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Capital Markets

Bond Outlook by bridport & cie, April 25 2012

The French must now choose between the Hopeless and the Horrible. If it is the former, say goodbye to European cohesion and competitiveness. Maybe the Horrible is the lesser evil!

When the Netherlands, Germany’s most faithful ally in the fiscal pact favouring full-blooded austerity, begins to have second thoughts, it is powerful sign that a rebellion is growing throughout the euro zone. How far will this rebellion go, and will it bring about a change of heart in Germany?

 

If it were not for the forthcoming French presidential election, it would be quite easy to answer at least the first of these questions. Spain led the way in accepting the need for austerity, but opted to slow the pace of debt reduction with what we have called “austerity light”. It is probably true to say that where Spain led, every euro zone country wants to follow, except, of course, Germany. We understand, and even sympathise with, such rebellion. Excessive austerity leads to economic contraction, removing the very economic growth needed to bring about deleveraging. Merkel is very stubborn, but even she must listen when all the other euro zone countries oppose her view. However, as we spell out below, it is a change of heart towards proceeding with fiscal union that we judge to be the most important.

 

Determining the degree of stimulus required via increased money supply, versus the fiscal tightening to reduce government indebtedness, is a very delicate exercise. We suspect the USA has neglected fiscal tightening, while the euro zone has overdone it. The UK is an interesting case as it may have achieved the best balance (only “may have” - the jury is still out).

 

To assess the required mixture of monetary stimulus and fiscal tightening obviously requires the collaboration of central banks and treasuries/finance ministries. That seems to be missing in the euro zone. It would not be missing if the euro fiscal union were put in place, but a central bank with no central Treasury, able to issue bonds and influence fiscal policy, is just not sustainable.

 

The supposed breathing space created by the ECB’s support of banks was supposed to allow euro zone countries time to reform their labour laws to improve their competiveness. Yet facilitating hiring and firing, necessary though it is, is not in itself enough for growth. That requires the encouragement of innovation and entrepreneurship. It is a partial answer to the question we suggested last week that governments should be asking, viz.: “What can we do beyond budget cuts, and how do we create growth?”

 

That brings us back to the greatest danger now facing Europe: France’s likely swing to the left. That country is already so bureaucratically driven that job creation through new enterprise is stifled; obviously there are innovators in France, and we take our hats of to them for their persistence, despite the heavy regulation and social charges. Now put Hollande in charge of a country already with an anti-entrepreneurship bent, and we all have reason to tremble. In addition, if he reduces the retirement age to 60, and chases successful business people out of the country with forfeiture taxation, the damage caused will not be limited to France but will extend to whole EU project.

 

Greece, Italy, Spain, Portugal, Ireland – all can be managed because, in the end, the countries of the euro zone have enough financial strength overall, and the level of budgetary rebellion to which we referred above is actually quite moderate. If, however, France goes its own way, then all bets for the EU and the euro zone are off. We nevertheless allow ourselves to finish on a more hopeful note, viz., that post-election reality brings unsustainable policies back to earth.

 


Macro Focus

US: leading indicators rose for a sixth month in March. However, consumer confidence declined from 70.2 to 69.2 and manufacturing in the Philadelphia region expanded at a slower pace in April, suggesting a long slow recovery. The housing market showed signs of stabilization: home prices dropped at a slower pace and new home sales stabilized above 300,000

 

US Treasury: almost half of the more than $400 billion a year in interest paid is on government securities that are not traded in financial markets and carry higher rates: 3.9 % on $5.2 trillion of nonmarketable debt versus 2.2% on $10.3 trillion of marketable debt as of March

 

Ireland: € 5.8 billion ($7.6 billion) of capital was injected into banks, creating a deficit was 13.1 % of GDP, large, but down from 2010’s 31.2 %

 

Euro zone: the 17 euro nations’ debt climbed to a new high of 87.2 % of GDP in 2011 from 85.3 % in 2010, reflecting governments’ increased borrowing to plug budget deficits and fund bailouts of fellow nations crippled by the fiscal crisis. Increasing German confidence underlines the strength of Europe’s largest economy and its contrast with the deficit countries. In Spain, non-performing loans jumped to 8.16 % of total lending in February. The economy contracted in Q1, entering its second recession since 2009. Italian consumer confidence plunged to the lowest in more than 15 years in April

 

UK: in March, unemployment fell for the first time for almost a year (8.3%) and retail sales rose at the fastest pace for more than a year. Nevertheless, disposable income declined the most in a year as income growth slowed and consumers spent more on essential items such as food and utility bills

 

Switzerland: investor confidence rose for a fourth month in April, adding to signs that the economy may be stabilizing

 



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