Who would have thought it only takes for PIIGS spreads to go back to all time records, and for Ireland and Portugal to be hours away from joining Greece in the bailout corner, for Goldman's Erik Nielsen to turn bearish again. To wit: "if investors are running for the door out of fear of being the last one left behind, then there’ll be a liquidity crisis (as there would be for anyone with a financing need), and they’ll need help." Way to stay ahead of the curve Erik. The problem is that while the economic reality below the surface cracks and collapses, investors are largely ignoring the perpetual words of optimism from Europe's politicians, and sellside cheerleaders (which begs the question - is it time to take this Goldman acknowledgment of reality as a buying opportunity?). What happened in Greece may have been brushed under the carpet for a few months, but the policy response there, which is identical to what is happening in Ireland and Portgula now, i.e., blatant lies, has left those holding relevant securities with a bitter taste in the mouth. And now, unlike before, the possibility of holder haircuts is distinctly on the table. Which is why we expect that before the Asian open, there well may be some key news out of Ireland (and/or Portugal)- no matter how much Nielsen believes that Ireland is not in a solvency crisis, with Bund spreads in the 700 range, no matter how much prefunding the government has, it will be irrelevant and will create yet another toxic debt spiral. The biggest threat is not so much to Ireland, which supposedly has its cash needs met through mid 2011, but contagion hitting other European countries, which do have solvency issues, yet have been spared the liquidity hammer so far. And with Italy CDS also hitting record highs, look for the core to start crumbling as everyone, especially Chiswick's perpetual optimist, to appreciate the gorgeous mushroom cloud over the European periphery.
From Goldman's Erik Nielsen
I’m back in my beloved Chiswick after having been on the road most of this past week; and what a week it was! Here’s the way I see it all:
- It’s been a week of scary spread widening for the periphery mostly due to the uncertainties stemming from the stated policy initiative to include private sector participation in future debt workouts.
- On Thursday, European finance ministers – finally - clarified that this initiative will not apply to existing debt, but whether this is enough to put the genie back in the bottle remains to be seen.
- It is being reported that Ireland has started informal talks with Brussels on a rescue package, but so far there has been no formal request. I summarise my view on how it may all play out.
- French PM Fillon submitted his resignation yesterday; a cabinet reshuffle is likely later today or tomorrow.
- On the data front it was a quiet week generally lending support to our constructive pan-European views.
- Tuesday-Wednesday will see the Eurogroup and Ecofin meetings; an opportunity to express support for the periphery, if that has not happened before then, but formal agreement on a package will take longer. Also look out for politics in Italy.
- On the data front we’ll get inflation and trade numbers out of the Euro-zone this coming week; not that exciting although we’ll be hitting the ECB’s target of 1.9%.
- The UK also prints inflation this week along with labour market and retail numbers. And we’ll get the MPC minutes – and loads of MPC talk.
- And Switzerland prints inflation - and trade - data this week.
-1 What started as confusion among investors about a sentence in Merkel and Sarkozy’s communiqué from Deauville in mid-October referring to the participation of private creditors in future debt workouts (after the Treaty has been changed by 2013) escalated to real market worries after the Council approved this language in late October. It was clearly a grand political statement of intentions rather than a concrete proposal taking into considerations the umpteen legal and practical issues involved in marrying such an approach with the need to keep the process orderly, but it spooked the market and raised a lot of unnecessary uncertainty. I am sure that this problem was being conveyed to the policymakers from many sides. On Wednesday, I had a piece in the FT highlighting some of the complexities, concluding that “the sooner Van Rompuy and his team – and the rest of the political leadership – clarify these complex practical and legal issues, the sooner premiums on peripheral sovereign issuance will evaporate. Otherwise the peripheral countries could see their borrowing costs hit levels not seen since the Greek rescue, in effect, shutting them off from commercial borrowing – hence forcing them to rely on the existing rescue facilities.” When LCH.Clearnet imposed substantial margins on Irish bonds things turned outright scary because of the possible effects of the sovereign spread-widening onto the financial sector.
-2 Facing mayhem in the periphery, the finance ministers of France, Germany, Italy, Spain and the UK issued a statement on Thursday saying that considerations for private creditor participation “does not apply to any outstanding debt and any programme under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements”, which – at least for now – seemed to put the genie back into the bottle. (Btw, can anyone explain to me why the UK was part of this press release after having made explicitly clear earlier this year that this crisis is none of their business since it’s all Euro-zone related – this was the explanation given for why the UK would not participate in financing the Greek package and the EFSF? – Am I just being confused, or doesn’t it seem a bit odd for someone refusing to be part of the official financing to be part of the clarification that there’ll be no private sector (which includes UK institutions) participation in the debt work-outs?)
