The Eurozone and the Bucket Brigade
The Eurpean Central Bank’s (ECB) decision to launch Long-TermRefinancing Operation 11ast December and LTR02 in Februaryled many economists to forecast the end of Europe’s recessionby midyear, with a recovery commencing in the second half of2012. The Forward Macro Strategy Team did not agree withthat assessment. We expected Europe to remain in a recessionthroughout 2012. Recent data suggests Europe’s recession is intensifying as previously strong countries are now slowing, and the weak become weaker. According to Eurostat, the European Union’s statistics agency, econom ic activity in the 17-country eurozone fell at an annualized rate of -0.7% in the second quarter. In the fourth quarter of 2011, eurozone GDP contracted -1.2% and was flat in the first quarter. (Please note, the figures in GDP from the Previous Quarter chart have not been annualized).
Germany’s GDP growth was almost halved in the second quarter, falling to 1.1% from 2.0% in the first quarter. Germany is the China of Europe. The slowdown in China has had an adverse effect on all the countries that feed China’s supply line. A marked slowdown in Germany could be especially hard on Spain and Italy, which are already in a recession. Germany’s IFO Business Climate Index for manufacturers fell to 9 5.6 in July After falling four consecutive months, it is at its lowest level in three years. More importantly, it has fallen by more than eight points from July 2011. Whenever that has occurred since 1995, German GDP has turned negative and a recession followed, according to GaveKal. Clearly, the second quarter did not get off to a good start for the largest economy in the eurozone.
Insee, France’s Institute of Statistics and Economic Studies, reported that G DP in the eurozone’s second largest economy contracted -0.2% on an annualized basis in the second quarter. France has had three quarters with no growth, unemployment is at a 13-year high and manufacturing confidence at its lowest level in three years. Insee also reported that consumer’s optimism about their future plunged 13 points to minus -47. On April 29, France elected socialist president Francois Hollande, who said he intends to give Europe “a new direction.” The recent measures of consumer and manufacturing confidence suggest he’s doing a “great job.” Mr. Hollande has pledged to raise the tax rate to 75% for those earning more than $1 million euros a year. The plunge in optimism suggests there are far more millionaires than anyone knew in France, or everyone else realized they would be paying a lot more in taxes after all the millionaires left.
Mr. Hollande has also promised to raise taxes on big corporations, which should do wonders to improve their global competiveness. Peugot is the second largest carmaker in Europe and employs 100,000 people in France. Unfortunately, European car sales have fallen from 15.5 million in 2007 to 12.4 million in 2012, the lowest since 1996. Earlier this month, Peugot announced they would lay off 8,000 workers and close a major plant outside of France in an effort to cut costs by $1.85 billion by 2015. Mr. Hollande responded to Peugot’s announcement by saying, “It is not acceptable, and therefore it will not be accepted.” Politicians are always surprised when taxpayers-individuals or corporations-respond to negative incentives by moving or making changes to limit the negative impact of higher taxes to fund more government spending. It should be noted that the government of France is already spending 55.7% of France’s GDP. For every $1.00 of spending by the private sector, the French government spends $1.30. It won’t be long before France is treated like Italy and Spain.
Italy’s GDP fell -2.9% in the second quarter, after contracting -3.2% in the first quarter. Italy is the third largest economy in the eurozone, and has had four consecutive quarters of negative GDP. As Italy’s GDP shrinks, its debt to GDP ratio continues to become more imbalanced, so the hole is just getting deeper.
Spanish banks recently received a bailout of $121 billion, but it has not dampened fears that Spain is heading down the same road as Greece. Spain is the fourth largest economy in the eurozone, and is too big to fail. We expect the austerity measures Spain has adopted, to lower its budget deficit to 3% of GDP, to be relaxed. That will help slightly, but will not reverse the ongoing contraction in bank lending, or decline in Spanish home prices. Over the last year, nonperforming loans held by Spanish banks have increased by 30% to $200 billion. (Chart based on euros.) Since June 2011, lending to companies and households has contracted by a cumulative $67 billion. This is squeezing small- and medium-sized businesses, which depend on bank lending for their survival. The number of active companies fell 1.6% in 2011 to a five-year low, after the fourth consecutive annual decline. Spanish businesses have been shedding young inexperienced workers, which has pushed the unemployment rate for those under 25 to 54%.
The contraction in bank lending is not limited to just Spain. Loans to the private sector throughout the eurozone fell 0.2% from year-ago levels as did loans to households. The ECB pushed $1.3 trillion into the European banking system through the LTRO program. However, that money is not finding its way into the European economy. European banks are so hobbled they aren’t even lending to each other. Since 2008, eurozone interbank lending has plunged from $2.45 trillion to $1.2 trillion, according to the Bank for International Settlements. Unfortunately, lending is not likely to improve in the third quarter, according to the ECB’s quarterly lending survey. Eurozone banks tightened lending standards in the second quarter, and plan to tighten them further in the third quarter. Given the widespread economic weakness engulfing Europe, the increase in lending standards is prudent. Since banks provide 80% of credit in Europe, higher lending standards and the contraction in credit virtually guarantees that Europe will remain in recession through year-end. As the recession persists, and unemployment among those under 25 remains extraordinarily high, there is a real danger that Europe is not only facing a lost decade, but a lost generation.
European policymakers are likely to proceed with their plan to leverage their $600 billion bailout fund so it can buy distressed Spanish and Italian sovereign debt. This will certainly lower borrowing costs for Spain and Italy and help both countries move away from the abyss. Spain and Italy are sinking under the weight of excessive debt. Since they will be responsible for their proportionate share of the increased bailout fu nd, their total indebtedness will increase. Both are effectively borrowing more money, so the new borrowing can be used to buy some of the old distressed debt in order to lower yields. This scheme may buy some time, but only increases the odds of a bad outcome.
The European Union’s financial and economic crisis began more than two years ago, with its smallest member, Greece, needing help (2% of eurozone GDP). After several hundred billion in dollars of “help,” Greece’s GDP contracted by 6.2% in the second quarter. The game plan European policymakers devised to contain the Greek crisis has obviously not succeeded since it depended on creating more debt to fix an over-indebted problem. Although policymakers are working hard to keep Greece, Portugal and Spain afloat and in the European Union, the strategy they are using is almost certainly destined to sink the entire European Union. As each weak country’s ship has sprung a leak, all the other countries in the EU have steered their ships to come along side those taking on water. With all hands on deck, the sailors on the Greek, Portugal and Spanish ships have been bailing water as fast as they can, passing their full buckets to the sailors on the other sh ips, who are pouring the water into their ship’s hold. As the leaks in Greece, Portugal and Spain have grown, they take on water even faster, so the call goes out for bigger buckets. After a number of high level summits, bigger buckets are requisitioned and distributed. Soon the sailors are bailing even more water into the holds of the healthy ships in the EU, causing them to gradually sink lower too. We are told the EU will do whatever it takes to stem the leaks since the ECB will provide the “European Bucket Brigade” its biggest bucket yet.