News in Charts: From Behind the Maginot Line
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“What you need to understand … is that the crisis in Europe is over,” François Hollande, President of France, 8th of June 2013
Markets appear to agree with M. Hollande – the crisis is over, the euro zone economy is out of recession, and equity prices are on the rise. French and Euro Area officialdom has, since the recession, been focused on protecting the Core countries from the bad debts accumulated by the Peripheral economies. And they feel their efforts have been triumphantly successful – so much so that Mr Barroso last week described their joint efforts as “fantastic”.
A pity then that the French government seems to disagree. It lowered its growth forecast for 2014 to 0.9% from 1.2%. At the same time its estimate for that year’s budget deficit has been increased to 3.6% vs. an initial estimate of 2.9%. For 2013 the budget deficit is now expected at 4.1% from 3.7% reported previously. The changes in our view reflect a lacklustre recovery and a realignment of over-optimistic government projections with those of the IMF/OECD.
The threat from rising yields and a flight to safety in global capital markets that result from Fed tapering is not a problem for Germany – which needs tighter monetary conditions, and is regarded as safe – and the Peripheral economies will be protected by the ECB if necessary. But while all their attention was focused on defence against the risk from the Periphery, the banking crisis may have already reached the banlieues of Paris.
We identify a key risk that is not currently priced into the market, in the French corporate and banking sectors. French NFCs are experiencing low and falling profitability, reflected in stock market earnings. Moreover, French banks are highly exposed to French NFCs, and are also relatively vulnerable to a potential flight to safety in international capital markets. There is a pronounced risk that Fed tapering could trigger a major non-performing loan (NPL) problem in the French banking sector. But higher yields will erode the already weak profits of the corporate sector. And the prospect of capital flight is a threat to French banks. The central importance of French banks in the Euro Area means that a problem for them could quickly become a problem for the entire Euro Area banking system.
France is vulnerable…
The balance of opinions of Primary Dealers in the New York Fed’s survey is convinced that tapering will begin in September. We agree with that assessment and look to a modest reduction in the Fed’s rate of asset purchases to begin then, even after Friday’s mediocre non-farm payrolls data. This tapering will add to pressure on the most fiscally challenged European economies as their sovereign yields could follow US yields higher. But France is not among them – at least, not yet. Our Sovereign Fragility Index still has France in Aaa territory, but only barely. Further evidence lies in the fact that the rating agencies have been more cautious and have all stripped France of her AAA rating.
…and needs looser policy rates which are not on the horizon
Given the economic conditions prevailing in the country today the last thing France wants is tighter monetary conditions, such as might result from Fed tapering. France and Germany are both core Euro Area economies, but their needs are very different. Our Taylor rule analysis suggests that the German economy would not just survive but might actually benefit from tighter money – perhaps much tighter. But the French economy needs a monetary loosening. Higher interest rates in these circumstances could be profoundly damaging for the French corporate sector which in turn could lead to a substantial rise in NPLs there.
Fed tapering means NPLs could become a problem for its banks…
The French Non-Financial Corporate sector is already suffering from low profitability. Non-performing loans to the French NFC sector currently stand at only 4% as of Q1 2013, according to Bank of France data – low by historical standards. However, a scenario of continued falls in profitability, rising costs of external finance and weak growth in aggregate demand, triggered by the impact of Fed tapering, could see that ratio rise sharply. In such a scenario, the NPL ratio breaches 10% by 2018, as shown in the chart below. A description of the model is available in the Appendix.
If this outcome materializes, the French banking sector would, in turn, be at risk with potentially explosive outcomes for the rest of the Euro Area banking system.
…and a problem for French banks is a problem for everyone in the Euro Area.
It is impossible to be sure about the channel through which any future shocks might be propagated through the Euro Area banking system. However, past correlations throw some light on this question – and underline the central importance of France. Using a correlation model, we can illustrate France’s central position in the Euro Area equity markets. The chart below maps the most efficient way of connecting all the markets represented in the ‘constellation’, in the sense that there is no other map that would deliver a higher overall degree of interconnectedness. The constellations map the likeliest path that shocks to the system might take: the path of least resistance (or highest historical correlation). Interestingly, the Peripherals tend to cluster together in both the stock market and bond market analyses, including some markets (like those of Slovenia, Slovakia and Malta) not usually considered along with the Periphery (Greece, Portugal, Ireland, etc.).
France stands out as the central Euro Area equity market, while Germany is directly connected only to France. A shock to the French equity market would be more significant for the rest of the Euro Area than would be a shock to any other country’s equity market, including that of Germany.
The nexus between over-extended French banks and unprofitable French NFCs represents the soft, vulnerable underbelly of the Euro Area as a whole. The impact of Fed tapering could expose that vulnerability – which, to date, has not been widely reported.
Should that risk materialise, we envisage direct and significant implications for French assets. Fed tapering could feed through to lower asset prices in France – according to our analysis, there is a risk that the CAC 40 index will shed its 2013 gains by 2015, repeating the experience of 2011.
Our central view on French equities remains hold. But the risk of a downside is growing, and we will be watching developments in France very closely in coming weeks with that in mind, specifically in relation to the performance of the banks and trends in interest rates. Any indication that NPLs might be on the rise would cause us to change our recommendation to sell. Investors need to be ready to move quickly and be cautious about increasing their positions in French and possibly Euro Area equities in general.
The focus of Euro Area policy since the recession has been protecting the Core countries from the Periphery. But, while attention is directed at the Periphery, the banking crisis has already, quietly, seeped deep into the Core. France is the centre of the Euro Area: geographically, politically, and in terms of the interconnectedness of its economy and banking sector. A problem for France is a problem for the whole Euro Area. Fed tapering could bring an issue that has been below the radar for some time – weak and falling profitability in the French corporate sector – right into the foreground. The impact on asset markets and the real economy, not just in France but right across the Euro Area, could be profound.
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