-3 Ireland is reported to have started informal conversations with the Commission on a support program, and an unnamed German official is quoted today saying that Germany is encouraging Ireland to tap the facility to help further calm markets. I apologise for not being able to take very many calls (or answer the many emails) Thursday-Friday when I was travelling, but my views on how all this may play out has not changed the last few weeks (i.e. after I realised that our original view on Ireland was too optimistic.) To recoup: the Irish government is fully funded – with no borrowing needs at all – until mid-2011. They are in the midst of budget negotiations which should be done by December 7. If they were to breakdown before then, pressure on Irish spreads would surely widen further, putting the country further at risk. If the budget gets through, then I suspect the original Irish game-plan was to spend the next couple of months convincing markets that things are back on track before they restart the government borrowing sometime late winter/early spring. This could include the involvement of some of their domestic resources, but I tend to doubt it. Given its own strong cash position, the spread widening has no immediate or direct effect on the government, but the part of the private sector with financing needs will be hurt, of course, and this degree of market stress will increase the risk for the financial system as a whole (well beyond the benefits stemming from the weaker euro.) And it may be fuelling the spread widening for other countries as well. In other words, whether (or when – if before early summer) the Irish government seeks financial help from the EU and IMF is a purely political decision on the back of an assessment of the broader risk of the spread levels to economic and financial stability.
-4 There has been no official request for help so far, but if the Irish want it, there can be no question that they’ll get it without much trouble; i.e. no need for long negotiations on conditionality. As I have argued throughout this year, their policy adjustments have been impressive, and apart from the valuations of assets transferred to Nama (which triggered the beginning of the sell-off – but was that really bad for the government balance sheets?), I am not really aware of any material macro or political news that would justify the present spreads. But that said, if investors are running for the door out of fear of being the last one left behind, then there’ll be a liquidity crisis (as there would be for anyone with a financing need), and they’ll need help. In my book, this is not a solvency crisis, and the government’s policies are surely not far off what the Commission and the IMF would demand in return for a loan (which would eliminate the need for private funding for the next 2-3 years.) The Commission – and fellow Euro-zone members – will surely ask the Irish to raise their corporate tax rate, but the Irish will resist, although they may end up with some sort of “gentlemen’s agreement” to move in that direction over the medium term. IMF programs (and surely EU-IMF programs as well) do not set specific detailed fiscal policy measures, but more general frameworks. That said, the Euro-zone will need towards greater tax harmonization, and while Ireland has fought this for a long time, the power is naturally now shifting to those providing the bail-out. Importantly, with or without a facility to include private creditors in a debt workout in the future, this would not apply to a liquidity crisis like the Irish.
-5 Portugal is quite different from Ireland. The 2011 budget is further ahead (and the deficit is smaller), but their financing needs are more acute, and they are facing some significant amortizations in April and June (two times €4.5-5.0bn) which will require measurable borrowings before then (Portugal does not publish their cash holdings, so we don’t know their exact needs.) Like for Ireland, a decision to ask for help is a political one, but given their ongoing borrowing needs, the present spreads hurt the budget process directly. Also, if they were to ask for help, negotiations on the underlying policy conditionality would likely be more complicated than for Ireland because of the need for much more wide-reaching structural reforms in Portugal (but do-able, of course.) While I haven’t seen any reports on it, I rather suspect that the Commission is reaching out to Lisbon this weekend to encourage a more detailed discussion of a Plan B on Tuesday. In spite of their differences, if (when) Ireland or Portugal officially seeks help, it can only be in everyone’s interest to start the process for the other country at the same time.
-6 Following months of speculation and hints, yesterday French PM Fillon submitted his resignation to president Sarkozy. A cabinet reshuffle is likely to be announced later today or tomorrow. The key objective will be for Sarkozy to re-energise his government for the last 15 months of his presidency and create a stronger platform for himself from which to run for re-election in 2012. We do not think it’ll have material impact on domestic policies relevant for investors. A number of commentators have suggested that Fillon may be re-appointed as the safe pair of hands he is on the domestic front, leaving Sarkozy the necessary time to roam on the global stage as chairman of G20. Lagarde has been mentioned as a possible new foreign minister, unless she stays in her present position.
-7 In terms of data, this past week was dominated by the key Euro-zone GDP numbers for Q3, coming in at the expected +0.4%qoq (non-annualised), driven largely by Germany (+0.7%), while Spain delivered a respectful flat number. The German locomotive helped several others perform well; the Czech Republic and Hungary reported Q3 GDP growth of 1.1% qoq, non-annualised, and 0.8%, respectively. We also got industrial production numbers for September, and for this volatile series, the third quarter ended relatively poorly for the Euro-zone, erasing much of the strong gains in previous months, bringing us back to our estimated trend-line. Quarter-on-quarter, IP was up 0.4% (non-annualised.) As I discussed last week, the early indicators for Q4 are looking good, suggesting some (moderate) upside risk to our +0.3% Q4 GDP forecast; +0.3% Q4 growth would give us our full-year 1.7% growth number (which I was laughed out of the room on on more than one occasion when we launched it earlier this year - Dirk Schumacher discussed these numbers in greater detail in Thursday’s European Weekly Analyst, and we’ll publish revised 2011 and new 2012 forecasts in early December.)
