Whither the Eurozone? The Outlook for the Second Half of 2012
Europe needs more than patchwork solutions to a systemic crisis; developing real solutions to the eurozone’s woes will be politically tricky, but the success of leaders in this endeavor will shape the direction of financial markets and the future of the eurozone.
The drama surrounding the Greek election is over, and the victors have managed to form a coalition that is committed to remaining within the eurozone, and – at least in theory – willing to embrace the austerity measures the country’s fellow eurozone members demand as the price of Greece’s continued participation in the common currency.
But the Greek elections, like so many other milestones in the nearly three-year long unfolding of the European sovereign debt crisis, is merely another interim step. It resolves little, and, like the various bailouts and other measures taken to contain the prospect of a full-blown global market panic, is merely a band-aid slapped onto a wound. It’s not a solution; not a cure for the eurozone’s underlying woes: the fact that debt loads are unsustainably high.
In the years leading up to the crisis hitting the headlines, debt levels within many of the eurozone nations, particularly those on the periphery, were rising rapidly, as seen in the chart above. What is often lost in the debate today, when the crisis is simply dubbed the eurozone’s debt problem, is that the reasons for this surge in indebtedness varied. In Ireland and Spain, for instance, government finances appeared to be in generally good shape pre-crisis, as visible in the chart below. Only in hindsight was it clear that much of that growth was financed by unsustainable levels of bank lending – and when the wheels came off global growth following the financial crisis of 2008, banking sector collapses contributed tremendously to the government debt problems of both nations. Ireland was forced to bail out its own banks, and a bailout of Spain’s financial system is just getting underway. It remains to be seen how much bank debt will end up as a de facto liability of the Spanish government, but until now, despite the country’s acute economic problems (including the eurozone’s highest unemployment rate, close to 25%), the ratio of government debt to GDP hasn’t been as troubling as in, say, Italy.
In Italy, the problem has been that the country’s growth has been consistently sluggish even as its economy has remained tremendously uncompetitive vis a vis its eurozone rivals. That proved a toxic combination, and when anxious bond investors began demanding higher yields in exchange for what they saw as the heightened risk of owning Italian government debt, EU leaders began to worry that the crisis could simply escape any efforts to control it. It’s one thing to propose bailouts of Greece, Ireland or Portugal; another matter altogether to ponder doing so for Italy, the eurozone’s third-largest economy, boasting a debt load in excess of two trillion euros. Italian bond yields have flirted periodically with the critical 7% level: the point at which a government is believed to find it impossible to access the global capital markets. (The Greece problem proved particularly intractable, as it was a mixture of the worst of all possible worlds: a lack of competitiveness and slow growth exacerbated by the excessive debt levels at all levels of the economy.)
There’s no perfect quantitative “measure” of the crisis and its impact on other markets, but measuring the relationship between changes in the spread between yields on the Italian bonds and comparable German Bunds and changes in the Standard & Poor’s 500 index. When that Italian bond spread widens and the S&P 500 falls on the same day, the correlation is a negative one. As can be seen from the chart below, which examines that relationship over a rolling 60-day period, during the pre-crisis period, the correlation was essentially zero, signifying that there was no link between what happened to U.S. stocks and movement in Italian bond prices. Since 2010, as the crisis has only deepened, the correlation has turned negative and stayed there. Indeed, it has only become more negative in recent months, reflecting the widespread “risk off” sentiment that has gripped global financial markets and intensified as the crisis in Greek politics and the Spanish banking system reached a peak.
The events in the eurozone – and the seeming inability of eurozone policymakers to come to grips with the root causes of the crisis – has caused ripples to spread well beyond the eurozone itself and into global markets. Europe is a major trading partner of companies and nations worldwide, accounting for a heft share of exports and imports from China, for instance. Unsurprisingly, as the chart below demonstrates, the global banking sector has been singled out for punishment; share prices there have been most correlated with these various measures of eurozone stress. Other industries most heavily affected by the crisis are those that are commonly seen as economically cyclical in nature: the construction, energy and chemicals businesses, for instance. Meanwhile, those that remain more skewed to domestic markets – health care, for instance, or even parts of the retail industry – have been able to provide investors with some kind of protection from the eurozone storm. The third column shows which market sectors respond most closely to the measure of the movement in Italian bond yields relative to yields on Germany’s 10-year bund.
