Sunday, 17 April 2011

The Good, the Bad and the Ugly - Update on some Macro situations

First of all, apologies for not having posted more frequently. I have been quite busy recently on other matters.

In the current market environment, differences between countries are more marked than ever.

While in the Euro area clear divergences are showing, between the German power house and the weak peripheral countries, Greek, Ireland and Portugal sinking further, some countries are clearly doing better than some others.

Not everything is all Doom and Gloom.

It is become more paramount to carefully study in details the full macro pictures in this difficult investment environment, plagued by low yields, rising inflation and high unemployment. Are we moving towards stagflation? Not yet, but signals are getting stronger.

In this post we will review the Good, the Bad and the Ugly, highlighting the differences and reviewing the current market context and significances.

The Good:

We will start by Sweden:

"The Gross Domestic Product (GDP) in Sweden expanded 7.3 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1994 until 2010, Sweden's average annual GDP Growth was 2.68 percent reaching an historical high of 6.90 percent in September of 2010 and a record low of -6.70 percent in March of 2009."
Source - Trading Economics.

Furthermore, Sweden predicts a budget surplus and plans to tax cuts are economy beats Europe according to Bloomberg article from Johan Carlstrom.

"The largest Nordic economy will expand 4.6 percent this year, compared with the 4.8 percent predicted last month, the government said in its spring fiscal policy bill released today in Stockholm. The government raised its forecast for growth in 2012 and 2013 and predicted a widening surplus over the next four years as unemployment falls."

"The Swedish economy grew 5.5 percent in 2010, the most since 1970, as exports recovered from the global financial crisis."

Sweden is doing the right thing:
"Reinfeldt’s four-party government alliance had already revealed it will invest more money in the country’s railway infrastructure and that it wants to ease benefit rules for long- term sick leave. It’s also considering next year cutting income taxes for foreign nationals with “expert knowledge,” dividend taxes for some small businesses and allowing bigger write-offs for investments in research and development."

Applying recipes for expansion:
"The government has cut income taxes by 70 billion kronor ($11.1 billion), or about 2.1 percent of the economy, since coming to power in 2006. It has also reduced corporate and payroll taxes and abolished a levy on wealth."

The results, a booming economy and a fall in unemployment:

A History of Balanced budgets:

Leading to a rising GDP per Capita:

Finance Minister Anders Borg wants Sweden to introduce tougher rules on capital buffers than other countries.
The government is closely monitoring housing to avoid a bubble and already has introduced measures to contain rising household debt such as introducing a loan-to value cap of 85% for mortgage borrowing.

Sweden definitely sits in "The Good" camp, macro wise.


I posted before on Canada as a leading example:

Canada, a great example of successful structural reforms and efficient banking regulation

Here is an update on the macro picture for Canada.

GDP Growth for Canada, January 2007 until January 2011:

Canada's budget was either balanced or in surplus, ensuring a reduction of Canada's debt to GDP and enabling them to face the financial turmoil in a much better shape than many other countries.

According to the IMF, Canada’s economy will grow by 2.8 per cent this year, up from an earlier forecast of 2.3 per cent.
The Canadian economy grew 3.1 per cent in 2010.

For the OECD, the forecast is that Canada’s GDP will grow by 5.2 per cent in the first quarter, and 3.8 per cent in the second. In comparison, the OECD has the U.S. economy growing at 3.1 per cent in the first quarter and 3.4 in the second.

"Canada’s economy will grow faster than any other country in the G7 in the first two quarters of 2011."

That’s full-steam ahead. 5.2 per cent would rank as the second-best quarter of the past 10 years,” said BMO deputy chief economist Doug Porter of the OECD’s Canadian outlook.

Unemployment is falling thanks to solid growth prospects:

Canada is clearly part of "The Good" section of our current macro review.

Another strong member of the group, Germany, the clear power house of Europe.

