March 21st, 2012
Written by Macrotides
Volatility rises and falls in response to stock market trend changes, which are created when investors. expectations of the future are not realized. The largest market moves occur as the gap between perception and reality is closed, as we.ve discussed previously. In late 2007, expectations were that the U.S. economy might slow, but there would be no recession and the rest of the world would decouple from the U.S.
When those expectations proved ridiculously wrong, the gap between perception and reality was closed violently, resulting in a huge spike in volatility. (Chart below) At the lows in March 2009, 'hope' was being treated as a four letter word, with perception dominated by despair. When reality proved the sun would come out tomorrow, the stock market rose and volatility plunged.
In 2010 and 2011, investors were blindsided by the emergence of Europe's sovereign debt crisis, which caused volatility to pop, and then recede as investors perceived the crisis having past. These outbreaks roughly coincided with the end of QE1 and QE2, which has led many to believe the end of the QE programs caused the declines. That assessment overlooks the role played by the European sovereign debt crisis.
The current low level of volatility begs the question, “Is the perception the European debt crisis is contained correct?” We don't think so, since the primary factor driving the crisis – too much debt and too little economic growth – will worsen in 2012, especially for the countries at the center of the crisis. At some point in 2012, bond yields in Portugal, Spain, and possibly Italy will rise, as investors realize these countries are going to find it difficult to emerge from recession and lower their debt to GDP ratios and budget deficits. The tipping point will come when investors begin to compare the increase in yields in these countries to Greece.s experience. The volatility index will remain low until investor.s perceptions are confronted with this reality. We don't know if it will take two months or six months. Home prices peaked in the U.S. in the summer of 2006, but it was more than a year later before investors realized it would lead to a crisis. Investors don't sell stocks because the VIX is low. They sell when reality does not support their expectations. The current low level of volatility suggests another gap is developing between perception and Europe's economic reality.
Central Bank Balance Sheets
Since the financial crisis in 2008, every major central bank around the world has expanded its balance sheet significantly to prevent a deflationary financial collapse. Many observers have concluded that central bank balance sheet expansion is the equivalent of printing money. It is not.
If a large portion of the money sitting on central bank balance sheets was entering the economy through a surge in bank lending, it would have inflationary potential, as too much money chased too few goods. Currently, there is too little demand chasing too many goods in all the developed countries, while growth is slowing in China, Brazil, and India. In the U.S., the velocity of money is the lowest in 50 years, so the money that is in the economy is not turning over. People are just not spending as they have in the past. GDP = (velocity * money).
The sovereign debt crisis developed because a number of countries had too much debt and too little growth to support their debt loads. In the wake of the financial crisis, many countries were forced to run large budget deficits, which drove their debt levels above the key breaking point of 90% of GDP. When the recovery from the 2008 financial crisis proved weak, global investors in 2010 realized that Ireland and Greece would not be capable of paying back their accumulated debt. As global investors shunned Greece's debt in 2011, its interest cost rose to unsustainable levels, triggering the need for a second bailout. Irrespective of all the fanfare, Greece.s bailout allowed it to default on $100 billion of its debt, so it could receive a loan for $130 billion.
Sadly, the austerity measures being imposed will deepen the economic contraction overwhelmingly Greece. The bi-annual survey by the Small Enterprises Institute, representing almost 800,000 businesses throughout Greece, found that 55% of small entrepreneurs think they will be unable to avoid bankruptcy. In 2011, there were 105,000 small business failures, and another 55,000 are expected to close this year. More than 70% of owners have used private savings to finance their businesses as bank credit dried up. Over 30% said they are behind on payments to suppliers, utilities, and social security funds. According to the survey, 244,000 jobs could be lost this year, with only 1 worker hired for every 7 workers laid off. We expect another bailout will be needed, unless Greece chooses to leave the Euro first.
The European Central Bank has trimmed its 2012 estimate of GDP from +.3% to a slight contraction. If accurate, the European Union will be in recession for most of 2012. However, their broad estimate masks the fundamental issue of the sovereign debt crisis. The weakest countries, Greece, Portugal, Spain and Italy, will all be in a deeper recession, which will only worsen their debt to GDP ratios. A review of new orders for manufacturing and service companies shows the disparity within the E.U. and the U.S. Greece is still in freefall, while Italy and Spain have bounced from the depths of the fourth quarter, but are still quite negative. Britain and Ireland are stable, with manufacturing near zero and showing positive a reading for services. New orders for manufacturing in both France and Germany are negative, which is a bit of a surprise. New orders for services are modestly positive in both countries.