Turning to this coming week:
-8 In the Euro-zone, the highlight will be the Eurogroup meeting on Tuesday, followed by the Ecofin on Wednesday. It’ll obviously be an excellent opportunity to express support and solidarity with the crisis-hit periphery, if they don’t do so even before Tuesday, but I rather doubt it’ll be more than that. As discussed above, I think we are still some way away from a formal announcement of official financing being launched – but this is, of course, pure guessing on my part because, the Irish government does not need the money for several months so its all a political decision. Also on the political side, it’ll be important to keep an eye on Italy. Last Thursday Future and Liberty Party head Fini refused to a proposed cabinet reshuffle without Berlusconi first resigning and an aid to Fini then said that the Future and Liberty Party will pull out of the coalition this coming week; the press reports that the resignation letters are already on his desk. The crisis may lead to either a reshuffle of the cabinet or it could lead to early elections. Either way, we do not think it’ll impact the 2011 budget process or outcome.
-9 In terms of data releases, it’ll be an extremely light week in the Euro-zone. We’ll start Monday with September trade data. They have an EMEA-relevance score of zero, so our interest is more in terms of the growth rates for exports and imports. The shift in Q2 from Euro-zone growth being primarily export driven to primarily domestic demand driven was accompanied by stronger import growth (than export growth), opening up a (still small) trade deficit, so it’ll be interesting to see if that remained the case as Q3 closed. Then on Tuesday we’ll get the full inflation report for October; the flash estimate showed an increase in headline inflation to 1.9%yoy (from 1.8%), so the news will relate to the underlying components, specifically core inflation which we think has remained stable at 1.0% before moving gradually higher towards the end of the year. On a normal reaction function, the ECB should already be well into its exit, but – like other central banks – normal reaction functions seem a curiosity of the past these days, so it’ll come slowly during 2011’H1, we think. Finally, Eurostat is set to publish 2009 Greek deficit and debt figures on Monday, and the Troika will discuss the Greek loan program – I’m sure this will attract considerable attention, comments and questions, but we are nowhere near a place where the program is in trouble.
-10 In the UK, we are heading into a week of CPI inflation (Tuesday), unemployment and wages (Wednesday) and retail sales (Thursday). We expect inflation to have eased to 3.0%yoy in October (from 3.1%) mostly due to base effects, although food and energy prices moved higher in October (and a major provider has just announced a big jump in retail gas prices in November), so one shouldn’t get carried away here; these elevated inflation levels seem likely to be around for a long time. We are in line on unemployment and earnings growth (7.7% and 2.3% respectively) and slightly above on retail sales (0.5%mom versus 0.2%). Wednesday also sees the release of the minutes of the MPC’s November meeting. The consensus expectation is for an 8-1 vote in favour of unchanged policy; we’d be surprised if Adam Posen reversed his vote for more QE after only one meeting. In any event, as Ben Broadbent has pointed out, it’ll be more important to watch for any shift in the general tone of the minutes, in particular, to see whether the sentence depicting the dovish bias of the Committee – “some members felt the likelihood that further monetary stimulus would become necessary had risen in recent months” – is retained. Released alongside the minutes are the monthly Agents’ survey and, as is usual a week after the Inflation Report, the detailed numbers behind the MPC’s latest set of forecasts. It’s also usual to see a spate of MPC speeches after the purdah of the quarterly forecasting round and we get three – Weale on Monday, Posen on Thursday, Tucker on Friday. Tucker and Dale also give evidence to the House of Lords Economic Affairs Committee on Tuesday afternoon.
-11 In Switzerland, we’ll get producer and import price inflation for October on Monday and trade data (also for October) on Thursday. We expect the headline Supply Price Index to jump to 0.8%yoy (from 0.3%) on the back of a massive base effect. The key component to watch will be import prices, for any evidence of further disinflation as a result of CHF appreciation. The trade data will be important to watch in case the trend line (in a volatile series) for exports were to continue its softening into the end of the year.
… and that’s the way it all looks to me on this lovely mid-November day in Chiswick. I somehow feel that I’ll be writing more emails to you this coming week, but for now I’ll be heading to the High Street for my (belated) morning coffee.
Erik F. Nielsen
Chief European Economist