It Is Not All Bad Actually, But …
Markit has just released the final PMI data for the , , (all files in pdf format) and others, and they essentially confirm the message from the 'Flash PMI' data discussed here. Things continue to look bleak and the euro area remains mired in recession. However, we would point out that not everything is bad. For instance, with the exception of Italy, most euro area peripherals (most notably Spain) have managed to narrow their 'competitiveness gap' with Germany considerably. Bank borrowings from the ECB have declined slightly even in Spain, bond yields and CDS spreads remain tame in the wake of the ECB's 'OMT' announcement. We would note to this that given how late the ECB was to the party every time, its interventions may have merely reinforced what the markets were about to do on their own anyway. There is of course no way of ascertaining to what extent the move lower in peripheral sovereign bond yields was due to the interventions and promises of the ECB and to what extent the previously very high yields attracted buyers motivated by the apparent opportunity. However, given the vast expansion in government bond holdings of e.g. Spain's banks, we are inclined to mostly blame the intervention effect.
Speaking of Spain, it was recently reported that unemployment fell slightly there. Every bit of good news is of course welcome, but then again, with unemployment already at nearly 26%, it cannot be expected to just keep rising every single month. One thing is certain though, financial markets continue to give the euro area the benefit of the doubt for now. Also, as BNP Paribas has shown with its “transformation” in 2012, even banks that look a bit shaky can materially alter their situation for the better if their management is bold enough.
5 year CDS on Portugal, Italy, Greece and Spain – a nearly complete round-trip to levels last seen in early 2011.
Spain's 10year government bond yield, weekly candlestick chart. It remains elevated at just above 5% and it remains to be seen whether lateral support in this area will halt the decline.
European stock markets are cheap, and none of them is cheaper than that of Greece. After declining from its 2007 highs by the same percentage as the DJIA in the first three years of the great Depression, the Athens General Index performed nicely in the second half of 2012. We were a bit early in calling it a buy, but not by much. This is a case where we can really say 'you heard it here first'. Especially the observation about the parallel with the 1932 pattern.
It is certainly true that European stocks remain quite cheap. Long term investors have probably little to fear. However, we also believe that bond yields and CDS are currently not properly reflecting the risk that the debt crisis could make a comeback. In addition, we see that in the short term, a divergence is developing between the Euro-Stoxx 50 big cap index and the Euro-Stoxx bank index, with the latter failing to confirm a recent breakout of the former. This must be considered a warning sign.
The Euro-Stoxx 50 index has broken out above the resistance level we have previously discussed. Note that this breakout does not yet alter the long term corrective character of the rebound.
The Euro-Stoxx banks index is not yet confirming the Euro-Stoxx 50 index breakout. While it won't take much for it to do so, this is a subtle warning sign at this point.
Reasons To Remain Wary
If one looks at euro area bonds and stocks today, it certainly appears on the surface as though the problems have been overcome. However, one would do well to remember that we have seen a number of false dawns in the course of the crisis before. So what is actually different now?
For one thing we have of course the ECB's announcement of 'OMT' ('outright monetary transactions'). This is an – allegedly to be fully sterilized (we have previously noted that this is actually not really true, as any new deposits created in favor of non-banks will definitely add to the money supply) – program of buying short term (0-3 years) bonds of governments that submit to an ESM bailout while they are still able to access the market. Clearly this program is aimed specifically at supporting Spain and Italy. The announcement alone was enough to depress their yields considerably.
Spain's 2 year note yield and the ECB 'announcement effect'
Italy's 2 year note yield is back to 2010 levels when the world was still alright….
10 year government bond yields of Portugal, Greece, Spain and Italy (the latter shows the bid price – Italy's generic 10 year gross yield stands at 4.29%)
One thing worth noting about the above charts is that although Spain's government bond yields once again exceed those of Italy (there was a brief period in late 2011 when this relationship inverted), CDS spreads on Italy's debt are only 11 basis points below those on Spain's debt. This may be due to the markets expecting Spain to be the first country to eventually become subjected to the OMT program.
Here is the main reason to remain wary of the current period of relative calm: while clearly some time has been bought and there is a decent-sized improvement in competitiveness relative to Germany and a notable reduction in current account imbalances in several of the peripheral economies, the economic situation remains dicey. Reforms have not yet gone far enough and have been too strongly weighed toward the perceived needs of the State as opposed to those of society. What is highly likely to happen in the course of this year will be further 'target misses' in terms of the budget deficit and cumulative public debt targets euro area member nations have committed to in the course of the 'fiscal pact' and various bailout related agreements. This could eventually lead to rising bond yields again, until the ECB's 'OMT' promise is finally tested.
One major issue remains that there is very little support for the eurocratic elite's policies among voters. What support there is left is in fact dwindling fast. It may well be that certain reform efforts would bear tangible fruit if given enough time and if they were deepened, but it seems actually more likely that voters will not be so patient and will instead boot current political incumbents out. The victors of elections in turn may find that they will have to form coalitions with euro-skeptic parties, which would lead to a considerable hardening of political attitudes in both the crisis-stricken and the donor countries.
It should also be noted that there is more and more reason to worry about the so-called 'core' as well. A real estate bubble is in the process of collapsing in the Netherlands, in parallel with a similar development in Denmark (Denmark is not a member of the euro area, but it is noteworthy that its real estate bubble is being kneecapped in spite of its central bank recently even imposing negative interest rates on excess reserves). France's real estate bubble is likewise standing on shaky ground, although it has recently still expanded in view of record low interest rates. As we asked rhetorically in a previous missive in the context of the French housing bubble:
“Surprise, another real estate bubble egged on by too low interest rates and a 'law meant to stimulate the housing market'. Prices in terms of rental income 150% above trend? Mortgage lending up 73%? What could possibly go wrong?”
