Eurozone pinball

In my youth (a long time ago) I used to enjoy playing pinball. A judicious nudge here and there would manipulate the ball out of harm’s way and garner extra points. However, nudge too hard and the “Tilt – Game Over” light would come on. The eurozone is a bit like a game of pinball at the moment. The eurocrats are trying to cheat and delay the inevitable end of the game with a few “illegal” nudges. Bail-out loans and the supply of liquidity to the ECB through the repo of unacceptably low-grade collateral (i.e Greek, Irish and Portuguese government bonds) would have been considered illegal before the crisis. However, rules are there to be broken for the “greater good”. Even Herman von Rompuy has admitted lying.

The eurocrats can get away with cheating for the smaller economies, but they will find it impossible for the “game over” light not to flash if Spain goes the way of the other GIPS (I don’t like the acronym PIGS). While Spain is certainly not as extreme as Greece or Ireland, it does have some serious structural problems, namely uncomptetiveness and a real estate bust that is yet to fully mature into the banking system. Apparently there has been a note from Societe Generale’s Klaus Baader suggesting that Spain is “fundamentally strong”. Well I suppose he has to argue that Spain is OK and the eurozone is OK as SocGen will be bust if the eurozone implodes. However, Edward Hugh neatly deconstructs his argument on his blog. I urge you to read it as it illustrates the fantasy world that a lot of euro elite inhabit.

Fundamentally, Spain’s competitive position is not getting better relative to Germany and the improvement in the trade account is mainly due to collapsing domestic Spanish demand. Spanish inflation continues to be higher than German inflation, so deflation to restore a relative price advantage is NOT occurring, in fact, it’s getting worse. Given that investment growth is flat (German investment is rising BTW), it doesn’t augur well for a future boost in Spanish exports (the UK has a similar problem BTW, but at least the currency has depreciated).

While personal sector debt is not outrageous compared with the UK/Netherlands/Sweden, Spanish house prices still have a long way to adjust and unemployment is very, very high. Corporate debt is very high and a good deal is associated with the construction boom. Government debt appears well contained but there is hidden debt in the regions and late payments are hiding the true picture.

The end game is approaching because the interbank market for the GIPS is drying up. International banks are not rolling over short-term lending to distressed country banks and domestic deposits are fleeing. At the moment this is most acute in Greece and Ireland. However, Spain is being dragged into this. As Merve the Swerve said recently, this is a solvency problem not a liquidity issue. Extending liquidity can delay the GAME OVER light but eventually the global financial system recognises the futility of extend and pretend and will no longer play the game. We appear to be on the cusp of that now.

While the denouement will be horrible in all sorts of ways, it will pave the way to a restoration of balance and of renewed growth, but until the catharsis happens, everyone will be dragged down. There will need to a massive recapitalisation of the eurozone banking system, not just in the GIPS but in Germany and France as well. When this happens, it will be a sign to get bullish, but there’s a lot of pain and gloom to go through yet. Just as an aside, if oil prices continue to slide, then it should provide a growth boost to the global economy by the end of the year, will might provide a short-term boost to markets come September/October.

Extending the game

The announcement that bonds issued by the eurozone rescue fund through the ESM will not have preferred creditor status is a significant move. It means that distressed countries should find it easier (less difficult) to come back to raise money in private markets. If the ESM had preferred creditor status, then each round of financing would push a greater and greater potential loss on private bond holders. By sharing the load, this removes one disincentive to invest in distressed country bonds. It is also, potentially, a fiscal transfer by the back door, so it will be interesting to see whether German politicians or the True Finns pick up on this. It is not a cure, but it does give the can a hefty kick down the road.

If you haven’t read John Mauldin’s “Outside the Box“, please have a look at the latest article. What is especially interesting to me is the thought that China will have a recession in 2013/14. You have been warned!!!

2013 is the year

Wolfgang Munchau makes an interesting point in his column in today’s FT that it would be tactically unwise for Greece to default until it has achieved a primary budget balance. His estimate is that it is unlikely to be achieved before 2012 and more likely 2013. This makes a lot of sense as the Greek government would not be reliant on foreign capital to finance government expenditure before interest payments. It could then default on those interest payments and continue to function. 2013 is shaping to be an interesting and testing year.

Credit crunch 2.0

An article in the Telegraph claims that British banks have been “radically” reducing their exposure to eurozone banks, especially the weaker ones. You can bet that other banks have been doing the same. Banking is all about confidence. Once that confidence starts to evaporate, a credit crunch can’t be far behind. Greek, Irish and Portuguese banks are becoming ever more reliant on the ECB for liquidity and funding. No wonder the ECB is fighting so hard to avoid anything smelling of default. It is teetering on the brink of insolvency. Recapitalisation and monetisation of sovereign debt can’t be far around the corner.

