Europe faces recession, not regression

PORTFOLIO POINT: The financial crisis isn’t over for Europe as the Continent enters recession, but talk of the union’s breakup or the euro’s dissolution is just plain wrong.

It’s an election year for many important economies. Some of them will be democratic – India, South Korea, Mexico, Queensland – while others will be less so: Russia, Iran, Burma, Egypt. Most importantly, however, it's an election year in the United States and with the Republican Party still seemingly unable to choose a front-runner this weekend, Obama’s chances of re-election look stronger by the day (for this and other forecasts, see Twelve predictions for 2012).

Also helping the US President is a recovering economy, falling unemployment numbers and a stabilising business environment. While America is still hampered by a fractious Congress, a matter that won’t be solved if the Democrat incumbent retains the Oval Office (and the main reason behind Standard & Poor’s credit downgrade), it’s looking as though the worst is over for the world’s biggest economy, notwithstanding of course its still-too-high public debt.

In Europe, however, things aren’t looking nearly as good, which is all for the worse for sitting governments in France, Finland and Lithuania, among others (the party of outgoing Finnish president Tarja Halonen last night polled fifth in the first round). With France losing its coveted AAA credit rating last week, President Nicolas Sarkozy in particular is fighting an uphill battle against not just his traditional Socialist Party rival François Hollande (Dominique Strauss-Kahn decided not to run), but far-right Eurosceptic candidate Marine Le Pen, who proposes to pull France from the eurozone and whose father, Jean-Marie Le Pen, managed to take their Front National party to the presidential run-off in 2002.

At a time when financial markets are so skittish, such a prospect only adds to worries about Europe’s viability as a single economic unit. And, as finance ministers prepare to meet in Brussels tonight for the umpteenth time, many are also questioning whether like Japan, Europe is about to enter its own lost decade (see Continental drift).

Yet while it’s almost certain that most European economies will spend the next year in recession, and while the Continent is unlikely to be a significant source of global economic growth in the coming years, talk of the European Union’s breakup or the euro’s dissolution is just plain wrong. Europe has plenty of reasons to stay together and plenty of policy options left to make sure that happens. What that means, however, is that the euro and euro-denominated securities, in US and Australian-dollar terms, are likely to fall a lot further from here.

First, it’s important to understand a bit of context to the media-led panic over Europe.

In terms of the ratings downgrades, it should be noted that similar moves on US sovereign debt ratings failed to lift treasury yields and while there is the theoretical risk that Germany – the sole major economy retaining a AAA imprimatur from S&P (the biggest of the ratings agencies) – will see a flow of funds out of France. But that has yet to materialise beyond what has already been happening in the bond market. In fact, recent sovereign bond auctions have actually exceeded expectations.

The fact is that France retains its AAA rating from the other two agencies, Fitch and Moody’s, as do EU members Denmark, Finland, Netherlands, Luxembourg, Sweden and the UK. And as far as ratings go, France’s new S&P rating, AA , still puts it well ahead of places like China (AA–), not to mention the other major emerging markets: Brazil (BBB), Russia (BBB) and India (BBB–). Indeed, even Spain (A) and Italy (BBB ), not to mention Japan (AA–), are considered safer than these other members of the BRIC quartet.

And with the European Union itself still retaining its AAA rating, reports of that institution’s death are also greatly exaggerated. While most pundits are analysing which countries will leave the EU (none so far), Croatia last night voted with a 68% margin to join the Union and the EU has scheduled accession negotiations with Montenegro for June. As for the eurozone itself, it was little reported that this year Estonia adopted the currency, and this year Romania is taking steps to join the European Exchange Rate Mechanism as well. Denmark, Lithuania and Latvia already have a euro peg and have not changed plans to eventually adopt the single currency.