The answer is of course: “everything”. Whatever can go wrong, probably will go wrong, and this particular bubble is really begging for it.
France's 10 year government bond yield recently stood at a 270 year low.
As we have amply documented in the course of last year, France represents a growing problem for the euro area, in spite of having one of the better demographic profiles in Europe. This is because its new socialist government is deeply committed to an anachronistic ideology and is busy turning the clock back by about 30 years. Every failed socialistic policy is tried all over again, as though the past had never happened. The French government actually seems to believe that “it can order nature around” as Fred Sheehan has put it. In other words, it thinks it can suspend economic laws by government decree. This has never worked and never will. The eurocrats better hope that the markets don't unexpectedly turn on France.
5 year CDS on Japan, Belgium, Ireland and France. At a recent 89 basis points, CDS spreads on French government debt have retreated quite a bit from their highs, but remain very high for a developed nation. A number of CEE countries sport lower CDS spreads for instance. Moreover, the recent reading represents a big increase from the late 2012 low at about 65 basis points.
The bigger near term worry is however Italy. While the markets are by now used to apocalyptic news flow from Spain, they seem remarkably unconcerned about the potential for the upcoming election in Italy to upset the apple cart. And yet, it is Italy where there has so far been the least progress in terms of reform and restoration of competitiveness. Consequently, the country's economic performance continues to disappoint, to put it mildly. Most recently it was reported that new car sales in Italy have plummeted to a 30 year low in 2012, nearly 20% below the 2011 numbers. Fiat recorded its worst sales in 33 years. Note bene, Italy is Europe's third largest car market, so this is quite significant.
We have most recently discussed the developments on Italy's political scene here. Silvio Berlusconi's comeback and the strong support enjoyed by euro-skeptic newcomers like Beppe Grillo's 'Five Stars' party all make for a potentially interesting election outcome. While the former communist (now 'center left') Pier Luigi Bersani is widely expected to win the election (he remains officially in support of the 'Monti program'), it won't be smooth sailing even if he does, as he is unlikely to get control of the senate. Moreover, the potential for an election upset remains considerable.
It turns out that in 2013, sovereign bond issuance in the euro area will be only slightly below the levels of 2012. In other words, it will involve a huge amount, namely €747 billion.
Euro area sovereign bond issuance, gross (including redemptions) and net, via JPM. The 2013 numbers are an estimate.
Obviously the euro area remains highly dependent on investor perceptions not deteriorating. These enormous funding requirements will pose a very big problem if investors turn sour on euro area sovereign bond markets again.
Two indicators we keep an eye on in the context of gauging the health of the European banking system – or rather the market's perception of its health - are euro basis swaps and our proprietary bank CDS index. Both continue to look favorable for the moment. However, apart from the BNP Paribas turnaround story we are not really aware that anything has materially changed. It seems highly unlikely that the banks will be able to deal any better with crisis stresses next time around than they were last time. The banking system remains too highly leveraged and it is to be suspected that the ECBs special funding measures have induced a bit of complacency with regard to the need to raise more capital and bring leverage down. At least the banks enjoy healthy demand for their unsecured senior debt at the moment, so a major funding headache has temporarily been alleviated in the course of the past year. Whether that will remain so is an open question – we suspect it won't.
Three month, one year, three year and five year euro basis swaps – still recovering further. Dollar funding seems not to pose a problem at the moment.
Our proprietary unweighted index of 5 year CDS on the senior debt of eight major European banks -the white line (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito), compared to 5 year CDS on the senior debt of Goldman Sachs (orange), Morgan Stanley (red), Citigroup (green) and Credit Suisse (yellow) – the market continues to give banks the benefit of the doubt, but euro area bank CDS spreads remain well above those in the US.
In spite of numerous official pronouncements to the contrary and a number of positive developments under the surface, the risk that the euro area debt crisis reignites remains fairly high. Points of weakness can be discerned both in the periphery and the core. We didn't mention Germany above, which remains the lynchpin of the bailout policy, as it is the euro area's paymaster, but it is worth noting that economic weakness elsewhere is beginning to be felt in Germany as well, with especially the manufacturing sector coming under pressure in recent months.
The markets are as of yet not giving any signals that their assessment of the situation is changing, but changes in perception usually tend to happen very quickly and with little forewarning. There are however a few small signs that constitute a potential heads-up, such as the recent divergence between bank stocks and the big cap Euro-Stoxx index discussed above.
Political developments remain a wild card, with elections looming both in Italy and Germany this year. The outcome of the former is very much in the air, and the outcome of the latter probably largely depends on whether the crisis can be kept at bay until then.
However, the importance of Germany's election in the fall lies in the fact that until then, Mrs. Merkel's government will be extremely reluctant to do anything that increases Germany's already sizable commitments to the bailout policy. In short, should crisis conditions return prior to the German election, there will be very little willingness on the part of Germany to throw even more good money after bad. The ECB however remains committed to print should push come to shove, a commitment that the markets are likely to eventually test.
Addendum: The Euro
We will discuss the euro currency in more detail in an upcoming post, but would like to mention here that the previously extant very big speculative net short position in euro futures has been largely covered by now. In short, the euro has now room to fall again.
Charts by: Bloomberg, BigCharts
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