GDP growth is way above its European peers:

Consequences, unemployment is falling faster than in other EU countries:

What is very interesting is that, 10 years ago, France and Germany were at the same economic levels, both were the leading European power economic houses. Now France is clearly lagging behind. In a future post I endeavour to go into more details about this evolution which we witnessed in the last 10 years and the consequences for France in the not so distant future. Unless some major structural reforms are implemented, like they were in Germany, France will not move in the right direction.

The German discipline:

"The Good, the Bad and the Ugly" in the Eurozone per GDP Growth in 2010:

"The Good, the Bad and the Ugly" in the Eurozone per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Scandinavia per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Latin America per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Major Economies per Government Budget Country Ranking in 2010:

Governmnent Yields 10 Year Notes - Source Trading Economics:

The Bad:

United Kingdom struggling to surge from the ashes of the financial crisis:

Inflation lower this month to 4% thanks to price war between major UK retailers:

I posted extensively on the effect QE in the UK would have on inflation on this blog. Previously, I commented that the Bank of England is facing a difficult situation, with the rise of inflation and its mandate of keeping it around 2%. At some point the Bank of England will have to raise rates, but, given the fact two thirds of UK mortgages are depending on short term rates and UK households are already massively leveraged (debt to income at a record level in the G7 countries club), the risk of a double-dip is massive and Mervyn King is fully aware of the difficulties that lie ahead. Mervyn King is trying to delay as much as possible the inevitable rise in interest rates and the March inflation figure at 4% clearly gave him some small room to breath.

UK budget deeply stretched:

UK unemployment levels not falling fast enough at the moment:

UK unemployment rate for the three months to February 2011 was 7.8 per cent of the economically active population, down 0.1 on the quarter. The total number of unemployed people fell by 17,000 over the quarter to reach 2.48 millions.

France is yet again, delivering below par performance which is clearly not helping its already strained budget.

A slow GDP growth below potential for France:

A sticky unemployment level due lack of structural reforms and flexibility in the labor market:

A decaying trade balance, January 2000 - April 2011:

As a comparison, France's closest and biggest trading partner, Germany has seen its trade balance soar, leading to a faster and more solid GDP growth.

Could France lose its coveted AAA rating? One thing for sure, the decoupling of the French and German economy has increased dramatically in the last ten years. I will post more on the subject in a future post.

Another member of "The Bad" group in the Eurozone is Italy.

"The Gross Domestic Product (GDP) in Italy expanded 1.5 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1982 until 2010, Italy's average annual GDP Growth was 1.45 percent reaching an historical high of 4.70 percent in December of 1988 and a record low of -6.50 percent in March of 2009. This page includes: Italy GDP Annual Growth Rate chart, historical data and news."

Italy GDP growth from January 2000 to April 2011:

While benefiting from a GDP boost following the introduction of the Euro after 1999, since then, Italy's GDP growth has been overall muted.

As The Economist posted in early April, Italy can be seen as the Achilles heel of Europe.

"ITALY’S public debt is the sleeping dog of the euro zone’s crisis. So far the markets have mostly let it lie. Although in 2010 it rose by three points, to 119% of GDP, Silvio Berlusconi’s finance minister, Giulio Tremonti, held the budget deficit to an impressive 4.6%, well below his target of 5%."

The article goes on:

"In fact the euro crisis has again laid bare the structural weaknesses in Italy’s economy. When euro-zone GDP falls, Italy’s falls by more; when it rises, Italy’s rises by less (see chart). The country has too few big firms. It is not generating jobs for the young: more than a fifth of the country’s 15- to 29-year-olds neither work nor study. Too few women have jobs (in the euro zone only Malta has a lower female-participation rate). The south remains a huge drag: in broad terms, GDP in the north may grow by as much as 3% a year, but in the south it shrinks by 2%, pulling the average down. Youth unemployment in parts of the south is 40%. And, as the Bank of Italy’s governor, Mario Draghi, has noted, Italian entrepreneurs have to cope with an unusually high level of organised crime. Police operations show that the ’Ndrangheta from Calabria has burrowed deep into the economic fabric of the north."

