Super Mario Brothers to save Europe?
14.11.11 16:11

It was another traumatic week in Europe, with a second head of government becoming the casualty of an aggressive stance by major eurozone partners and unsympathetic sovereign debt markets. Whether the Italian Prime Minister’s resignation proves sufficient in easing longer term concerns over political gridlock and debt sustainability (similar to that experienced in Greece) is still doubtful.

We still see the issue at this point as systemic to the monetary union itself and requiring an appropriate solution – an explicit backing by the European Central Bank (ECB), dramatic intervention by  the International Monetary Fund (IMF), or the introduction of a Eurobond in the longer term. A sharp increase in Italian yields – 2-year yields rose from 5% to over 7% before falling back towards the end of the week – highlights that further fiscal tightening is clearly required. New Prime Minister Mario Monti will lead a technocratic government with the task of restoring confidence in Italian debt; but support from another Mario (ECB President Mario Draghi) is still required to stabilise markets in Europe.

Events in Italy at the start of last week highlighted the speed at which the eurozone crisis has been escalating. Despite obtaining sufficient support to pass the 2010 Budget, the lack of a majority was the last straw in Berlusconi’s long political career as he resigned over the weekend. However, the damage looked done as Italian yields breached 7%, the level the market perceived as unsustainable for previous peripheral countries. But key differences with Greece should be noted.

First, Italy is not insolvent. Due to a favourable current average yield paid on existing debt as well as an average debt maturity of around 7 years, the government can actually sustain current high yields for longer than is often perceived. Second, Italy runs a primary budget surplus (that is, excluding interest payments on its debt) which is forecast to increase in the coming years. According to recent projections, Italian debt to GDP can actually decline by the end of the decade, despite higher interest rates.

However, this does not mean the market is wrong in being worried. Political uncertainty is a sufficient reason, as has been seen all summer. Furthermore, Italy’s growth projections are far from inspiring and the economy’s low productivity is known by most (the economy has annually grown less that 1% on average over the last 15 years!).

The austerity package passed on the weekend will save roughly €60 billion but this would be entirely offset by higher funding costs should rates remain at current levels for the next 5 years. According to a recent IMF Staff Report “another decade of disappointing growth would make public debt difficult to sustain.” Clearly then, half his task will be restoring Italy’s medium term growth potential to build the market confidence in Italy’s solvency.

As we see in Greece, favourable domestic developments are simply not enough at this point. The markets are doubtful that the reform process will prove durable and of course the near term economic backdrop has deteriorated significantly.

To bring Italian yields lower – and ensure the crisis does not spread to France – will still likely require more active bond purchasing by the ECB (Italian yields fell towards the end of the week on speculation the ECB was actively purchasing the sovereign’s debt). A guarantee of lender of last resort by the central bank via an effective QE program is still some distance away, but increasing its current sterilised purchases of Italian and Spanish debt would clearly buy the time necessary for fiscal reform. We expect data to show increased purchasing by the ECB in the coming weeks, particularly if market conditions deteriorate further. A risk would be that a more active ECB provides a disincentive for Italy to undertake necessary reforms but Mr. Monti’s experience in European politics should urge otherwise.

The fall of two governments is most definitely not the only consequence of the Eurozone crisis. It increasingly looks as if the profound political change has come too late to avoid a second recession in 3 years. BofA-ML Economic Research last week downgraded 2012 GDP growth from 0.8% to -0.6% due to three factors: 1) tighter fiscal policies, 2) bank deleveraging and tighter credit conditions, and 3) persistent uncertainty around the sovereign crisis. The combination of these factors is also sure to undermine consumer and business confidence, with both business investment and consumer spending to fall in 2012 from already low levels.

While not being as negative, the European Commission also downgraded their 2012 GDP numbers, with growth slowing to 0.5%; that is barely positive. Under such an environment of weak private demand and a rising unemployment rate, inflation will likely fall back in the absence of wage pressure, forcing the ECB to cut rates. The research team is expecting the central bank to cut interest rates to 0.5% by the middle of next year.

A eurozone recession will have adverse effects on the global economy in two principal ways. First, the eurozone’s major trade partners will experience a negative shock (the Eurozone imported about 4% of global GDP last year). The U.K. for instance is now forecast to re-enter a mild recession in 2012 which could force the Bank of England to further expand QE2. The government’s fiscal austerity may yet require trimming back. This week’s Bank of England Inflation Report will likely show a downgrade of the growth trajectory.

The second way is through eurozone bank deleveraging, which will have a larger global impact. Eurozone banks provide substantial credit to the global economy, particularly the emerging regions, and look set to take a more aggressive deleveraging approach going forward. The global slowdown in 2008 was exacerbated by credit contraction and a slowdown in trade. To give an indication, according to BofA-ML Research, European bank claims as a share of local GDP are over 18% in Latin America and Emerging Eurpore and 13% in Asia. The U.S. is expected to be more resilient. With economic data almost universally surprising in a positive way since the end of the summer, the central scenario is still not one that backs a U.S. double dip.

No one can argue the deep political changes that the crisis is provoking – a number of political careers have already been terminated. In other circumstances, the markets might have been impressed. Yet these are not normal times and time itself is in short supply. Investors want to see a clear ‘circuit breaker’ by policymakers that rebuilds confidence and allows a gruelling debt adjustment to be carried through. For instance, while we hear a good deal of talk about a deeper fiscal and political union, there are growing doubts as to whether it will ultimately include all current members. For risk markets, developed economies’ growth in 2012 is still in doubt and tail risk has not been contained. Of course, equity valuations do discount a lot of bad news (especially when compared to where bond yields stand) but the catalyst for earnings upgrades remains as elusive as ever. For asset allocators, we see three consequences.

First, everything points to a substantial weakening of the euro. Eurozone member economies desperately need it and the ECB under Mario Draghi may facilitate it. Second, growth pessimism and downside risks are material and justified but we see little in the way of value in sovereign debt markets at these yield levels. Third, given the extent of anomalies in how different assets are priced, we do see opportunities (e.g. corporate debt) to take risk in portfolios. Where we are more cautious is how big a role the bet on equity markets advancing should play in portfolios going forward.

Macroeconomic-driven markets often draw people’s attention away from intangible aspects of businesses’ operations. However, one aspect that may grow in significance is the attitude of firms toward issues of environmental, social and governance measures (ESG). Environmental factors are those that arise from corporates’ operational decisions concerning the natural world.

Social factors concern a company’s policies regarding its workforce and human capital. Corporate governance issues, defined as processes for robust management, include shareholder rights and defences against takeovers. Investing along ESG guidelines might be both an enduring and a potentially profitable theme, not a short-lived Zeitgeist. For one, many investors consider the future impacts of their investments upon the wider world. The emphasis of sustainability inherent to ESG-based investing echoes the naturally longer term investment time horizons of pension funds or endowments with decades until payments start to arise. Certain investors may place more emphasis on the performance of a portfolio in terms of positive effects upon broader society, in addition to potential financial returns.

A second reason for the possible longevity of ESG-based investing concerns the steps taken by emerging nations to embrace the theme at relatively early stages in their economic development. According to the Pew Charitable Trusts, for example, Chinese investment in clean energy in 2009, in order to meet environmental criteria, was $35 billion, with the U.S. in second place at $19 billion of spending. Were ESG considerations to become fully integrated within a broader, global setting, these factors may become a more mainstream part of client portfolios and a theme to stay.



source: Merrill Lynch CIO Weekly
 
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