As Europe continues shouldering the burden of the devaluing dollar, courtesy of a Euro that just wont quit, even as the Eurozone is constantly putting out fires in its own backyard (Greece, Hypo, Latvia, ongoing downgrades), the optimism over European prospects is now more pervasive than ever. In a report titled "Key Surprises for 2010" Morgan Stanley's ever insightful Teun Draaisma has attempted to present the intangibles: the unquantifiable risks. As he points out "if there is a lesson the markets keep telling us, it is the persistence of uncertainty. Unlike risks, which are known and measurable, uncertainty is difficult to calibrate. We can never know the exact payoff distribution for any given investment." In order to conceptualize the 4 key areas of possible systematic impact, the strategist has provided 4 main scenarios he believes may shape equity returns over the coming year in a downside case.
And while the favorable surprises are relevant, but never as important in making investment decisions, Teun's four axis of downside "surprise" are the following:
- A late-cycle credit crunch seriously curtails access to bank lending in the non-financial sector.
- Brisk growth in emerging economies and/or renewed supply set-backs causes another spike in commodity prices.
- Ample liquidity helps to keep government bond yields subdued, notwithstanding massive debt issuance.
- Country-specific political risks replace systemic risk concerns in driving intra-EMU spreads, but matter less than expected in the UK.
Some more detail from the Morgan Stanley strategist:
Our base case for the euro area economy in 2010 is that of a lacklustre, sub-par cyclical recovery, subdued consumer price inflation and a hesitant removal of policy stimulus in the second half of the year. We and the consensus expect the European economy to expand by around 1% next year, thus recovering only some of the ground lost when the currency union plunged into the deepest recession in post-war history. With capacity utilisation still extremely low and unemployment set to rise until the second half of 2010, domestic demand dynamics will likely remain rather muted. Overall, we believe that the risks to our baseline forecasts are broadly balanced.
Surprise #1: A late-cycle credit crunch seriously curtails access to bank lending, causing the recovery in investment spending to falter.
A year ago, everyone (ourselves included) talked about the credit crunch as a serious risk to the economic outlook. But, what we were debating at the time should probably have been more accurately labelled a liquidity crunch for banks and corporates in funding markets. Since then, credit spreads have come in sharply, corporate debt and more recently equity issuance have surged, and financial institutions have been propped up by a variety of government measures. Lately, euro area and UK banks have projected looser credit standards. Effective interest rates on loans have been falling for a while. Our banks team believes that the provisioning cycle has likely peaked. And we ourselves have played down the fact that bank lending is falling on a year-on-year basis, arguing that much of the drop is due to a fall in demand. At this stage, this is probably largely true. But, it could change when the recovery in corporate spending gets under way. While companies will initially be able to draw on internal cash flows, eventually they will likely need external funds to bump up investment spending – even if it is largely to repair and replace – and possibly also for re-stocking. If they cannot obtain these funds, the rebound in activity following a turnaround in the inventory cycle could quickly
At this (vulnerable) stage of the recovery in euro-area domestic demand, the yet-to-be crystallised write-downs, timid recapitalisation and excessive reliance on ECB funding might backfire in a financial system that is still largely bankbased. Such a credit crunch could potentially be a particular problem in Germany, which ironically is the only large euroarea country that deleveraged in recent years and which – as its current account surplus shows – enjoys a funding overhang from domestic savings. A credit crunch would spell bad news for growth in the near and medium term and would likely hit investment spending hard. More prolonged feedback effects between bank profitability and economic growth in bank-based financial systems could make the credit crunch a constant feature weighing on euro-area growth in the coming years. In contrast to the earlier liquidity crunch, there would be little that the ECB could do, for it cannot boost banks’ equity capital buffers. This would need to come from either governments or private investors. Without decisive government action, we would not be able to rule out that euro area banks just shrink their loan books.