For the excellent The Economist interactive guide on the Eurozone spreading infection please use the below link:

Europe's economies - Spreading infection

Unemployment for Italy is still too high: January 2000 - April 2011.

But Italy's public finances were held tight thanks to its finance minister.
Italy Budget Deficit from January 2000 until April 2011:
Much tighter than France for instance.

The issue for Italy is that to meet the European rules on public debt, Italy will need annual economic growth of about 2 percent and a balanced budget. I do not see it happening in the near future.

ECB’s Draghi Says Italy Needs GDP Growth Near 2% for Debt Rule - Bloomberg

"The European Union last month reached an agreement on tougher economic oversight rules for member countries, including fines for governments that don’t cut overall debt fast enough. The accord came after Italy, with debt of 118.9 percent of gross domestic product last year, pushed for a broader definition of government borrowing that may offer a better chance of avoiding future sanctions for violators of the debt rules.

While countries with debt over 60 percent of GDP will be required to make annual cuts equal to 1/20th of the excess, progress will be judged against a range of “relevant factors,” the ministers agreed. Italy has pushed for private debt levels, which are low in Italy compared with the EU average, to be included in the gauge."

Analysis: Marchionne offers reform model to stagnant Italy - Reuters

"There is no doubt Italy is in dire need of reform."

According to this article from Reuters by Gavin Jones and Lisa Jucca

"Its economic growth consistently lags its euro zone partners and, according to International Monetary Fund data, it was the world's fourth most sluggish economy between 2000 and 2010, ahead of Zimbabwe, Eritrea and Haiti. Real disposable income has been stagnant since 1990 and the average hourly wage, adjusted for the cost of living, is 30-40 percent below that of its three main European peers, Germany, France and Britain. It is the only euro zone country where per capita output is lower now than it was in 2000.

Of course there are many reasons for this state of affairs, but analysts agree that one factor is the rigid and centralised system of industrial relations and an inability to increase productivity in line with its competitors."

But it is not too late for reforms. Germany remain's Italy’s largest trading partner. Germany is purchasing 12.7 per cent of Italian exports.

What is currently plaguing Italy's economy remain its ongoing North-South divide. Italy is a two zones economy and it is hindering its growth dramatically:

It is not too late for France either.

Both Italy and France, need to become probably more like Germany. In order to do so, they have to go through much needed structural reforms: Productivity and competitiveness were key to Germany's recent success.

The Ugly - Peripheral Europe:

Ireland has been the subject of quite a few posts on this blog.

Ireland debt status is now closer to junk following another round of downgrades from the rating agencies:
Moody's downgraded Ireland to Baa3 status with a negative outlook.

The Irish economy contracted for the third year running in 2010. GDP growth of 0.9% and 2.2% is forecast for 2011 and 2012.

As I posted previously, the Irish financial sector sunk the country.
Allied Irish Banks latest financial results is a good indication on how the country's public finances were deeply put into the red. AIB used to be Ireland's largest lender. AIB revealed additional losses recently: 10 billion Euros in 2010 from 2.3 billion Euros in losses a year earlier.

Now AIB, which is almost totally owned by the Irish government.

So far AIB has received 7.2 billion Euros in government aid to date and we know now it needs an additional 13.3 billion Euros in capital, following the latest Irish banks Stress Tests. On its own, AIB's capital injections so far represents an incredible 12.5% of GDP. And this is just for AIB, I am not including, Anglo Irish or Bank of Ireland.

There is only one explaination for the high losses in the Irish financial sector: High concentration of risk in property lending. Anglo Irish's loan book was on 10 promoters only as indicated previously.

Since Ireland embarked on its fiscal austerity programme two years ago, the Irish economy has contracted by at least 11%, and, 16% in three years in total. Consumer spending is down 14 percent since 2008.

