Joel Seleskie : Northwestern Mutual - Economic Commentary - March 2010 : Article: Economic Commentary

Economic Commentary - March 2010

Christopher Bremer

Senior Investment Consultant

Dionysius of Syracuse, Where Art Thou?

The history of currency devaluations can be traced to Greece in the fourth century B.C. Dionysius of Syracuse (then a Greek colony on the island of Sicily) borrowed in the form of promissory notes and likely waged one expensive war too many. Issuing a decree to all his subjects to turn over all the money in circulation, he collected the coins and “stamped each one-drachma coin with a two-drachma mark and used the proceeds to pay off his debts.” Non compliance, naturally, was to be met with death. Throughout history, other widely used methods for getting out of debt included melting, diluting and reissuing coins with less gold or metal than before. Such swindles effectively serve as government defaults.

Let’s transition from the tyrants of ancient Greece to the tyranny of unsustainable government deficits and debt burdens. Towards the end of January, risk assets took a breather from their ten month ascent. The highly anticipated 2009 fourth quarter corporate earnings reporting period (beginning around January 11, 2010) was overshadowed by two global macro events, Greece and China.

In the past few months, Greek government bond yields have spiked as concerns escalated about the possibility of default. In China, risk assets, such as bonds and equities, sold off after China announced measures to reign in aggressive bank lending. The two macro situations could not be further apart, not just geographically, but economically – Greece from a position of weakness and China from a position of strength. In a cruel twist of financial market irony, risky assets sold off on both accounts.

Often, heightened levels of market volatility are conveniently explained as the market’s disdain for the uncertain. When viewed in isolation, there is nothing uncertain about each of the two recent macro-economic events. Greece is in serious financial trouble, and its sovereign debt yields spiked as its stock exchange declined. Chinese policymakers are concerned about creating asset bubbles, particularly in real estate, and risk assets sold off in reaction to the prospects of higher inflation and the need to tighten monetary policy.

For sure, far more dangerous economic events have conspired to target risky assets over the past two years. These two episodes, though, are symptoms of something much larger. Greece is a symptom of massive structural budget problems that threaten most of the developed economies. China is a symptom of the effects of easy credit. Together, market participants are trying to diagnose these symptoms and assess how the Fed and other global central banks will unwind the massive amounts of government stimulus that is artificially propping up global economies. This is the uncertainty Greece and China represent.

A Symptom of Massive Structural Budget Problems

Greece is a symptom of the fiscal budgetary mess most developed countries borrowed and spent their way into (Fig 1).

Risk assets in Europe, from stock markets to the Euro currency, have sold off upon Greece’s reporting of the 2009 budget deficit of 12.7% of GDP budget deficit for 2009. Rating agencies downgraded Greece’s sovereign debt, and further downgrades may ensue. Recently, the European Commission (EC) approved Greece’s budget plans to reduce its budget deficit to the 3% limit mandated by the European Union.

Does Greece really matter from an economic perspective? The short-term answer is no. Greece accounts for just under 3% of Eurozone GDP, compared with 17% for Italy and 12% for Spain. Ohio’s GDP is larger than Greece’s, and approximately 24 constituents in the S&P 500 index have larger market capitalizations than Greece’s stock market.

The longer-term answer, however, is yes. While Greece has been the target, it is by no means the only culprit. While Britain, France and the U.S. all carry significant budget deficits, Portugal, Ireland, Italy and Spain are closer to a crisis of confidence that is afflicting Greece. Greece and Italy lead the countries with regard to total government debt outstanding as a percentage of GDP, with debt almost double the European Union’s (EU) 60% limit. For the time being, Greece is the only country today where the market is reacting to both the government debt burden and the budget deficit.

Higher debt levels translate to lower growth over medium and long term periods. Getting the long-term debt burden under control will be painful. Fiscal tightening can result in a significant growth drag over the short to mid-term, while overstretched government debt burdens will cramp growth for sustained periods of time.