You might want to read John Mauldin’s latest “Thoughts from the frontline” which has a guest post from Nouriel Roubini. While there is nothing particularly new, it is a nice summary of the problems and how they are building. The main problem is that the political elite are blind and are forcing populations down the route of penury. At some stage there will be an almighty political explosion. Until then, the can kicking becomes more expensive and less effective with each kick.

Slip-sliding away

We have more evidence of weakness in the US economy this week. The Fed’s NY Empire State Manufacturing Survey fell to -7.8 for June. This is the first negative reading since November last year. Of particular note is that the new orders element has gone negative. The NY Survey can be a bit volatile, but it is confirming the weakness in other surveys.

This week we also had the National Federation of Independent Businesses (NFIB, the small business association) Survey. Optimism fell for the third straight month. Delving into the figures, the employment component has gone negative. Given that small businesses are a significant driver of employment patterns in the US, this doesn’t bode well for employment prospects over the next few months.

Completing the trio of gloom is the NAHB Housing Market Index, which fell back the lows of last August. The recent weak recovery in the NAHB survey seems to have aborted.

In yesterday’s online FT, Gavin Davies wrote an interesting piece about whether the US economy has slowed to stall speed. Worth a read. He produces a chart based on some research by the Fed and his own firm, Fulcrum, to quantify the chances of a recession. Ignoring the yield curve, the red dotted line, derived from recent economic releases suggests that the chances of a recession having already started in the US has risen to around 30%. David Rosenberg is on Bloomberg suggesting that there’s a 99% chance of a recession in the US in 2012. No wonder markets are twitchy.

Source: FT

Lastly, the OECD Leading Indicators have peaked out and are starting to weaken for a number of countries.

All I can say is that it is looking more and more tricky. I still think, at the moment, that we will see some pick up in activity later in the year as supply chain disruptions drop out. My best guess is that a global recession won’t happen until 2013. However, this is only a guess. All the pundits are guessing as well, so don’t be fooled. This is a time of incredible uncertainty.

More on trade and savings imbalances

This latest blog entry from Michael Pettis reminds us that the US/Chinese and German/Eurozone periphery problems are very simple looked at through the lens of trade and savings, but they are no closer to a solution. Calling low savings nations “lazy and profligate” is neither an accurate description nor a policy. At least the US and China could solve the issue through changes in currency parities. Indeed, even without a rise in the renminbi, the high rate of Chinese inflation is changing relative currency values in the right direction by stealth. Unfortunately in the eurozone, relative inflation rates are making the situation worse. Germany still has a lower inflation rate than, for example, Spain. That’s why the eurozone crisis isn’t going to end in a hurry, whatever happens to Greece.

Spurious accuracy

This is a paragraph from an article in the FT on Chinese inflation:

“In other signs that the economy is gently slowing, industrial output moderated to a 13.3 per cent year-on-year increase in May, down from 13.4 per cent in April. Meanwhile, retail sales rose 16.9 per cent from a year earlier, down from 17.1 per cent in April.”

Given the famed inaccuracies of Chinese economic numbers do you think a drop in the rate of growth of 10bp in industrial output and a 20bp fall in retail sales really means anything?

The end of European freeloading?

I thought this report of a speech by Robert Gates was interesting. The US appears to be losing patience with European countries that are not taking responsibility for their defence. This has been an implicit subsidy by the US and is probably coming to an end. One group of countries that is taking the weakening of NATO seriously is the Visigrad group of countries (Poland, Czech Republic, Slovakia, Hungary), forming a battlegroup under the command of Poland.

Many of the certainties that we have lived with in the post-war period are disappearing. The dominance of the US on the geopolitical stage is slipping. The weakening of NATO will cause uncertainty in central Europe. Russia has become assertive and unpredictable. Germany is in the process of alienating southern Europe. The UK is a busted flush. What price a political uncertainty premium on European markets?

2013: the crunch year

I’ve been saying to all my friends that I think 2013 is going to be a very difficult year and might be when the world has another crisis/recession. The reasons are very simple:

1. First year of a new US presidency. Whoever gets in will have to apply some severe fiscal medicine to bring the budget deficit under control.
2. First full year of a new Chinese administration. The new Politburo will have to address a real estate bubble, fixed investment bubble and bad debt problems in the banking sector.
3. The new European Stability Mechanism comes into operation, with the likelihood shared debt restructuring.

It seems that Nouriel Roubini agrees. However, investors might start to anticipate these problems next year, so watch out for a roller coaster ride.

