David C Gale : Northwestern Mutual - Economic Commentary - June 2010 : Article: Economic Commentary

Economic Commentary - June 2010

Christopher Bremer
Senior Investment Consultant

Defiance to Contagion

In Edgar Allen Poe’s short story “The Masque of the Red Death,” the Red Death disease plagues the fictional country causing victims to die quickly and gruesomely. In recent weeks, headline watchers may be forgiven for thinking something similar is happening to the European Union (EU) and its common currency, the euro.

The prince in Poe’s tale, Prospero, tries avoiding the Red Death by inviting one thousand knights and dames into the seclusion of his abbey, “With such precautions the courtiers might bid defiance to contagion…All these and security were within. Without was the ‘Red Death.’”

European leaders have invited all countries facing instability behind the protection of a trillion dollar loan package and a program of bond purchases. Like the contagion of the Red Death, European leaders were faced with the potential contagion of southern European government bond markets spreading to the wider net of banking and global credit markets. The primary purpose was to halt growing financial panic and the plan, in the words of The Economist, “may have been received with euphoria, but it was born of despair.”

A few months into his seclusion, Prince Prospero decides to throw a huge masquerade ball. In fact the market’s recovery from the lows of the severe recession in March 2009 to the current European debt crisis (including a nearly 80% gain in the S&P from trough to peak) seems to have moved like the progression of Prince Prospero’s party, “There was much of the beautiful, much of the wanton, much of the bizarre, something of the terrible, and not a little of that which might have excited disgust.”

In our March commentary we discussed global macro events that were having an adverse impact on markets, Greece’s debt crisis and China’s initial stages of policy tightening. We summarized Greece’s budgetary woes and noted that Greece is a symptom of massive structural budget problems that threaten most of the developed economies. The situation has since deepened dramatically, as investors realized that without aid, Greece is insolvent. Insolvency without rescue leads to illiquidity. Illiquidity results in financial and market turmoil.

In the following commentary, we provide an overview of the rescue program and a brief list of key corollaries; contagion, austerity measures, structural competitiveness, the euro, regulation and implications for the United States.

Prince Prospero’s Abbey

On Sunday May 9, European leaders erected their modern day version of Prospero’s abbey by announcing a massive bailout package for Greece. The European Central Bank (ECB) announced that it will buy public and private debt under a new program, the Securities Market Program.

The almost $1 billion in credit pledged by the EU and the International Monetary Fund (IMF) had exactly the “shock and awe” effect hoped for by European leaders, well at least for one day. European markets reacted by soaring over 7%, temporarily averting the spread of the “Red Death” to other Mediterranean countries.

The objective of the package is to prevent Greece from defaulting on its debt and to suppress contagion of the crisis to other European countries, including Portugal, Spain, Ireland, and Italy. The political message of the rescue package from European leaders is that a financial assault on one country will be met with a decisive response by the EU. The European Commission president, José Manuel Barroso, said that the rescue package showed the euro zone would do “whatever it takes” to defend itself.

The size of the bailout program is roughly equivalent to three years of gross financing needs for the four most distressed countries (Greece, Portugal, Spain and Ireland), according to Barclays Capital. Short-term sovereign debt yields declined, implying that the EU action appears to have staved off short-term liquidity fears. And on May 18th, Greece received the first installment allowing it to pay back about €8.5 billion of maturing bonds. To secure the aid, the government pledged €30 billion of budget cuts to reduce the budget deficit from 13.6% last year to 8.1% this year.

Even prior to the first installment, investors began to think about the subtext of the credit extension: does extending a bailout incent profligate countries to curb their spendthrift ways? Will the loans only serve to increase debt burdens and slow economic growth? Does a weakened Europe impact the steadily and improving U.S. economy by increasing the price of its exports in Europe?

The market continues to have its doubts about the ability of Greece and the EU to act decisively. Even if the Greek government can convince the nation to undertake drastic austerity measures, it will be hard pressed to not only pay down its suffocating debt, but simultaneously lower its double digit deficit and grow its feeble economy. If Greece cannot do so, contagion may spread to one of the other countries in similar economic straits, such as Portugal or Spain.

Contagion – Fear of Exposure

Greece is a symptom of a much more global debt and deleveraging problem. While Greece has cast a long shadow over the sovereign market, it is emblematic of the problems confronting a number of developed nations. Many imbalances need to be addressed by the developed world before a sense of normalcy can be regained. Most of these imbalances are directly connected to the leverage that was encouraged by low interest rate policies, lax regulation and public policy decisions made during the past several decades.

