Across the Ponds - Market Overview

“It seems most of the developed world is trapped within the confines of excessive debt and uncertainty.” 

This is an excerpt from a previous Market Overview: An Era of Debt and Uncertainty, November 25, 2012.

Excessive debt and uncertainty are the underlying reasons we have been trapped within our “New Reality” of slow economic growth and underemployment for the past seven years.  

The depth of our situation has been driven by factors that are mostly self-inflicted.  This might include things such as increased regulation, political stagnation or under funded pensions.

There are also questions concerning the future impact of recent legislation such as the Affordable Health Care Act, future taxation and the future costs associated with the avalanche of new regulations being thrown at companies both big and small.

All of these things have occurred at a time we have been racking up fiscal deficits that have increased our national debt to almost inconceivable heights.

It is these conditions that have created uncertainty within the private sector making companies hesitant to hire full-time employees or increase capital expenditures and making households reluctant to spend.

We are not alone.  Across the ponds in Europe and Asia they are also facing this New Reality brought about by the accumulation of excessive debt, internal structural problems and the pursuit of questionable fiscal and monetary policies

Just how did we all get here?  Even though the U.S., Europe and Asia all seem to have arrived at the same spot, our paths have differed.  However at the same time, the solutions taken to address these problems are all the same and all too familiar. 

It is these similar solutions that have produced the same lackluster results.  

There is the misguided belief around the world that monetary policy alone can cure all ills.  In other words, there is a mind-set in the world that says: “If we just keep short-term interest rates as low as possible and print more money then everything will be OK.”

However this hasn’t produced stronger economic growth even though we have seen massive quantitative easing programs from the U.S. and the U.K.; we are seeing similar programs being aggressively followed by the European Central Bank and the Bank of Japan; and we are witnessing the beginnings of the upcoming program from the People’s Bank of China. 

A similar situation has existed in regard to fiscal policy in that governments feel like they can spend their way to prosperity.  In this case governments have thought: “If we just spend a little more then this will stimulate the economy and everything will be OK.”

One look at our own past experience and it is obvious this form of thinking was misguided and false.  Even though we threw over a trillion dollars of taxpayer money at the economy it achieved very little since it was wasted on pork projects in order to satisfy political ambitions and agendas.

So what is happening across the pond in Europe today?  Let’s take a look.

Europe

The eurozone - which includes the eighteen member nations that use the euro as their common currency - is facing the dual threat of slow growth and potential recession coupled with deflation. 

They are also facing internal problems due to excessive debt, and the fact that each member nation has a different political and economic system, have internal structural problems and have different opinions on how they should address their overall situation.  This is in addition to the problems that exist due to the structural makeup of the eurozone as a whole. 

Some of their problems include the following:

Monetary Policy.  As previously noted the European Central Bank - or ECB - has embarked on its own quantitative easing program where they will buy 60 billion euros of A-rated sovereign debt and private asset-back/covered securities per month.  When completed in September 2016 this program is expected to flood the eurozone with over 1 trillion euros and increase the central bank’s balance sheet to 3 trillion euros.

Sounds good but they face a huge problem due to market liquidity and the availability of A-rated sovereign debt.

Under the announced program the proportion of A-rated government debt the ECB buys each month will depend upon the country’s share of the Europe Union population and GDP.  This makes German debt the biggest piece of the program by far.  

That being said, the ECB’s quantitative easing program is coming at a time when the German budget is balanced, which reduces their need to issue additional sovereign debt and creates a scarcity of paper.  This differs greatly from the Federal Reserve’s QE program that was enacted at a time when the U.S. was running up huge deficits thus creating the need for new Treasury debt issuance. 

Since Germany will only be issuing 15 billion euros of net new bond issuance this year and the ECB will need 215 billion euros of German debt between now and September 2016, the ECB will be forced into the secondary market to buy German bunds where there is already a shortage of top-rated bonds. 

The market for private asset-backed and covered securities is also very small meaning they are probably limited to about 13 billion euros per month in these types of securities.  As a comparison, the Fed had a huge mortgage-backed securities market to draw upon.

Therefore, it is questionable the ECB will be able to fulfill the provisions of their QE program.  Even if they do, it is doubtful it will have any lasting impact due to the dysfunctional political systems and structural problems that exist in the eurozone.  

Fiscal Policy and Dysfunctional Political Systems.  Europeans are resistant to change, which makes their politicians equally resistant to change.