View from the sidelines w/e 10th June 2011

Weak European industrial production

Last week saw a slew of weak industrial production numbers in Europe for April. Eurozone powerhouses Germany and France saw industrial production decline by 0.6% and 0.3% mom respectively. In Germany this mainly due to construction, while in France it was blamed on supply chain disruption. Spanish IP fell by .6%, confirming the weakening of the Spanish economy recently. Outside the Eurozone, the UK saw a fall of 1.6%, made worse by the holiday disruption of the royal wedding. One ray of optimism was the strong bounce back in German manufacturing orders (+2.8% mom).

Divergent trends in Eurozone GDP growth

Eurozone GDP growth numbers showed growth of 2.5% yoy for 1Q11. This was driven by strong German and French growth. Belgium GDP growth was also stronger than expected at 3.0% yoy. However, weaker economies are struggling. Italian GDP was virtually unchanged, while Portugal showed a decline of 0.6%yoy. The growth split between the core and periphery looks set to widen over the next quarter.

US continues to weaken

Indicators in the US continue to look weaker. The Fed’s Beige Book confirmed the sluggish picture. However, much of the weakness in activity is blamed on supply chain disruption from the Japanese tsunami. This suggests that there could be a recovery in activity later in the year. The report also showed little pass through of recent rises in input costs into inflation. Another interesting indicator was the Job Openings and Labour Survey, which was very weak. This bodes ill for the next employment numbers. The ECRI Leading Indicator declined, suggesting a continuation of the near-term weakness in economic growth.

Beige is the colour

The Beige Book from the Fed is always worth a look to check what is happening in the US economy. Not only does it give a useful snapshot, it forms the base for much Fed thinking on the US economy. Two things are worth pulling out. Firstly, the disruption to supply chains because of the Japanese tsunami is prominently featured. This suggests that the recent weakness in the industrial surveys in the US (or even globally) may reverse in the next few months. If they don’t, then this is evidence of a deeper malaise. My guess is that the ISM will bounce in the next three months and investors will breathe a sigh of relief. How soon? The best thing to do is keep an eye on the regional Fed surveys and the weekly ECRI Leading Indicator. One thing to worry about is that an exogenous shock like Yemen imploding, would catch the global economy at a vulnerable time.

The second feature of the report is that rising input costs do not appear to be broadening out into pervasive inflation. Whether that is a an overly optimistic interpretation is open to question, but if that’s how the Fed sees it, then that suggests the Fed will remain relatively relaxed about inflationary pressures. Speaking of inflationary pressures, the drought in Europe is causing some problems. Harvests are likely to be adversely affected. It is also causing problems for transport and power generation. Following last year’s poor harvests, it couldn’t come at a worse time. A great example of Murphy’s Law.

ISM falters

I warned you that the regional Fed surveys were pointing to a slowdown in manufacturing. The ISM Manufacturing Index dropped sharply yesterday. Time to panic? Perhaps, but if faltering global growth puts downward pressure on commodity prices, then there could be a revival in activity by year end. Keep an eye on the regional Fed surveys and weekly ECRI Leading Indicator, which will give a timely steer.

China attacks Gmail users

More cyber attacks from China. When will the West call a halt to this? US considers retaliation by conventional military strikes:

The Wall Street Journal reported the policy document would classify major cyber-attacks as acts of war, paving the way for possible military retaliation.  The strategy was intended in part as a warning to foes that may try to sabotage the US electricity grid, subways or pipelines, officials said.  “If you shut down our power grid, maybe we will put a missile down one of your smokestacks,” a military official told the newspaper.

Denmark enters recession

Amidst all the wailing and gnashing of teeth about the UK’s weak economic growth, it has been missed that the UK is not alone. Last week we saw that Norway suffered a contraction in 1Q11 GDP. Now we see that Denmark has gone one better (or worse) and has recorded two successive quarters of contraction. Weak consumption is blamed. Danish households, like the UK are heavily indebted. The outlook for UK growth remains weak, in my view.

We now have an end date for the euro

If you haven’t already, I urge you to read Martin Wolf in today’s FT. He refers to a some analysis by Hans-Werner Sinn of the Ifo Institute for Economic Research. His argument is essentially that the ECB by acting as lender of the last resort to the banking system has ended up financing governments. The direct consequence of this is that the Bundesbank has been accumulating claims against other central banks. Prof. Sinn suggests that this process will have to cease within two years. I quote:

“Prof Sinn makes three other points. First, this backdoor way of financing debtor countries cannot continue for very long. By shifting so much of the eurozone’s money creation towards indirect finance of deficit countries, the system has had to withdraw credit from commercial banks in creditor countries. Within two years, he states, the latter will have negative credit positions with their national central banks – in other words, be owed money by them. For this reason, these operations will then have to cease.”

So there you have it. Kicking the can down the road cannot go on for more than two years. 2013 is looking increasingly ominous. Drastic reform of the euro or the end of the system itself is inevitable.