We noted in March’s commentary that Greece hardly matters from an economic perspective, accounting for less than 3% of EU GDP. However, other European countries are now under pressure to cut budget deficits. When including Britain, Italy, Portugal and Spain, 40% of Europe’s GDP is now under such pressure. This is

how contagion begins, by casting a wide net across reckless sovereign spenders. The first direct impact is through the costs countries must shoulder to issue debt (Fig. 1). As the yields on Greek sovereign debt spiked, there seemed a real threat that investors would simply cease buying Greek debt.

While many Europeans would just assume this to be the case, particularly the Germans, the real fear is how much Greek debt other European governments and financial institutions own. This represents the next stage in contagion- other countries’ exposure to problem debt. Once a crisis hits, uncertainty about exposures results in the market bunching together credit default spreads of all countries and all financial institutions.

The third stage engulfs not just all sovereign related entities, but all financial entities that play in the credit markets. This drives up borrowing costs even for banks that do not have material exposure to the afflicted country. One way to view this stage of contagion is through credit default swap spreads, which pay the buyer “insurance” if the underlying credit defaults. Figure 2 shows how contagion spreads to all financial institutions as the market lumps them all together during periods of trauma.

Once financial companies become stricken with the contagion, other financial entities cease lending short-term funds, leading to an outright liquidity crisis where the financial markets simply freeze up. This occurred in the aftermath of the Lehman Brothers’ bankruptcy in September 2008.

From a fundamental perspective, Greece is considerably worse off than the other peripheral countries. When liquidity evaporates, however, the qualitative differences between countries and entities quickly disappear.

Austerity Measures

Greece’s budgetary situation is problematic on two primary accounts. European Union guidelines (specifically, the Treaty on European Union, commonly referred to as the Maastricht Treaty), call for budget deficit ceilings of 3% of GDP and external debt ceilings of 60% of GDP. Greece’s budget deficit is close to 14% of GDP and the debt to GDP ratio exceeds 120%, both well above those permitted by the EU. But Greece is not alone, as 25 of the 27 EU member states exceed the EU limits.

As Figure 3 shows, while other countries’ share unhealthy budgetary situations, Greece clearly stands out in the severity of its financial stress.

In exchange for tapping the rescue funds, Greece has pledged to implement austerity measures accounting for almost 14% of its GDP. The government of Greece is trying to reform a country where an astounding one out of every three people has a civil service position, which, until recently, was guaranteed for life.

Cutting deficits will be quite challenging. For example, Spain recently announced a further 5% cut in public sector pay and 13,000 cut in the workforce, no indexation of pensions in 2011 and the abolition of the payment for newborns. As The Economist notes, all that effort from a Socialist government will cut the deficit by just 0.5% of GDP this year and 1% next.

Greece finds itself in an even more precarious position. Even if the government successfully implements all austerity measures to which it has pledged, the country could still end up with public debt over 150% of GDP with meager growth potential. This is the insolvency problem and insolvency is usually not remedied by adding more debt. Debt restructuring then is simply shifted from today, out a few years.

For other countries, the current crisis presents warning and opportunity - warning against failing to act as Greece failed and an opportunity to act before the markets do.

Competitiveness

The Mediterranean countries of the EU have materially lower levels of productivity and competitiveness relative to the larger EU economies. Greek industry has for years suffered from declining international competitiveness, in part due to high wages and low productivity. According to the Congressional Research Service, wages in Greece have increased at a 5% annual rate since the country adopted the euro, about double the average rate in the euro zone as a whole. Greek exports over the same period grew 3.8% per year, only half the rate of those countries’ imports from other trading partners. Greece needs to increase

productivity, cut wages and increase savings. This is an extremely challenging task for a country with a small export base and no ability to devalue its currency.

Euro

All these fears over resolving the long-term fiscal challenges underlying this crisis are reflected in the euro currency’s significant decline against the U.S. dollar (Fig. 4), more than 18% since the start of this crisis (as of May 20).

During the stock market recovery from March 2009 to December 2009, the U.S. dollar fell just over 16%, precipitated by a reversal in the flight-to-quality trade. Cracks in the demand for dollars, however, tend to cause more intense and emotional responses. There is also a common, sometimes misplaced, perception that a strong dollar at all times is beneficial, even essential, for U.S. economic strength. To some degree, the same goes for the euro.