In various ways, Europeans enjoy a West European style of socialism that has left many dependant upon the welfare state.  They have become so accustomed to this way of life that they cannot imagine any other.

Looking at this from their perspective, who in their right mind would be willing to give up guaranteed employment, guaranteed health and pension benefits and four-to-six weeks of vacation per year in order to help the economy?  No one would.

Politicians understand this and heed the will of the people.  This makes them dysfunctional and resistant to any change in fiscal policy that could benefit their country.  The ECB QE program merely gives politicians and bureaucrats added room to do nothing.

Structural Problems.  As noted the problems in Europe revolve around West European socialism.  This is in addition to other internal structural problems such as oppressive regulation and bureaucracy, inefficient judicial systems, high private-sector taxes and liberal labor laws.

As German President Merkel once noted: “Europe has 8% of the world’s population, 25% of its economy and 50% of its welfare spending.”

Looking at the eurozone as a whole, the structure of the eurozone has been a mistake from the beginning.

Under the Maastricht Stability Pact, countries utilizing the euro were required to adhere to certain debt restrictions.  The primary requirement was that eurozone members had to maintain an annual deficit-to-GDP ratio of 3 percent or less, and a total national debt equal to 60 percent or less of GDP.

The problem was that there was no process in place to verify the numbers produced by individual countries and no serious penalty in place if a eurozone member broke the terms of the treaty.  There were also no provisions included in the treaty regarding the exit or the expulsion of a member nation out of the eurozone.

This allowed several eurozone members - mainly in the south - to lie or use fuzzy accounting to make them appear in compliance; or allowed them to simply ignore the debt restrictions knowing there were no serious repercussions.   

The underlying problem was that the Maastricht treaties failed to recognize the vast differences between the economies of the 18-member nations included within the eurozone.  This is probably due to the fact the original treaty was drawn up by a small number of nations in the north with similar economies.  These failures are apparent today in the drama known as Greece.

Greece.  Greece will default on loans from the International Monetary Fund - or IMF - at the end of this month if they cannot reach an agreement with creditors.  Even though talks to avert this event have been going on for months they remain at an impasse as of the time of this writing (6/16/15). This has caused uncertainty regarding the eventual outcome. 

What if Greece does default and eventually has to leave the euro and the eurozone, or what is commonly known as a Grexit? 

Initially a full Grexit would create a tremendous financial shock wave with Greece bearing the brunt of the impact. 

Their currency would immediately need to be converted into the drachma, which would take months and would probably have about half the value of the euro.  This would make capital controls necessary to prevent runs on the banks and capital flight out of the country.  These developments would further result in a massive liquidity squeeze and soaring inflation.

As for the rest of the world, a Grexit would cause disruption in the financial markets with global stock markets falling to some extent.  However the biggest losers in a Grexit scenario would be the creditors and taxpayers that held worthless Grecian debt.

There are options available that would allow the process to muddle along past the June 30 deadline.  This would probably be the best course of action.

However the IMF and Germany, who are the major players on the creditor side of the equation, are sick and tired of Prime Minister Tsipras’ refusal to enact reforms within Greece.  The head of the IMF has even stated publicly that a Grexit might be inevitable.

Right now our full attention is on Greece.  Even if they do default, Europe will make every effort to prevent a full Grexit since this would push their financial markets into disarray.  Therefore, a default might initially cause disruption in their markets but not full chaos, at least in the short term. 

Perception

It all comes down to perception.  If there is the perception that a full Grexit will not occur, then financial market reaction will be contained.  Naturally if the perception goes the other way then we could see a full correction in the market, but not a disaster assuming there’s no contagion factor involving other countries such as Spain and Portugal.

In our opinion this could create a buying opportunity.  Of course this opinion could quickly change since events surrounding Greece, as well as around the world, change on a daily basis. 

- David B. Prilliman
 

 

Note: The impact of the monetary and fiscal policies of countries across the ponds and a discussion of Asia will be presented in the next issue of the Market Overview: Across the Ponds, Part II, which is due out shortly.

Professional Investment Counsel, Inc.  Principals: Gary M. Borsch (garyborsch@sbcglobal.net) and David B. Prilliman (davepic@sbcglobal.net)

© Copyright 2015, David B. Prilliman.  All rights reserved.  All opinions and estimates included in this report constitute our judgment as of this date and are subject to change without notice.  Although the information in this report has been obtained from sources we believe reliable, they are not necessarily complete and cannot be guaranteed.  This report is for information purposes only.