"Commercial property prices have plunged 60 percent since peaking in 2007, while rents have fallen an average 50 percent, according to real-estate agent CB Richard Ellis Group Inc. (CBG)"

Source Bloomberg: Irish Retailers Fight Investors Over Rents After Economy Sinks

For the IMF, Irish growth will be "Ugly" in 2011, a miserable 0.5% according to there latest forecast.

In comparison:

"Growth for the Euro Area is estimated to be 1.6%. In advanced economies worldwide, growth is estimated at 2.5%, with developing world growth put at 6.5%."

The employment in Ireland is as well, a truly "ugly" picture:

Ireland Unemployment: January 2000 - April 2011

The blame for financial crisis is not all our own
We need to draw attention to punitive stance on financing of bank resolution, writes Colm McCarthy

"Holders of Irish bank bonds should take losses instead of the Irish Government footing the bill for their bailout," European Central Bank governing council member Axel Weber said.

Mr Weber added:
"To save a country's banking system, it is not necessary to write a blank cheque for the total balance sheet of the banking system."

"'In Ireland, the question is whether the banking sector has to be saved as a whole,' he added. 'Would it not be a better route to isolate deposits, to minimise losses to Irish taxpayers and to find a complete solution . . . with private sector participation instead of buying them out.'"

"Mr Weber echoes the consistent editorial position of the Financial Times, the Wall Street Journal and the Economist magazine among others."

This is the difficult dilemna, Ireland is facing, haircuts or more austerity for its taxpayers.

As for Portugal, last time it received an IMF package in 1983, the result was higher productivity and exports. Is it going to be different this time?
The key element for Portugal, as well as Spain to some extent, lies in a major structural reform of its labor market. Portugal needs to become more competitive again. Competitiveness is a key factor of success as highlighted by the German economic situation.

Portugal benefited as Italy in a short boost to its GDP growth after 1999, but since then, its GDP growth has not been stellar to say the least:

Portugal GDP Growth: January 2000 - April 2011

"The Gross Domestic Product (GDP) in Portugal expanded 1.20 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1989 until 2010, Portugal's average annual GDP Growth was 2.16 percent reaching an historical high of 6.50 percent in March of 1995 and a record low of -3.70 percent in March of 2009."
Source Trading Economics.

Austerity is biting even more Portugal's employment levels:
Portugal Unemployment Rate Jan 2000 - April 2011

As a reminder, CDS for financials are deeply correlated to Sovereign CDS levels as of the 7th of April 2011.

In regards to Greece, the writing is on the wall and a restructuring seems to be the most likely outcome:

Greek Government bonds run on the 14th of April 2011:
Price Yield

GGB 4.6 05/20/13 78.4410 17.8539
GGB 5 1/2 08/20/14 68.2760 19.1830
GGB 6.1 08/20/15 67.1960 17.3838
GGB 3.6 07/20/16 58.9710 15.5923
GGB 4.3 07/20/17 59.1350 14.7267
GGB 4.6 07/20/18 59.2450 13.8444
GGB 6 07/19/19 61.2950 14.257
GGB 6 1/4 06/19/20 64.1660 13.1971
GGB 5.3 03/20/26 58.6110 11.0967
GGB 4.6 09/20/40 53.6850 9.2031

Greece Sovereign CDS 5 year spreads reached a record on the 14th of April 2011 to 1164 bps, implying a Cumulated Probability of Default of 60% according to CMA.
CDS 5 year levels for Peripheral countries as of the 14th of April 2011:

A real recovery in productivity is the only way for a sound economic recovery.

An interesting article as a follow up on European Banks financial woes:

Euro vs. Invasion of the Zombie Banks

By Tyler Cowen in the New-York Times

Are we seeing the application of Gresham's law in current market turmoils and hot money pouring into Emerging Markets? I will discuss on this subject in a future post.

Gresham's law as per wikipedia:
"Gresham's law is an economic principle "which states that when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation."

"It is commonly stated as: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law."

Robert Mundell believes that Gresham's Law could be more accurately rendered, taking care of the reverse, if it were expressed as, "Bad money drives out good if they exchange for the same price."


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