Anyone expecting that the events over the last 24 hours will have changed the persistently negative outlook of one of the original skeptics, will be disappointed. The SocGen strategist falls back to that old time-tested principle in complicated situations: math and logic. His summary of events released this morning: "The increasingly frenzied attempts of eurozone governments to persuade financial markets that they can draw a line under this crisis will ultimately fail – even if this week’s measures bring some short-term relief. I have minimal confidence that governments can turn this around within the confines of the eurozone project. You might be surprised though that I feel more bullish! Why? Both Dylan and I have come to the view that the ECB will be forced, by events, to monetise debt in the GIIPS and beyond. And if investors believe the governments in Spain and Italy are bust, then Germany, France, and not forgetting the UK and US, are far, far worse." To be sure, we may see a brief respite as we get the traditional post-TARP knee jerk reaction, only for markets to digest the sad reality of the situation in the proceeding 48 hours. And what will that imply? To Edwards, it will be nothing short of the realization, that even with €1 trillion (or more), the ECB will have no choice but to commence outright monetization as well. And the real question will be whether or not "Germany, will leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?"
Looking at the macr Edwards, first points out the unsustainable fiscal picture at the "other" countries, assuming one applies the same logic to them as to Italy:
Italy never "enjoyed" a boom to suffer any bust. And on many measures, including reputable attempts to take account of off-balance sheet liabilities, Italian public sector debt fares well on cross-country comparisons (see chart below). These off-balance-sheet liabilities will now increasingly become visible to all. Who then will be really bust?
The complexity of Europe is only exacerbated by the feedback loop with a recessionary America:
Regular readers will know we like to use leading indicators. These have been weakening for some months in the US and elsewhere. We have not highlighted the Economic Cycle Research Institute's (ECRI) weekly leading indicator for some time, although it is as weak now as it was last year. But, unlike last year, this time around the ECRI have put out a rare recession call - link.
Lakshman Achuthan, the ECRI's COO notes that they made the recession call only after an array of economic indicators showed a “pronounced, pervasive and persistent” downturn consistent with a recession. “By contrast, in the summer of 2010, when some market bears interpreted the decline in one of the institute’s indexes as a signal that a recession was in the offing, the institute said the pattern pointed not to recession, but only to weakness.” (Does he mean me? Surely not!) The last time we entered a recession with unemployment this high was back in 1937 (see right-hand chart above). This is indeed a crisis.
Analyst optimism on profits has also slipped sharply recently (see left-hand chart above, optimism defined as EPS upgrades as % of all estimate changes). We find the change in optimism (dotted lines in both charts above) is a good leading indicator for the official leading indicators (see right-hand chart above). This signals continued weakness ahead.
But enough about the rest of the world. The ticking time bomb in Europe is and has always been Italy, and specifically its horrific governance structure.
With Italian 10 year bond yields once again pressing towards 6% in recent weeks, they are definitely still in the eye of the storm. The trigger for this was back in early July, when Italian Prime Minster Berlusconi turned on his well-regarded Economy Minister. Reuters reported on 8 July that "Speculation is growing that Italy's Economy Minister Giulio Tremonti – credited with shielding the country from the eurozone debt crisis – will soon be forced out of government, which would further raise the heat on Italian bonds… Tremonti overcame cabinet resistance to push through a tough austerity programme last week, but now looks increasingly isolated and appears to no longer have the full support of Prime Minister Silvio Berlusconi.
"He thinks he's a genius and everyone else is stupid," Berlusconi said in an interview with Repubblica daily on Friday."He is the only minister who is not a team player," Until this untimely outburst, Italian bonds yields had consistently traded below Spanish yields by about 75bp (see chart below). Now they trade at a clear 50bp premium, with yields once again pushing up close to 6%. Belgium, without a government to speak of (an advantage?), but also suffering from a very high government debt/GDP ratio, has by contrast managed to keep below the market's crisis radar. Italy has been ill-served by its politicians for dragging the country to its knees unnecessarily. It could/should have escaped this debacle.
Albert concludes that "the real issue is Italy's incredibly low productivity growth (see top right-hand chart above). Hence, having been in excess of 2% yoy in the late 1990s, Italy's trend GDP growth rate is now barely positive on Vladimir's estimates (see left-hand chart below) and investment in people is poor (see right-hand chart below). The near-zero trend rate of growth means that Italy simply cannot grow its way out of its debt and will remain highly vulnerable to market shocks."
Furthermore, when looking at the present, one must not ignore the future, and the future hinges on a demographic crunch: "As populations age and
unfunded liabilities increasingly appear on the balance sheet, all governments are effectively bust. Reinhart and Rogoff in their book This Time is Different: A Panoramic View of Eight Centuries of Financial Crises - (link) show that there is no magic public sector debt threshold that determines when a crisis hits. It happens when the markets decides it is time to happen."
And going back full circle to the most recent events, Edwards redirects to a new and interesting question: not whether this bailout attempt will succeed: it won't; not whether the ECB will be forced to step up to the plate and monetize: it will, but whether or not Germany, after being once again overruled by Europe will say enough, and leave the eurozone.
Dylan and I feel more optimistic about the medium term. The current eurozone talks will not solve this crisis and it will get worse - much worse. But we would agree with the well known eurozone commentator, Paul de Grauwe of the Leuven University, who wrote “Everyone needs the ECB to step up to the plate. The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the eurozone.
The ECB will have to choose between its two most cherished ideals: the euro or its hard money principles. Notwithstanding some legal issues to get around and Germany being outvoted, we think the impending threat of a euro break-up will force the ECB to begin printing money, very reluctantly joining in the global QE party. Let's be clear - neither Dylan nor I view ECB monetisation as a "solution". Indeed its actions will mirror those of Rudolf Von
Havenstein, president of the Reichsbank in the early 1920s. He kept printing because he was scared of the mass unemployment that would ensue if he stopped - link. The question for me is not if the ECB will print, but rather will Germany leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?
In other words, as we have been saying for over two years, the fundamental question boils down to whether the opportunity cost of being part of the eurozone and funding the entire continent is greater than the loss of returning to the Deutsche Mark and abandoning the implicit peg which has kept the country's "currency" about 50% lower than its fair value since 1999. Last night's decision will bring the answer that much closer.