Some economic forecasts project some of these economies to decline in 2010. As we pointed out in last month’s commentary, weak economies result in lower government revenues and higher outlays, which will only compound current budget shortfalls. If that were not enough, Greece’s unit labor costs are above average relative to the rest of the EU. According to a European Commission report, Greece was ranked the worst country to do business with in the EU and among the Organization for Economic Cooperation and Development (OECD). And we have not even broached the demographical challenges Europe faces that will contribute significantly to lower growth trends.

The fiscal crisis in Greece is occurring simultaneously with an increase in the dialogue in the U.S. concerning our own budgetary ailments. In 2009, Greece’s deficit amounted to 12.7% of GDP. At 9.7% of GDP for 2009, the U.S. deficit is not far off. In Greece, government bond yields have spiked and unions have taken to the streets (although the headlines are probably more impactful than the actual demonstrations). Here at home, the deficit has overtaken healthcare as the most important issue. According to The Economist , about 60% of
Americans think deficit reduction should be the government’s top economic priority.

Figure 2 shows the current costs for Greece to borrow new money. As the graph illustrates, prior to joining the EU in 2001, Greek sovereign spreads narrowed to almost German levels. The rationale was that Greece would become a fiscally responsible member of the European Union, despite the fact that the country’s historical record argued against this presumption. Greece benefited tremendously from cheaper borrowing costs from 2001 to 2008. The recent spike in Greek yield spreads signifies that the bond markets disapprove of the country’s fiscal situation. Also of note in Figure 2, the German 10 year bonds actually yielded more than Spanish 10 year bonds over multiple brief periods from 2002 to 2006.

While the bond markets are punishing the weakest countries today, they were largely silent for much of the past 10 years as governments simply ignored the EU’s budget and fiscal rules. The spread between Greek and German 10-year yields averaged 19 basis points in 2004 even as Greece incurred a budget deficit of 7.5% of GDP, the highest in the EU at the time. Countries can often get away with undisciplined policies for extended periods when global credit is cheap. The current situation demonstrates, however, that market sentiment can change swiftly and ruthlessly. Therein lies the danger for other nations.

Fiscal Mess of Most Major Global Economies

Euro-region nations have exceeded the 3 percent limit on their budget deficits 44 times since the currency was introduced in 1999, according to Bloomberg. Greece leads the way with deficits in excess of the limit in eight of the nine years since it joined the euro in 2001, versus six times for Italy, and five times for Portugal, France and Germany. All 16 countries in the Euro single currency will post budget deficits above 3 percent for 2009, according to European Commission estimates.

The International Monetary Fund (IMF) projects that the government debt to GDP ratio for the G20 will reach 118% of GDP by 2014. According to one study, when debt to GDP ratios for developed nations exceeds 90%, going back to 1946, the median real growth rate is 1% lower. We should not concern ourselves with exact measurements, but clearly, these destructive fiscal trends point toward slower growth ahead. The more sluggish the economy, the more difficult it is to overcome sustained debt burdens.

As Figure 3 demonstrates, global investors have taken notice by driving up credit default spreads.
Credit-default swaps insure the buyer against a country or company defaulting on its debt obligations.

For the first time ever, the cost of insuring against government bond defaults is higher than the cost of insuring against U.S. corporate bond defaults. Markets for these EU countries will continue to exhibit heightened volatility, which may also have spillover effects into most global markets. Greece is simply the initial symptom. How serious the condition is and how contagious remains to be determined.

Single Currency

As the EU helped Greece borrow on the cheap, it is having the opposite effect now. The European Union single currency limits the options available to Greece. Prior to the single currency, Greece could have devalued its currency and inflated its way out, thereby reducing the value of its obligations to foreign bondholders, lowering the costs of its domestic labor and inflating asset prices. Now, membership in the Euro currency has shifted the burden of pain from the foreign bond holders to the Greeks themselves and other European taxpayers.

Today’s Lessons

When measuring economic contribution, Greece is insignificant. But the crisis serves as a crude reminder that global capital markets are intertwined. Like Greek bonds, higher yields on sovereign debt are likely to spread to countries lacking in global confidence. These types of confidence crises are rarely isolated events.