-Credit ratings of G-20 states plus Spain
	S&P		Fitch		Moody's
Germany	AAA	(Stable)	AAA	(Stable)	Aaa	(Stable)
Australia	AAA	(Stable)	AAA	(Stable)	Aaa	(Stable)
Canada	AAA	(Stable)	AAA	(Stable)	Aaa	(Stable)
Britain	AAA	(Stable)	AAA	(Stable)	Aaa	(Stable)
France	AA	(Negative)	AAA	(Negative)	Aaa	(Stable)
United States	AA	(Negative)	AAA	(Stable)	Aaa	(Negative)
Saudi Arabia	AA-	(Stable)	AA-	(Stable)	Aa3	(Stable)
China	AA-	(Stable)	A	(Stable)	Aa3	(Positive)
Japan	AA-	(Negative)	AA	(Negative)	Aa3	(Stable)
South Korea	A	(Stable)	A	(Positive)	A1	(Stable)
Spain	A	(Negative)	AA-	(Negative)	A1	(Negative)
South Africa	BBB	(Stable)	BBB	(Stable)	A3	(Stable)
Italy	BBB	(Negative)	A	(Negative)	A2	(Negative)
Brazil	BBB	(Stable)	BBB	(Stable)	Baa2	(Positive)
Russia	BBB	(Stable)	BBB	(Positive)	Baa1	(Stable)
Mexico	BBB	(Stable)	BBB	(Stable)	Baa1	(Stable)
Turkey	BBB-	(Positive)	BB	(Positive)	Ba2	(Positive)
India	BBB-	(Stable)	BBB-	(Stable)	Baa3	(Stable)
Indonesia	BB	(Positive)	BBB-	(Stable)	Ba1	(Stable)
Argentina	B	(Stable)	B	(Stable)	B3	(Stable)
				Source: Agencies

In terms of Greece’s fiscal crisis, meanwhile, there have been difficulties in agreeing to a debt haircut, but that situation too is greatly exaggerated. Official talks over private sector involvement (PSI in Euro bureaucratese) in the haircut have yet to conclude, but the fact of the matter is that Europe will not let Greece default while market sentiment is so fragile and backwards-looking analysts are obsessed with anything that could be construed as a “Lehman-style” event.

It thus doesn’t matter that Greece’s debt burden is unsustainable, the can will continue to get kicked until it is safe for Greece to default. My guess is that won’t be for at least another couple of years. I would be most surprised if negotiators don't come to another (typically compromised) agreement by January 31, the deadline for Greece's next €130 billion loan deal.

And even on the off-chance that Greece did default prematurely, or if, on the other hand, a “voluntary” PSI debt haircut constituted a “credit event” according to International Swaps and Derivatives Association rules, the net outstanding positions on Greek sovereign credit default swaps (CDS) is a paltry $US3 billion – less than a quarter of the cash revenues, at current exchange rates, that Greece enjoyed from foreign tourism during 2011 (officially the best year in history, according to the Association of Greek Tourist Enterprises).

There is more CDS outstanding on the average European multinational and, by their very nature, CDS contracts are marked to market; any risk of a Greek default has already been priced in. And considering the fact that it effectively costs $6.7 million to purchase $10 million of Greek CDS upfront, this is surely the most-telegraphed crisis since the Y2K bug.

In terms of fiscal reforms, while these will invariably take time to implement, Spain has dramatically improved its financial standing and Italy has returned to the top table in eurozone negotiations, thanks to the prodigious efforts of former European Commissioner Mario Monti, who took over from scandal-ridden Silvio Berlusconi as Italy’s prime minister last year (see New Euro Order).

Thus while Germany’s Angela Merkel’s pro-austerity leadership in Europe has to date compounded fears of a prolonged recession, now that Monti has joined France’s Sarkozy in the pro-stimulus camp, the chorus of dovish voices grows louder. This chorus is echoed too in eurosystem monetary policy outside of Germany where the European Central Bank (ECB), now led by former Bank of Italy governor Mario Draghi, is developing a strongly dovish bias, witnessed not only by lower eurozone cash rates, but by the ECB’s unprecedented Long-term Refinancing Operation (LTRO).

The LTRO, the monetary operation whereby the ECB recently gave European banks the option to borrow unlimited quantities at a 1% interest rate for three years, has done much to relieve lenders of funding pressures as they rebalance their books in line with latest Basel 2.5 and tough European Banking Association rules. Arguably, it has also contributed to the success of recent sovereign debt auctions, with some of those banks in turn 'refinancing’ the countries in which they operate (current ECB rules prevent it lending directly to sovereigns except in certain circumstances).

