While the catalyst for much of the recent rally in risk assets seems to have been on the back of Europe clambering back from the edge of the abyss (and admittedly hope for better global growth and US decoupling), JPMorgan's Michael Cembalest notes that Europe remains very much an Achilles Heel going forward. With former ECB member Stark's recent comments on the already 'shocking' quality of the ECB's balance sheet, it is the outflows (or net balance of payments) from the periphery that means the ECB will simply have to keep printing. ECB funding of Spanish and Italian banks is still a relatively small part of their liabilities and should we see even a crack in the resilience of these knife-sitting nations, the retail depositors, bondholders, and non-local wholesale/retail money is unlikely to stay put (especially if there is the continued lack of growth that seems inevitable). The latest Spanish data is dreadful, as Cembalest notes, but the economic situation in France remains weak and while JPM's analysis looks for a gradual closure of the periphery's current account deficit by 2015, the ECB's need to finance the gap in the interim raises a critical question. Since the ECB's printing has boosted the US stock market primarily, will the Fed now take the lead and return the favor (QE3 or more) to help its European partners grow their (net trade) way out of this hole?
J.P.Morgan's Michael Cembalest
While Europe was the primary catalyst for the rally since November, it remains an Achilles heel. ECB repo operations have been life-savers for European governments and banks, but will Europe keep printing its way out? Bundesbank head Jens Weidmann reportedly sent a strongly-worded letter to ECB head Mario Draghi regarding Germany’s concerns about ECB financing being permanent, and on declining ECB collateral standards. Former German ECB member Stark chimed in this week, calling the quality of the ECB’s balance sheet “shocking”. However, I am inclined to view Weidmann as a paper tiger, and not just because he sent his letter after ECB operations already took place. Why believe Weidmann would be any more successful in changing ECB policy after 2 German predecessors already resigned from the ECB over the same thing?
Here’s what Weidmann is up against: the ECB may need to print a LOT more. I asked our Chief Economist Michael Vaknin to convert what the ECB is doing into a single chart (above). The bars in the chart above show the net balance of payments in the periphery, combining their current account and capital account deficits; money has been flooding out. The red triangles show how much of these outflows were financed by the ECB. There would probably already have been a banking crisis/default had these rescue operations not taken place. There may be a lot more left for the ECB to finance; our estimates of future outflows are the yellow bars (We assume a gradual closure of the periphery’s current account deficit by 2015 (through further improvements in net trade), but that the ECB has to finance the gap in the interim. For the capital account, we assume that foreign lenders only roll half of their maturing positions). Will the ECB keep printing? We think they will, but this issue admittedly lies beyond the scope of fundamental investing.
Here’s another way to think about how much heavy lifting the ECB may still have to do. As shown above, despite 645 billion Euros in emergency lending to periphery banks since 2009, the ECB still represents a small portion of bank borrowing in Italy and Spain. Assume that retail depositors stay put, as do local interbank lenders. What about bondholders and non-local wholesale/retail money; will they keep leaving? It might depend on whether Europe starts growing again. Here, the news is mixed at best. The latest from Spain is dreadful, but enough of that; let’s focus on France instead.
The economic momentum in France is only modestly better heading into the election. Sarkozy has trailed Hollande consistently in second-round polling since January, by 56 to 44. The debates may change that, but as things stand now, Hollande is in the lead, and promises to shelve Maastricht 2.0 and start from scratch. A Merkel-Hollande summit would be worth the price of admission, that’s for sure. Current IMF and OECD forecasts for French growth this year round to zero, which sounds about right given the data above.