Initially, the Greek situation may look like an extension of the global financial crisis. In 2008-2009 the solvency of banks and major financial institutions was in question. Now the solvency of countries is being questioned. But the problems are more deeply rooted. In 2001, when it joined the Euro, Greece’s public debt to GDP ratio was already greater than 100%. It may well be that the Greek crisis eventually speaks more to the long-term sustainability of the European Union than of a global contagion of government debt fears. But implications of structural budget deficits need to be addressed, sooner rather than later.

Markets had become somewhat overstretched and volatility had declined toward a more complacent level, relative to recent average volatility levels. In such environments, the market tends to seek excuses to rebalance; Greece may be such an example.

China

In January, and again in February, China raised banks’ reserve requirements and restricted lending. The current reserve level for big banks is 16% and the new requirements add one-half of one percent, to 16.5%. China had targeted $1.1 trillion in lending this year, and Chinese banks hit 19% of that target in January alone.

Property prices then climbed the most in 21 months (Fig 4). The increase in reserve requirements is an attempt to avert asset bubbles and restrain inflation. The Chinese stock market index declined over 10% year to date as of early February.

The global financial crisis of 2008-2009 caused significant economic slowdown in China, although the Chinese economy never actually contracted. With an economy dependent on exports, about 30% of GDP, the Chinese government was quick to institute massive stimulus, about $4 trillion worth. The Chinese government instructed banks, which are really de facto government institutions, to increase lending. Bank loans grew more than 30% year over year by the end of 2009. As a result of the stimulus money and record lending, China’s recovery has been dramatic and has led the developed world by a wide margin (Fig 5).

Then, the risk outlook for inflation in China increased with December’s report of 1.9% year over year inflation, up from 0.6% the previous month. Chinese officials are concerned that this investment boom is unsustainable, and have therefore begun to tighten lending policy by increasing reserve requirements.

China has become accustomed to running trade surpluses while keeping the Yuan benchmarked to the U.S. Dollar. As a result, the Chinese government’s holdings of Treasuries has increased dramatically in recent years. The Chinese exchange rate policy is designed to foster exports.

Because exports are so critical to the growth of the Chinese economy, maintaining an inflated economic expansion due to aggressive bank lending will be challenging without a recovery in exports. Sound familiar? We have noted in recent commentaries that a sustainable recovery in the U.S. economy will depend in large part on the employment outlook. In the U.S. there is still a large degree of economic separation from pre-recession employment levels, as there is with Chinese exports. Fewer employed Americans results in fewer Chinese exports, although China has substituted some of its export base with other Asian countries. These are the global economic connections that directly influence valuations the global financial markets place on risk assets.

China is among the fastest growing economies in the world. Aggressive bank lending and massive amounts of stimulus are unsustainable, especially when viewed in context of its high growth rate. China’s decision to raise banks’ reserve requirements represents an initial foray into managing asset price risk (potential bubbles) and containing inflation. Acknowledging and managing against potential excess is positive for the long term. And there will certainly be some excesses associated with this lending as banks will have to take losses on some bad loans.

Rightly or wrongly, China is viewed by many economists and investors as the engine of global growth. An increase in banks’ reserve requirements may be a precursor to a more aggressive round of policy tightening, including interest rate hikes. Investors become startled when
Chinese policymakers slow the engine, even if moderately.

As the global recovery started in the emerging markets, most market participants expect monetary policy tightening to start there. Although there are divergent policy decisions within emerging markets, China’s recent actions of increasing bank reserve requirements are generally considered to be the beginning of policy tightening in that country.

What to Watch for

Given the developments in Greece and China, global investors are trying to assess the direction and timing of government policy. Market volatility is likely to be directly related to how successful governments are in clarifying policy. This is why Greece’s austerity plan must be clear, disciplined and credible. The European Commission is scheduled to conduct an interim assessment of Greece’s budget plan in mid March. Statements by EU officials after this assessment may provide more clarity on the EU’s desired course of action.