With GDP of $1.4 trillion, Spain is the world's twelfth largest economy. Overall unemployment is 23%, with unemployment pushing 40% for those under 25. Spanish banks cut lending by 3.3% in December from a year ago, the largest decline since the Bank of Spain started tracking these numbers in 1962. Bankruptcies rose 12% in 2011, according to Informa D&B. Spain reduced its budget deficit to 8.5% in 2011, but that was well above its EU target of 6.0%. In January, Spain signed an agreement as a member of the European Union to cut its 2012 deficit to 4.4% of GDP. In order to reach that target, Spain will have to reduce government spending by $52.3 billion, according to Moody’s, versus the $28 billion in cuts that were spread out over 2010 and 2011. Two weeks ago, Prime Minister Mariano Rajoy said Spain would aim to reduce its deficit to 5.8%, well above its 4.4% EU target. “This is a sovereign decision made by Spain.” Translation: “We will not allow the EU (Germany) to dictate to Spain how to run our economy.” Spanish trade unions, which represent 20% of Spain's total work force, announced they will hold a general strike on March 29, against labor market reforms they called “…the most regressive in the history of Spanish democracy.” Spain's real estate woes and weak growth are hurting bank balance sheets. Bad debts share of overall bank portfolios rose to 7.61% in December, the highest since 1994.
In 2011, Portugal's economy contracted by 1.6%, but shrank at a 2.8% annual rate in the fourth quarter. In December, lending to the private sector fell 3.5% from a year ago. Bankruptcy filings by companies and individuals rose more than 50% last year and have continued to rise this year, according to the Portuguese Association of Bankruptcy Administrators. Citigroup has forecast Portugal's economy will shrink 5.5% in 2012. In January, unemployment reached 14.8%, and will likely climb during 2012. With GDP falling and its economy shrinking, its debt to GDP ratio will climb to 118% from 107% last year.
The International Monetary Fund estimates that Italy's economy will shrink by 2.2% in 2012. Prime Minister Mario Monti introduced a “Grow Italy” bill to open up competition, reduce red tape, and bureaucratic barriers to growth that special interest groups have relied upon for a long time. Mr. Monti was forced to water down his bill, after special interest groups successfully engaged in a bout of arm twisting. Italy's debt to GDP ratio is 120%, and is desperate to increase tax revenue. How desperate? In February, Italy announced plans to change Italian law to ensure that the Roman Catholic Church pays property taxes on buildings used commercially. If adopted, tax revenue could be $650 million to $2.6 billion annually.
The biggest headwind facing Europe is the contraction in bank lending. As we have noted previously, bank lending in Europe represents 80% of credit creation, versus 35% in the U.S. Although the two LTRO operations by the ECB prevented a full scale liquidity crisis, they haven't spurred an immediate increase in lending, and we don't expect that to change until the third quarter at the earliest. Loan demand from strong companies, which the banks would love to extend credit, will remain tepid until a real recovery in Europe is in sight. With the EU in recession, banks will naturally be reluctant to lend to those medium and small firms that are struggling and need credit. This will affect small and medium sized businesses disproportionately, and result in a rise in corporate bankruptcies throughout Europe. The majority of banks in Europe need to increase capital ratios and additional lending makes that more difficult. This means many banks in Europe have an incentive not to lend in coming months. Given the current challenging environment, European banks will continue to be more interested in playing defense, which will make it difficult for Europe to pull out of its recession.
Going forward, the key metrics worth monitoring will be bank lending and yields in Portugal, Spain, and Italy. The LTRO operations have been successful in brining sovereign yields down significantly, which is certainly positive. We expect yields to reverse once it becomes apparent that the fiscal and economic conditions are not improving. If yields do rise and investors begin to compare Spain or Portugal to Greece, the bell will ring for the third round of Europe's sovereign debt crisis. We don't know if this will take two months or six months, but feel it's just a matter of when, not if.
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