Yet I see the LTRO as more a taste of things to come, than a comprehensive solution in its own right. While the ECB's so-called "wall of money" has been a pretty big deal as far as size goes – European banks are now in the same position as they would have been had the ECB instituted US Fed-style quantitative easing, estimates Goldman Sachs – because Frankfurt hasn't announced whether further three-year LTROs will be conducted beyond February, markets remain deeply uncertain, as can be seen in peripheral European yield curves at around the 36-month point.

Further, according to Benedicta Marzinotto, an economist at the Bruegel think-tank in Brussels, most of the ECB's money has not been used by the banks to recapitalise sovereigns but has instead been parked back at the ECB. The central bank's overnight deposit facility almost doubled to €480 billion soon after the LTRO was announced. And while, as such, there is at least little risk of the policy causing the kind of Weimarian inflation the ECB's German members have traditionally feared, a collateral squeeze is continuing in the eurozone repo market, according to the latest report from securities broker Icap.
And with this continued stress in both repo and sovereign markets, it's clear that the LTRO by itself will only go so far. Analysts at Citibank compared it with Dolly the Sheep in a note on Friday: "At the end of the day, artificial life is no substitute for the real thing: life created in the laboratory tends to die prematurely (ask Dolly). As we saw with the first Greek bailout, a wall of liquidity buys time, but the fundamental realities will assert themselves in due course."

Europe effectively has three simple solutions to its crisis:

• Instituting a transfer union.
• Eurobonds.
• Having the ECB act as lender of last resort to sovereigns.

Angela Merkel’s Germany opposes all of these solutions, preferring the current regime of austerity – whether that's due to some kind of Teutonic obsession with debt punishment, or a desire to force through reform – yet with doves like Italy again at the top table I’m betting that within the next year we’ll get at least solution number three, considering that the first two, being an effective “mutualisation” of debt, would require much legal wrangling and, as such, could take years to effect.

Beyond the essentially unworkable proposals for a Tobin Tax on financial transactions, or sundry efforts to use alternative circulatory financing for sovereigns through the IMF (as opposed to the already-attempted LTRO), direct printing by the ECB is the only realistic solution, in my view. And not only would this effectively monetise much of Europe’s debt through mild inflation in an otherwise deflationary or disinflationary recession, but it would support an export-led recovery through a lower euro.

While Angela Merkel has to date presented to act for the stolid frugality of Herr and Frau Fritz by opposing any measures that could inflate away their Sparkassen accounts, ultimately it would be in the thrifty burghers’ best interests for this to happen, as it would give Germany’s Mittelstand – the SME backbone of the country’s economic miracle – even greater international competitiveness.

One of the apparent failures of Europe’s economy is that it is a monetary union without a fiscal union. As such, however, it seems only natural that the solution is a monetary one until treaties toward greater fiscal consolidation and political federation are eventually achieved.

At the EU leaders' summit in exactly a week – coming hot on the heels of two more Italian bond auctions (€4.5 billion plus €7 billion) – I don’t expect any announcement of floodgates opening at the ECB, but seeds will continue to be sown in that predictable, ponderous, European way as the Continent edges towards the only and inevitable solution.

French diplomat Jean Monnet, regarded as the original architect of the European Union, once said that "Europe will be forged in crises, and will be the sum of the solutions adopted for those crises". This sentiment was echoed late last year by German finance minister Wolfgang Schäuble when he told reporters: “When things get really difficult '¦ suddenly solutions that seemed impossible become possible. Because of this, the crisis represents an opportunity."

In recent sessions the euro has strengthened against the US dollar, notwithstanding the string of credit downgrades. But backed by the majority of surveyed economists who see eurozone rates falling in the coming year, I'm inclined to view those gains as short-covering, especially with data from the Commodity Futures Trading Commission indicating a surge in net short positions.

Right now, with the euro still buying $US1.29 in the markets (it buys approximately $A1.23) the currency remains much higher than its $US1.20 average since launching 13 years ago. On the balance of probabilities, I’m inclined to view the Euro as a short and would not be surprised to see it near parity with the Greenback over the coming months. As for betting against the Continent itself, however, two world wars and 50 years of communism couldn’t stop the European project. This current crisis won’t either.

Follow Michael Feller on Twitter @MFellerEureka