In a February 10 testimony to Congress, Federal Reserve Chairman Ben Bernanke outlined a possible series of future policy moves, but did not address timing, noting that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period. In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures.”

The employment picture remains critical. The employment situation will have to demonstrate material and sustainable improvement before the Fed begins to tighten acutely. For those who like to stay current, jobless and continuing claims are typically reported each Thursday, and many market participants will attempt to extrapolate pending unemployment rate trends from these numbers. The monthly unemployment number is typically released early on Friday in the ensuing month. Another hint of imminent tightening may come from more hawkish statements from Federal Reserve officials, that is, more talk about the growing risks of inflation.

Where are We Headed?

The rally in risk assets from the market lows of March 2009 contains a contradiction. If the rally was dependent on economic stimulus, then it cannot continue indefinitely. Either the economy grows independent of stimulus, in which case stimulus is no longer needed, or the stimulus is still needed, in which case the rally is no longer legitimate. Of course, this is not an all or nothing proposition, and the real outcome will likely lie somewhere in between and be realized after more starts and fits. Greece and China are representative of this dilemma. These macro events do not necessarily signify a new flight from risky assets, but a more likely explanation is that the easiest part of the recovery in risk assets is complete.

When the global financial condition was deteriorating at a rapid pace, relative economic performance did not matter. Now that the global economy is experiencing broad-based recovery, relative growth has gained importance as central bankers vary in individual responses to growth. Relative growth creates contrast (Fig 6). The situations in Greece and China exemplify the emergence of global economic divergences. While today they may represent extremes—Greece suffocating from debt burdens and China tapping on the economic brakes—there is no certainty that contrasts in global economic performance will not become even more extreme.

But uncertainty is especially prevalent in the developed economies. What will be the outcome of health care and financial sector reform initiatives? In Britain, what potential changes will occur in this year’s election? How will Greece and other periphery EU countries manage their deficits? And will the EU bail out Greece or lend emergency support? How will the U.S. tackle its own deficit representing 10% of GDP? When should central banks begin to unwind stimulus and how should they do it?

The Chinese policy actions address timing issues. The Greek fiscal crisis addresses the “how” by forcing the government’s hand at dealing with the deficit and debt burdens. The lesson is not that every deficit is immediately perilous, but governments need to address their deficits before the markets do.

So if the bond markets are waiting to strike complacent deficit wielding countries, should we just sell our bonds, sit on the sidelines and wait for the bond markets to drive up U.S.
Treasury yields? Not so fast. There are a few positives to monitor.

First, the crisis in Greece and the concurrent anti-deficit discussions in Washington may help exert pressure on Congress (and other European governments) to instill some fiscal discipline. Second, corporate earnings are recovering and top line growth is improving. Third, the recovery appears to be slowly migrating toward the consumer. Fourth, shorter term employment numbers are improving at a faster rate than the vast number of “jobless recovery” pundits would have one believe. When measured relative to the maximum number of claims over the past 52 weeks, the current improvement of initial jobless claims from the worst case is significantly better than the previous two “jobless” recoveries. In fact, the improvement over the 12 month worst is a 3 standard deviation upside event and is right on target with previous strong employment recoveries (Fig 7).

Policy changes, particularly in the aftermath of a crisis, will almost always agitate the markets when they are announced or when they occur. We encourage investors to think about a simple axiom; is the policy change a reaction to a negative economic event, or is it designed to be forward looking? At some point, global economies need to stand on their own, and withdrawing stimulus is a necessary course of action.

We wrote about our own Federal budget problems last month, and one of our underlying themes in these commentaries is maintaining perspective. Sure, we have our own problems, but we are not today’s Greece. At least not right now.

If Dionysius of Syracuse were around today, he would take all of our money, inflate it and pay off the government’s debt. Our own government will be taking our money at a much more moderate pace, over the course of years or even generations through inevitable tax increases (non compliance of course is no longer met with death, just jail). At least this affords us a little more time to come up with a more disciplined budgetary framework.

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