Changes in exchange rates can have a material impact on the allocation of resources, economic production, employment and ultimately a country’s standard of living. An orderly decline in the euro over three to four years could benefit Europe by increasing exports that could offset pending reductions in government spending. Unfortunately for Greece, countries like Germany are much more likely to benefit from such an environment.

And therein lies one of the main criticisms of the euro. The EU has a single monetary policy with a single currency (except Great Britain), but 16 separate and disparate fiscal policies. As evidenced by the current crisis, this arrangement is prone to problems and imbalances.

Implications for the U.S.

Now that “Prince Prospero” and his EU cohorts have thrown a masked ball of government aid for the profligate members among them, what are the implications for the United States? There are several.

First, as just discussed, the euro could continue to decline in value against the U.S. dollar. A weaker euro could potentially make U.S. exports to Europe less attractive and increase U.S. imports from euro zone countries, thus widening the U.S. trade deficit. The U.S. and Europe have the largest bilateral trade relationship in the world, and together account for more than one half of the world’s GDP. U.S. companies derive a significant portion of their revenues and profits from business abroad. The S&P 500 companies generate close to 40% of revenues from non-U.S. locations. The economic situation of other countries can therefore have a material impact on individual company performance and the broad U.S. index in general. Given the strong interconnectedness of the two economies, financial instability in the EU can and does negatively impact the U.S. economy. President Barack Obama says he wants to double U.S. exports within five years and a weaker euro will challenge this objective.

Second, the risk aversion wrought by the European crisis may cause Fed policymakers to be more cautious. This means likely waiting longer before changing the “extended period” language, a prerequisite to raising rates, as indicated in the Fed minutes released May 19:

Economic conditions abroad…continued to strengthen in recent months…However, participants saw the escalation of fiscal strains in Greece and spreading concerns about other peripheral European countries as weighing on financial conditions and confidence in the euro area. If other European countries responded by intensifying their fiscal consolidation efforts, the result would likely be slower growth in Europe and potentially a weaker global economic recovery. Some participants expressed concern that a crisis in Greece or in some other peripheral European countries could have an adverse effect on U.S. financial markets, which could also slow the recovery in this country.

Third, U.S. banks holding Greek or other problematic sovereign debt may have to write down losses. With about $16.6 billion of Greece’s debt held by U.S. entities, a Greek default would likely have ramifications for these creditors. Although not an insignificant amount of money, the relative size of U.S. creditor exposure to Greek bonds however is likely too small to create significant effects on the U.S. economy if Greece were to default. The direct exposure of U.S. banks to Greece is fairly trivial: only about $17 billion as of yearend 2009. The far bigger risk is that a Greek default would freeze up financial markets as the markets worry about who owns bad debt.

Fourth, some have suggested that Greece’s current debt crisis warns of what the United States could face in the future, both at the federal and state levels. Should we be worrying about our own federal, state and municipal regions?

The budget deficit has risen to a percentage of GDP not seen since World War II and trillion dollar deficits are driving up the debt to GDP percentage at an alarming rate. Budgetary stress is also evident on the state and local levels. For sure, the United States is not immune as Moody’s fired a warning shot at the U.S. saying that unless the country gets public finances into better shape than the Obama administration projects, there would be “downward pressure” on its triple A credit rating.

According to The Economist, the states with the five biggest debts are California, New York, New Jersey, Massachusetts and Illinois. These states together total about $200 billion in debt, while Greece alone has $428 billion of debt. Where the combined output of the five states is around $4.45 trillion, Greece produces just $331 billion.

Most states must operate under balanced budget rules and short-term stress or even crises are common when recession hits and tax revenues fall. If the U.S. government must act as a backstop during these times then an additional federal debt burden ensues. But in the end, California, New York, New Jersey, Massachusetts and Illinois are not Greece.

Regulation

Just as the multiple single-colored rooms in Poe’s tale depict different personality types, so too does the response from European governments and regulators.

That financial regulation needs to be improved is a reasonable objective. Unfortunately, European policy makers more often than not attribute the escalation of the crisis exclusively to malicious speculators. Instead of looking at itself, EU leaders continue to point fingers at speculators and rating agencies for exacerbating Greece’s crisis.

