Authored by Nicholas Spiro (Spiro Sovereign Strategy) and Nick Stamenkovic (RIA Capital Markets) via Bloomberg Briefs [10],
With yields at record lows, it is all too easy to suggest that 'Europe is fixed' especially if you are a European leader, but that is not the case...
There are grounds for optimism about Europe’s single currency area. Yet beneath the surface of favorable sentiment towards the euro zone, the seeds of the next financial crisis are being sown.
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On the economic front, while Spain may be staging a brisker-than-expected recovery, Italy will struggle to post growth in the second quarter while private sector output in France continues to contract, exacerbated by rigid labour markets and deteriorating competitiveness. The lackluster and patchy recovery in the bloc will ensure that the specter of deflation lingers, boding ill for the region’s debt dynamics.
The deterioration in the fiscal fundamentals of Portugal and Spain, in particular, is deeply worrying in a deflationary environment.
But in fact - the situatiuon has got far worse, far more systemically worrisome, and far more fragile...
Since the first quarter of 2010, when the euro-zone financial crisis erupted, the public debt-to-GDP ratios of the two economies have risen by a staggering 48 and 40 percentage points, respectively, to 133 percent and 97 percent — increases which are more or less on a par with the surge in public indebtedness in Ireland.
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Concerns about debt sustainability in the periphery of the euro zone throw the failure to sever the pernicious links between vulnerable banks and sovereigns into sharp relief. The euro zone is caught between the Scylla of intense political and fiscal pressure for an end to taxpayerfunded bank bailouts and the Charybdis of fear that the proposed shift from a “bail-out” to a “bail-in” regime for troubled lenders will unsettle markets.
This dangerous predicament is likely to become more pronounced as investors start fretting about more “skeletons in the closet” in the run-up to the publication of the results of the European Central Bank’s closely watched Asset Quality Review in the autumn.
As Spiro and Stamenkovic conclude:
If markets connected all these dots — a weak and fragile economic recovery, the failure to break the “doom loop” between banks and sovereigns and, most importantly, scant prospect of a more secure political and economic union — the glaring disconnect between asset prices and underlying fundamentals in the euro zone would be a source of much greater concern.
And even Draghi is starting to realize the limits of his omnipotence...
It should set alarm bells ringing that the ECB itself, whose pledge to support the debt markets of the euro zone (and keep the door open to full-scale quantitative easing) continues to underpin sentiment, is increasingly worried about the lack of integration in the bloc.
President Mario Draghi’s call in London on July 9 for a new economic governance regime to force euro-zone members — in particular France and Italy — to implement structural reforms is a tacit admission from the ECB that its policies are unable to fix the underlying problems of Europe’s ill-managed single-currency area.
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Nicholas Spiro is managing director of Spiro Sovereign Strategy and Nick Stamenkovic is macro strategist at RIA Capital Markets.
