9th May 2012

Neptune Macroeconomic View

The European Central Bank’s (ECB) decision in December to support the Euro area’s banks come what may, for now, via the provision of unlimited three-year loans (affectionately referred to as the Long-Term Refinancing Operation) was a shot in the arm for markets from New York to Delhi in the first quarter of the year. This is because European banks were the cord between the crisis in Europe and the rest of the world economy – and the ECB snipped it. As a result we have seen the Spanish stockmarket fall 17% year-to-date, reflecting an intensification of economic problems there, while the US stockmarket has risen by more than 10% and the MSCI World Index has risen by 9%. This would have been impossible during the second half of last year, when investors were obliged to factor in a material risk that at least one of a number of major European banks might be allowed by the authorities to fail, á la Lehman Brothers in 2008 – with well-remembered consequences.

European Debt

Yet, while thanks to the ECB the past quarter has offered a welcome break from market pressure generated in the Euro area, behind the scenes the crisis has been limbering up for the next innings. Overwhelming evidence from falling Gross Domestic Product (GDP) growth rates, rising unemployment rates and missed government debt reduction targets have made it a matter of common sense that the Euro area’s current survival plan is too heavily reliant on government austerity in economies where demand is very weak anyway. Formed summit-by-summit during the past six months, the so called fiscal compact’s emphasis on centrally mandated budget-slashing in the mostly southern European debtor countries reflects the relative bargaining power of Germany’s politicians over theirs, owing to its larger economy and intraregional creditor status. In addition, the ECB’s main interest is not to end the crisis per se but to maintain its institutional integrity, which it assesses in terms of its independence from Europe’s politicians. In practice, this means that the ECB is almost as loath to let the beleaguered countries off the hook as Germany is; hence only in the face of acute market stress has it intervened in their government bond markets, taking the minimum actions required each time to keep the wheels on the fiscal compact. Parallel to this is the issue of how the loss of competitiveness of the debtor countries vis-à-vis the creditor countries over the past decade should be reversed if the debtor countries wish to regain their previous living standards now that the decade-long credit boom is over. Should the sole burden be on painful deflation in the debtor countries (with the nasty side-effect of aggravating debt reduction efforts), or should the creditor countries accept higher inflation for a time so as to actively contribute to closing the competitiveness gap? As it happens, Germany and the ECB together are politically powerful enough to force the debtors into a one-sided deflationary adjustment.  

European Politics and Austerity

Letting the natural result of the underlying balance of power in the region run its course in this way is all well and good until those who are really at the boot end of the plan find representation within the political process. Large public protests in some of Europe’s capital cities have failed to create a political short circuit – but the ballot box is more effective. The first round results of the French elections, which included strong performances by relatively extreme candidates, should be interpreted as a rejection of the mainstream policy thrust that France has bought into, while the fall of the governing coalition in the Netherlands is a direct result of unrest over austerity. Greek legislative elections and an Irish referendum on the fiscal compact are yet to come. The most likely scenario at this point is that Euro area policy is incrementally reoriented under the weight of accumulating evidence against it, but a round of dangerous brinkmanship as part of the process is a possibility.      

Growth in the US

The US economy is a relative bright spot. Economic growth is tracking at around 2.5% on an annualised basis and job creation, which will be the all-important economic factor in the presidential election in November, has picked up significantly, though there is a long way to go to restore normality in the economy. In fact some investors believe that the economic data has been so favourable this year that we must be destined to repeat the experience of last year, when positive momentum early on was halted by sharply rising inflation (which squeezed consumption), and then dealt a second blow by events in the Euro area from July onwards. Given the LTRO, the Euro area crisis will have a limited impact on the US economy notwithstanding the brinkmanship risk explained above. Meanwhile this year’s story with respect to inflation is that, in contrast to last year, it is falling. This means that US (and UK) consumers will not be subject to the same fall in purchasing power as last year, which did so much damage. So the outlook is considerably changed from this time last year. 

Emerging Market Progress

In the emerging markets, central banks are cutting interest rates in the face of falling inflation as opposed to raising them in the face of rising inflation as the case was last year. This should cause emerging economy growth to accelerate before long. China stands out as the major emerging economy easing policy most gradually. This is because the government recognises that short-term stimulus, to which investment is more responsive than consumption, is at odds with its strategic goal of shifting the economy towards a higher consumption and lower investment mix – so it is inclined to provide the minimum required easing to meet an (informal) desired growth rate of 8 – 8.5%. The government is waiting to see whether the next couple of months of economic data indicate that the growth rate of economic activity has already bottomed at just over 7% (annualised) or whether it will fall further, requiring a policy boost.

Source: Neptune Economics, April 2012.

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