It is also plausible that we see a similar dynamic in the UK. UK companies de-stocked rapidly and reduced investment sharply over this recession, but even an inventory-led subpar recovery in the UK could be held back by limited lending availability and higher cost of loans. Quantitative easing has helped to improve conditions for corporate issuance, the government has injected substantial amounts of capital into UK banks, and other Bank of England and government support programmes such as the Special Liquidity Scheme and the Credit Guarantee Scheme have eased funding conditions for banks. UK banks also indicated improvements in credit availability earlier than in the euro area. However, these support programmes will roll off over the next two to three years, so banks will look increasingly to wean themselves off these programmes. Banks have also been lengthening the maturity (and increasing the cost) of their funding. There is still a significant funding gap (customer
loans less customer deposits). These factors, as well as potential regulatory concerns and changes, may weigh on credit availability and increase the cost of that credit, even as the UK domestic economy shows increasing signs of life.
Surprise 2: Emerging economies expanding at a brisk pace and/or renewed supply setbacks fuel another spike in commodity prices.
In this scenario, a spike in commodity prices would put additional pressure on companies’ profit margins, eat into consumers’ purchasing power and potentially force central banks to hike interest rates earlier than expected if higher commodity price inflation spills over into higher inflation expectations. As a result, the composition of nominal growth would likely become more much stagflationary again, at least initially. The commodity price spike could be triggered by further upside surprises on growth, especially in EM, on the back of the unprecedented monetary and fiscal stimulus that has been put into place globally, or by a disruption in the supply chain, say, due to geopolitical events. For example, the price of oil might rise noticeably through the $100/bbl mark, in line with our commodity strategists’ bull case and above the $81/bbl implied by the forward curve. Such an overshoot would hit commodity importers particularly hard, such as virtually all the European countries with the exception of Norway and (to a much lesser degree) the UK.
Although this implies stronger European exports to commodity producers, the overall effect on economic activity would be detrimental, for three reasons. First, European companies would face significant pressure on profit margins, which are already under stress, as employment and hence labour costs have not fallen a great deal. Second, European consumers would need to tighten their belts even further, as was the case during the 2008 commodity-driven inflation shock. Third, the feed-through of higher commodity prices into inflation might push inflation expectations – which have remained relatively well-behaved for now – higher. As a result, central bankers could be forced to move earlier and more boldly than our base case forecasts show.
If central bankers didn’t act to anchor inflation expectations, a sharp rise in bond yields could equally derail the recovery. In this scenario, money markets would probably start to price in earlier and more aggressive tightening, and risky asset markets would probably be affected too. A sharper tightening of monetary policy – especially if coupled with faster fiscal consolidation in the face of rising interest payments – might well push the European economy into another (this time policy-induced) recession. Eventually, the commodity price shock would likely add to renewed deflationary pressures.
Surprise #3: Ample liquidity keeps government bond yields subdued, notwithstanding massive debt issuance.
Consensus is forecasting benchmark ten-year Bund yields to reach 3.8% in late 2010, some 60bp above the current level of 3.16%. We are even more bearish on bonds and forecast ten-year Bunds to break above 4% in 2H 2010. Our interest strategy team would be short the long-end and long forwardcurve steepeners (see 2010 Global Interest Rate Outlook, November 30). The reasons for rising bond yields are not difficult to find: ongoing economic recovery, abating deflation risks, and tightening monetary policy (through traditional interest rate hikes and unwinding unconventional quantitative easing). In the UK, on top of these factors is a strong issuance backdrop and, from February, likely without the offset of Bank of England asset purchases.
The wildcard in all of this is to what extent the unprecedented excess liquidity created by central banks globally in the past year and still sloshing around the global financial system could find its way into the government bond market. In the euro area, additional demand has come largely from banks, which have added €330bn to their government bond holdings since October 2008. With monetary policy still expansionary and policy rates potentially staying low for longer than our base case forecasts show, government bonds might actually be better bid. Additional demand for bonds could come from asset reallocation away from risky assets and from looming bank regulation on liquidity buffers (the latter particularly likely to provide a natural buyer of bonds in the UK). Finally, if a credit crunch causes deflationary concerns to resurface, bond yields could potentially fall further from current levels – as they did in Japan in the 1990s.
