The renewed flare-up in the sovereign debt crisis and accompanying political developments have brought the Eurozone back to the forefront of investor concerns in April. Strong prospects of a Socialist government taking power in France in May, the fall of the Dutch government, and heavy headwinds for the reform/austerity program in Italy have combined with spreading recession in much of the Eurozone, in particular in Spain. The European Central Bank’s massive 3-year LTRO variant of quantitative easing reduced pressures in the Eurozone’s financial system in the first quarter, lowering interbank spreads, and is still working through the system. However, it did not solve the Eurozone’s underlying economic problems, a fact reflected in the recent rises in sovereign bond spreads. On our web site, www.cumber.com , we track the credit spreads of sovereigns around the world, listing both the “good guys” and the “bad guys”. These charts, updated on a weekly basis, can be viewed at http://www.cumber.com/content/misc/EU_Contagion.pdf .
The market’s uncertainty about how Europe will address the continuing problems has increased significantly as leaders express their growing disagreements on the issues of austerity versus fiscal stimulus to promote growth, and market-friendly reforms to increase the ability to compete in a global economy versus protectionism and increased regulation.
The leading political figure questioning the fiscal pact agreed recently by the leaders of 25 European nations is Francois Hollande, whom polls indicate is significantly ahead of the current President of France, Nicolas Sarkozy, in the run-up to the May 6 second-round French election. He is directing his attacks at the German President, Angela Merkel, and the ECB, whom he sees as pressing for austerity to the detriment of growth and forcing all of Europe to accept their prescriptions. He is demanding that a component on growth be added to the pact. He evidently sees increased government spending as the way to stimulate growth. Were Europe to follow Hollande’s lead, the fiscal pact would be a shambles and the bond market would exact a high price.
Italy’s Prime Minister, Mario Monti, is experiencing some of the same public dissatisfaction with fiscal austerity and structural reforms. labour unions are strongly opposing Monti’s labour-market reforms and have caused him to retreat on some provisions. Monti also has criticised the push for greater austerity in the Eurozone. He has stressed that he is not calling for a renegotiation of the fiscal pact, but apparently would support suggestions by some in Brussels that tough deficit targets be delayed for the most severely affected countries, such as Spain and Portugal. He warned that without new growth measures, including public investment, the crisis could deepen. The bond market’s increased concerns about the situation in Italy are affecting the country’s borrowing costs. In the Friday, April 27th auction, the yield on Italy’s benchmark 10-year bonds rose to 5.84%, as compared with 5.24% in the March auction.
Spain has been at the centre of Eurozone concerns this month. Spanish bond yields rose above 6 %, a rate not seen since early December of 2011. This week Standard & Poor’s cut its rating of Spain by two levels, to BBB+. The deterioration in Spain’s economy was reflected this week in the report on the unemployment rate for the first quarter, 24.4%. The IMF expressed in strong terms its concerns about Spanish banks that have been heavily hit by the collapse of the bubble in construction: “To preserve financial stability, it is critical that these banks, especially the largest one, take swift and decisive measures to strengthen their balance sheets and improve management and governance practices.
Nevertheless, Spain’s Economy Minister, Luis de Guindos, ruled out the country seeking a bailout. “We don’t need it,” he claimed. Spain is maintaining its strict austerity policy. In Contrast to Hollande and Monti, De Guindos stressed that “I do not see that the growth pact should involve any sort of fiscal boost or stimulus.” He does call for a European growth program that “has to be much more focused on performance on the structural side.”
It is looking increasingly likely that Europe will add a growth annex to its fiscal pact. ECB President, Mario Draghi called this week for adding a “growth compact” to the budget rules. He was clearly not talking about fiscal stimulus measures but rather a focus on growth-enhancing structural reforms and a boost to competitiveness. German Chancellor Angela Merkel quickly expressed her support for this proposal, calling for “sustainable initiatives, not simply economic stimulus programs that just increase debt.” Hollande, true to form, disagreed, complaining that Draghi is proposing “adding even stronger competition, liberalization and privatization.” Hopefully, Hollande, if he does win the election, will lose this debate with France’s European partners and decide to back off from his campaign rhetoric. He will be constrained by France’s large budget deficit and the need to finance it.
We would agree that a “growth compact” along the lines proposed by Draghi is needed. The IMF is projecting the Eurozone’s GDP will decline by 0.3% this year, followed by a very weak recovery in 2013 of 0.9%. The April Purchasing Managers Index (PMI) for manufacturing in the Eurozone is consistent with this negative outlook as it fell to a new trough of 46.0. The IMF points at bank deleveraging as being an important headwind for growth in the Eurozone. Very little of the LTRO money provided to banks has ended up in the economy in growth-promoting activities, that is, commercial and consumer loans, but instead has been used by the banks to buy sovereign debt or to increase their deposits with their central bank. Draghi noted with concern the declines in demand for loans to business and consumers as fiscal austerity was “starting to reverberate its contractionary effects.”
Eurozone equity markets have reflected the above developments, declining in April after significant gains in the first quarter. At the end of the week, looking at MSCI country equity indices, Spain was down -11.4% for the month-to-date, Italy was down -7.2%, France -4.7% and even Germany lost -2.9%. The corresponding year-to-date returns are Spain, -15.4%, Italy, +1.0%, France, +6.8%, and Germany, +17.0%. At Cumberland Advisors we are continuing to hold Germany as the only Eurozone position in our International and Global Multi-Asset Class Portfolios.