Credit Writedowns

The data flow out of Europe today is pretty bad. German factories orders missed and unemployment rose to record levels in France and Greece. Meanwhile the IMF admitted that Greece’s delayed debt restructuring “provided a window for private creditors to reduce exposures and shift debt into official hands.” Does any of this change my bullish bias on Europe’s economy? No, I believe Europe will exit recession at some point in the second half of 2013.

As I have ben predicting here for months, the problems in individual large European economies have become to large to bear for the prevailing European policy mix. Therefore, today, in releasing the next year’s country specifici recommendations, the EC has moved away from front-loaded austerity, pushed back deficit reduction targets and instead stepped up calls for structural reform. The paradigm remains the same but the slant is away from austerity in order to accommodate the facts on the ground.

Now, you may well deduct from all of this that I am as bearish as I have ever been, but nothing could be further from the truth. The issues I have discussed in this month’s letter are clouds on the horizon which are likely to take years to play out and, in the meantime, investors will continue to be preoccupied with far more mundane issues. All I know is that financial markets cannot stay disconnected from economic fundamentals forever so, ultimately, the Tony Dyes of the world will be proven right. Unless they lost their jobs beforehand, that is.

I am not going to say a whole lot here in this post because I have been writing non-stop about Europe of late. I just want to share the European links with you. I think what the links show is that the European paradigm is in transition from front-loaded austerity to back-loaded austerity. This is something I have remarked on at length in the past. What I would like to know is what impact this move is going to have on bond and stock prices.

Over the past weekend, Italy’s caretaker cabinet formally approved plans to begin paying its overdue bills to domestic suppliers and service providers. Its official arrears have aggravated underlying problems, such as access to credit by small and medium size businesses, who are the main creditors. The problems of the SMEs has also contributed to the rising non-performing loans of Italian banks.

By Sober Look As discussed earlier (see post) the French economy continues to struggle. The nation’s consumer recession is now thought to be worse than Italy’s. Markit (Trevor Balchin): – “France has overtaken Italy as having the worst performing retail sector of the three largest euro area economies. Sales fell at a survey-record pace, as did employment. Italy registered another [...]

Europe is in recession right now, but the US is in a weak but fairly long-lived economic recovery. The difference in economic fortunes owes entirely to differing policy responses in both regions. In Europe, the economic paradigm has favoured austerity as a policy tool. And the result has been fiscal retrenchment met with varying levels of additional private retrenchment – no confidence fairies here. That is the reason for the recessions across Europe. In the US, the policy response has been varying degrees of fiscal and monetary stimulus. And the result has been a muted recovery in both output and employment. The question is whether either of these policy paths is sustainable. I say no on both counts and want to address. Here’s why.

The ball got rolling in Asia as China’s official manufacturing PMI eased to 50.1 from 50.4 in January. The details were poor, even if not that surprising after the HSBC measure. New orders fell to 50.1 from 51.6 and new export orders fell to 47.3 from 48.5. The take away is that although the world’s second largest economy has stabilized after slowing in the H2 2011- Q3 2012, the lift is not particularly impressive and appears fragile. Of note given the concern since the end of the lunar New Year celebration of a tightening bias by the PBOC, input prices fell to 55.5 from 57.2.

In Europe, German and French readings edged higher than the flash readings. The surprises were in the euro area were in Spain and Italy–and in opposite direction. Spain’s PMI rose to 46.8 from 46.1, and while still below the 50 boom/bust level is the best since June 2011. Output and export orders rose. Italy slumped and this was before the election. The 45.8 reading in Feb compares with 47.8 in Jan. This is a three-year low. Forward looking orders data, both domestic and foreign were particularly poor, as was employment.

France had pinned its hope that threat to EMU would be turned back before the wolf came it its door. The Italian political tensions come at the poor time for France. Its ability to absorb shocks is terribly constrained.
Recall what has happened in recent days. Q4 GDP showed a larger contraction than expected. The flash PMI showed the contraction is carrying into 2013 (though not for Germany). The EU’s updated forecasts released last week shows France significantly overshooting the 3% deficit target this year. A confrontation over its budget is looming.

The lessons for China, if I am right, are that China should forego the idea of nurturing national champions and should instead encourage brutal domestic competition. Beijing should also eliminate subsidies to production, the most important being cheap and unlimited credit, because senior managers of Chinese companies rationally spend more time on increasing access to these subsidies than on innovation, a subject on which, in spite of the almost absurd hype of recent years, China fares very, very poorly.

There is nothing wrong with protecting domestic industry, but the point is to create an incentive structure that forces increasing efficiency behind barriers of protection. The difficulty, of course, is that trade barriers and other forms of subsidy and protection can become highly addictive, and the beneficiaries, especially if they are national champions, can become politically very powerful.

Many investors understandably have not focused on France. The threat of scandal in Spain, the need for yet another round of government support for Italy’s third largest bank and the country’s upcoming election have commanded attention. What seems to have been a free ride for France may be coming to an end. Even though the German economy contracted twice as much as the French economy in Q4, we learned this week, the implications for France are greater. Recent data suggests that the German economy has stabilized and may be expanding albeit slowly this quarter. French data continues to disappoint.

The European Union released figures for Q4 2012 GDP today and they were awful. GDP fell by 0.6% in the euro zone and 0.5% in the entire EU. Stock markets are getting clobbered on the news and the euro is selling off. This is not unexpected and I expect sovereign bond markets to converge to this reality.