Surprise #4: Country-specific political risks replace systemic risk concerns as a driver of spreads in the euro area, but may matter less than expected in the UK.
In 2009, spreads in the euro-area periphery were characterised by a very high degree of co-movement, suggesting that systemic concerns were the main driver. Next year, the focus could swing towards country-specific issues. None of the euro-area countries has the option of inflating their way out, something that is still possible for EMU ‘outs’. We would argue that the ability of countries to address the fiscal policy challenges ahead crucially depends on the institutions. Of course, these challenges also differ between countries, depending on their fiscal position before the crisis, how hard they were hit by the crisis, and the size of subsequent stimulus packages. But to what extent they can be tackled successfully will very much depend on the institutional set-up. For starters, the extent to which the electoral system generates clear political mandates to reign in budget deficits is important. Where the system generates fragmented coalitions or hung parliaments, matters become more complicated. Whether a clear mandate can be executed also depends on the degree of administrative centralisation. Countries with a federalist structure – one that grants financial independence to lower levels of the administration – might find it harder to successfully implement their budget plans (for example, Germany).
In our view, rich developed countries would only experience a sovereign debt crisis if they became unable to act because of a political stalemate or unwilling to act because the costs of doing so were deemed higher than the benefits. The latter is especially relevant within the euro area, where the disciplining effect of a potential currency crisis is absent. In this case, often a sizeable share of securities held in other euro-area countries and substantial spill-over effects onto the borrowing costs of other countries create incentives for looser policy. Outside the euro area, a sovereign debt crisis could call the independence of the local central bank into question. Within the euro area, the ECB’s independence might be put to the test if the government debt of one country were to become in danger of not making the A- cut-off for eligible collateral when it reverted back to the pre-crisis pool at the end of 2010.
In the UK, fiscal policy looks set to be at the heart of party platforms for 2010’s general election (which needs to be held by early June at the latest). Recent polls suggest the election could result in a hung parliament (relatively unusual in the UK), although a lot can still change. This indicates plenty of scope for political and policy surprises in 2010. Our equity strategists outline one way in which the election and fiscal situation could result in a ‘surprise’ outcome for the UK. We would outline another: despite a hung parliament, a strong coalition in favour of significant further fiscal tightening emerges and this satisfies markets (and ratings agencies).After all, other countries live with coalition governments and this does not preclude policy action.
The UK’s relatively centralized system of setting government spending (and taxation) allows the coalition to start making progress on fiscal tightening, and a consensus emerges that the UK will successfully and significantly reduce its deficit. Indeed, the UK starts to look in better shape on this front than several of its peers, where fiscal policy tightening is not forthcoming. The government uses the opportunity to tackle longer-term fiscal issues related to aging ahead of other economies. Public expenditure declines as a share of GDP, accompanied by still very loose monetary policy, leading
analysts to raise their growth estimates. Market concerns about fiscal issues in the UK fade rapidly relative to other economies. A lot of ‘ifs’ to be sure, but a scenario we think investors could come to take more seriously.
Obviously these 4 considerations are not endemic to the eurozone: with liquidity and credit issue still a major concern in the US, the political climate could just as easily become a key unknown variable domestically, especially ahead of mid-term elections. With negative trends in unemployment slowing no signs of abating (sorry Steve Liesman) this has become the biggest bogeyman for Obama and his economic team. And could just as easily be the catalyst that ends up resulting in a very different political composition in the US legislative one year from now. Nonetheless, with optimism all around, it would be great to see a comparable report that attempts to capture the "what ifs" in America. After all, the US has shown that when it comes to screwing up the economy, the Federal Reserve still has to meet its match.