September 2011 Global Macro Picture

by MacroTides

A few days ago I posted my U.S. macroeconomic analysis.  Here is the rest of the world that is of primary interest to U.S. investors.


Last month we asked a simple question, “What happens when monetary and fiscal policy hit the wall?” This question is not only pertinent for the United States, but also for almost every developed country, since most of the G7 nations are confronting many of the same problems and the same monetary and fiscal limitations.  Monetary policy in the US and other G7 countries is basically running on empty.  Fiscally, debt levels are high and growing, while economic growth is weak and slowing.  The net result is debt to GDP ratios continue to rise.  The reductions in government spending to rein in excessive budget deficits will only dampen growth further, or cause a further contraction in GDP as illustrated by Greece. The unemployment rate for people under 25 years old is 20% throughout the EU, and far higher in Italy, Greece and Spain.  In the US, the unemployment rate for those under 19 is 25.4%.  As these high unemployment rates become chronic, social unrest and violence will become common place.  Labor strikes will disrupt everyday life, as the economic stress intensifies all over the world.

Last week, the Federal Reserve, Bank of Japan, Bank of England and the Swiss National Bank, said they would provide the European Central Bank with unlimited dollar funding for the remainder of this year.  After receiving dollar funding from the other central banks, the ECB will lend to banks throughout Europe who are having difficulty accessing short term funding.  This illiquidity squeeze has developed as US money market funds reduced lending to European banks by $700 billion in recent months, according to JP Morgan Chase.  According to Credit-Sights, at the end of June, bank lending between Euro-zone banks fell by $600 billion from year ago levels.  It has no doubt fallen further in recent weeks.  European banks have become so fearful of lending to other European banks that deposits at the Federal Reserve have soared to $849 billion.

The underlying problem is that European banks are loaded with holdings of sovereign debt from Greece, Portugal, Spain and Italy.  Not long ago, the sovereign debt of these countries was rated AAA, and holding sovereign debt was considered a sign of balance sheet strength.  Not anymore.  The recent European bank stress test used a 21% discount for Greek sovereign bonds, which are now selling at a 60% discount to face value.  Many large banks would be insolvent if they had to mark to market their holdings of Greek bonds.  And, to a far lesser extent, their holdings of Spain and Italy, which have also lost value.  The only viable solution is a large recapitalization of many European banks.

The central banks‟ arrangement to provide dollar funding to alleviate a severe short term funding problem does not address the real elephant in the room.  There is too much debt sitting on bank balance sheets, and too little economic growth in too many EU countries to support the mountain of debt they are carrying.  At the end of June, annual GDP growth was up .8% in Italy, up .7% in Spain, and down by .9% in Portugal and down 7.3% in Greece.  According to ECB data, bank lending over the past year was down 9% in Ireland, 3% in Greece and Italy, and 1% in Portugal and Spain.  Given the recent turmoil, it’s a safe bet lending has contracted further. This will lead to even slower growth in coming months in these countries, and in Germany too.  The European debt crisis is going to get worse, and it will have a negative effect on global growth.

China, India, and Brazil

The Peoples Bank of China has been tightening monetary policy since last October, through a series of interest rate increases totaling .75% in 2011, and nine increases in the bank reserves ratio from 15% to 21.5%.  For every $1 of lending, Chinese banks must hold $.215 in reserve, which has resulted in higher borrowing costs.  The average yield on top-rated, one-year corporate notes have risen 101 basis points since June 30 to 5.9 percent, and is poised for the biggest quarterly increase going back to 2007.  Chinese inflation slowed to 6.2 percent in August, from a three-year high of 6.5 percent in July, but is still far above the official target.  Monetary tightening has slowed growth, with the economy expanding 9.5 percent last quarter, the slowest since 2009.

The Reserve Bank of India raised interest rates for the 12th time in 18 months on September 15 to 8.25%. India’s benchmark wholesale price index hit a 13-month-peak of 9.78% in August, well above the bank’s comfort zone of 5.0%. India’s inflation is the highest of any large global economy.

After raising interest five times this year to combat inflation, Brazil’s central bank cut rates on September 1 from 12.5% to 12%. The central bank said high debt and weaker growth in developed economies could slow Brazil’s economy, which is still expected to grow by 5% over the next year.  Inflation is 6.9%, which made the cut a bit of a surprise.  However, the Brazilian Real has appreciated 50% since early 2009, which has made Brazilian exports expensive.  Lower rates may bring the Real down, and help export growth offset some of the global slowing.

The tightening of monetary policy over the last year by China, India, and Brazil will cause their domestic economies to slow. Coupled with the slowdown in developed countries, global growth is set to slow for the rest of 2011 and early 2012.

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About the Author

Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at[email protected].