Germany banned naked short-selling due to “exceptional volatility” in Euro area bond markets. The German government itself admits that this practice has little relevance in the Greek disaster. Risk assets were sold off in response. The markets were not debating the merits of Germany’s actions, but rather reacting to the fact that Germany acted in isolation. The reality is that investors globally have recognized and taken action against the extreme fiscal vulnerability of euro zone countries. Their actions are forcing budget cuts, or at least government pledges to cut deficits.

Regulation will continue to impact the markets, particularly with regard to volatility. On May 20, the U.S. Senate passed by a 59-39 vote a bill that imposes restrictions on proprietary trading by banks and creates a consumer protection agency designed to prevent lending abuses. As of the writing of this commentary, the legislation must be reconciled with a previously passed House of Representatives version.

We have noted in previous editions that global monetary policy during the recession was remarkably synchronized, but that the unwinding of stimulus was likely to be more disconnected. So too is the regulatory response. For certain, governments will overreact on the regulatory front. They always do. But when they choose to act in isolation for their own political agendas, the markets can show their condemnation in violent fashion.

What to Watch For

While financial markets fluctuate, interbank lending metrics offer insight as to exactly how well cash is flowing through the global financial system. If banks are weary of lending to one another, this ultimately works itself through to a heightened perception of risk for investment assets. The rate banks charge each other for three-month loans (in dollars) has almost doubled since February, a sign of, if not a crisis, certainly stress on liquidity (Fig. 5).

Where are We Headed

While the crisis in Greece could create economic ripples across the globe, many market watchers had been expecting a correction at some point this year given the strong recovery from the March 2009 lows.

Recall the global market turmoil from May 2008 to March 2009. Most market participants are hard pressed to recall any positive financial or economic news. Today, positive economic developments abound across the global economy. Even within Europe, economic activity is accelerating. Euro zone exports of goods grew 10.3% in March, the second largest gain ever. The weaker Euro boosted exports. Imports of goods also jumped, climbing 7.5%, the seventh straight gain and the largest in over two years. This indicates that the general recovery in Europe remains on course despite sovereign debt problems in the peripheral countries.

While investors remain concerned that the European rescue package is only a short-term solution, others have noted that the massive fiscal and monetary stimulus instituted by global central banks throughout the last two years is also short-term. After all, the Fed Funds rate cannot remain at 0% forever.

The subprime crisis and ensuing recession demonstrated just how fragile the financial system can be. Liquidity and financing problems can escalate at a pace far quicker than policy makers can plan. Investors have clearly become more fearful in the last few months. The markets have seemed to discount another Lehman type collapse more than the alternatives of climbing out of the Greek crisis or even muddling through it. But if muddling though becomes the worst outcome, the financial and economic impacts to the U.S. will not necessarily be disastrous. While a stronger dollar will cause headwinds to U.S. exports, lower interest rates and lower commodity prices are beneficial to U.S. consumers.

Global economic activity is more interconnected than ever before and a crisis in one region is very likely to reverberate throughout the other major global regions. Furthermore, we learned from the financial crisis of 2007-2008 that during crisis periods, asset class correlations increase globally. In other words, during periods of severe stress on asset prices, most assets tend to move downward in tandem. Of course, the same applies when there is a shift in sentiment, economic improvement or crisis resolution and asset classes tend to recover together.

Greece needs a credible plan and execution of fiscal austerity. Other countries, including the United States, eventually will as well. For Greece, this may ultimately involve some form of restructuring or default. Hopefully, the lessons from Greece will prevent such an outcome for other free spending countries.

Adversity has a way of bringing disparate parties together. Faced with a pending liquidity crisis, European political leaders have agreed to common risk management measures - call them bailout measures - that would have been politically impossible in a more healthy sovereign bond market environment. But what are the future costs of this newfound cohesiveness, particularly with regard to moral hazard?

For investors, the volatility associated with the debt crisis is akin to Poe’s mysterious masquerade ball intruder who “had gone so far as to assume the type of the Red Death.” Just as this masked figure “had arrested the attention of no single individual before,” the current debt crisis serves as a reminder that volatility is present and the world is not as insulated from it as perceived over the last 14 months. Investors should expect plenty more opportunities for the markets to question, assess and react to the European Union’s resolve, all of which is expressed through heightened market volatility.

Prince Prospero’s castle was supposed to serve as a protective shelter, defying contagion and escaping death. But once the Red Death found its way in, there were no means of escape for the courtiers, therefore entombing the partygoers in the very place they were supposed to be safe. Will throwing even more debt after bad debt have the same affect on Europe?