Greece a 23.1% discount does not suggest that
regulators have a great deal more faith in the long-term survival of the
Eurozone than the markets.
It seems in the short
term an immediate crisis has been averted. The Euro and sterling are both
appreciating against an increasingly sickly dollar and, if growth projections
are maintained, there is an outside chance that the PIIGS will be able to grow
their way back to financial stability.
The immediate concerns about consumer spending and unemployment have the
capacity to derail this recovery in both the Eurozone and the U.S. The market is pricing in poor non-farm
payroll figures for Friday and an expectation of some form of renewed
quantitative easing in the U.S. By the time of going to press both these
unknowns should be known. For the
Eurozone things are less clear. Suffice to say this crisis hasn’t gone
away. It is waiting for the next catalyst
and only then will we see if the Northern European countries are prepared to
stomach another bail out. Cynics might
argue that the real outcome of the recent stress tests was to reassure the
markets that the banks could stomach a sovereign default within the Eurozone.