What lies ahead is the question on everyone’s mind, given the potential for the eurozone crisis to become a global one. A greater degree of fiscal policy integration has been proposed and is on the way to being ratified by eurozone members – that will certainly help reduce the possibility of a repetition of the recent events. But eurozone members must agree on a way to strike a balance between austerity and growth; already, it has become clear that austerity alone isn’t going to help Greece get back on its feet any time soon. The political rhetoric is starting to become uglier, too; as François Hollande, the newly-elected French president, proposed raising taxes on the country’s richest citizens to help finance his stimulus initiatives, his British counterpart, Prime Minister David Cameron said he’s be happy to welcome any French tax exiles in Britain, which has just lowered its top tax rate. In a particularly shocking move, Ewald Nowotny, an Austrian member of the governing council of the European Central Bank and head of Austria’s own national bank, spoke out at a conference early this week in defiance of what he called “single-minded austerity policy”, noting that similar strategies in the 1930s contributed to the rise of Nazism. Nowotny is now backpedalling furiously to contain the furor he triggered, saying that he didn’t mean to say what he did, but the comment itself remains an example of how acute political tensions are surrounding what is ostensibly an economic problem.
One option commanding more attention of late is the question of debt “mutualization” – the pooling and joint underwriting of the eurozone’s collective debt load. Backed by, among others, European Commission President Jose Manuel Barroso, the idea flows from the fact that when viewed in aggregate, eurozone debt levels are manageable. But will the “core” nations, who have patted themselves on the back for their fiscal prudence, be willing to pool their debt with those on the periphery? Essentially, voters in Germany, the Netherlands, Finland and other nations will see this as simply another form of bailout or subsidy. The International Monetary Fund has argued that losses of national sovereignty are inevitable if the eurozone is to be salvaged, and said that such risk-sharing across the eurozone may make austerity plans and other unpalatable but necessary economic policies imposed on the periphery more digestible. For now, the only measures that seem likely to have relatively low hurdles to being accepted are those involving more rate cuts, or a new round of LTRO, the “Long Term Refinancing Option” aimed at boosting liquidity within the banking system that has been seen as the eurozone’s functional equivalent of quantitative easing in the United States. The problem is that those measures aimed at resolving the eurozone debt crisis that are real game-changers – such as a banking union or fiscal union – will require major changes in national and EU legislation that may be politically impossible in various eurozone nations.
Germany, as the eurozone’s de facto strong man, is attracting a great deal of attention of all kinds, as well as political rhetoric, these days. Today Germany and Greece will go head to head – on the football field, at least. Germany is hoping to snatch the right to advance to the semifinals of this year’s Euro 2012 soccer tournament away from the Greeks, just as they have laid down the law on Greek economic policies as the eurozone’s largest creditor nation. Even the German finance minister – who opposes any concessions on austerity – was quoted in a newspaper interview as predicting a German triumph.
Regardless of whether Germany’s team manages to outplay and out-score their Greek rivals (you can follow the action beginning at 2:30 p.m. ET; 7:30 p.m. GMT), it seems probable in the eyes of many analysts that German markets will emerge as eurozone winners. Already, those analysts are clearly displaying their preference for German securities: as discussed in another article earlier this week on AlphaNow, analysts worldwide have “buy” or “strong buy” ratings on 55% of all German equities, even as they recommend selling a mere 13% of German stocks. The expectations gap for corporate earnings from German companies and their counterparts in Spain and Italy continues to widen, as shown in the chart below; German businesses will benefit from rock-bottom lending rates even as borrowing costs soar for their Spanish and Italian counterparts.
But is it possible that this scenario already is priced into the German stock market? Certainly, German equities have outperformed their peers on the periphery of the eurozone, as the chart below shows, suggesting that this trade may be a very crowded one.
And some German data has begun to show signs that the country’s economy isn’t immune from what is happening elsewhere in the eurozone and has begun to weaken. For instance, PMI data released in Germany Thursday showed that the manufacturing sector contracted at the fastest rate seen in three years, even as the service sector posted its lowest reading in seven months, barely expanding.
How an investor decides to approach investing in the eurozone in the second half of 2012 and beyond may well be determined by how he or she views the prospects of the countries in the region finally banding together to devise a sweeping resolution of the crisis – one that likely would have to involve Germany and other members of the “core” taking on an additional burden in the form of debt-sharing or other measures. If the region’s leaders feel desperate or determined enough, such a move might lead to a big reversal in the “go long Germany/go short Spain” trade that has been so profitable for so many hedge funds and others for so long. On the other hand, if the next six months bring simply “more of the same”, with Germany taking a firm stand and refusing to budge, then financial markets likely will continue to lurch forward from one crisis to the next, combatting each fresh potential disaster as it arises. It will be a bit like tiptoeing across a minefield – nerve-racking and potentially devastating. In that kind of climate, however, markets on the periphery of the eurozone clearly will be the ones to avoid, while German bonds and other safe haven investments will continue to rule the roost.