Crunch Time For Europe
May 21 – May 25, 2012
The European debt crisis has been a long, slow motion catastrophe. The powers that be (the European Central Bank and European Union leaders) have lumbered from one critical juncture to another, doing just enough to prevent calamity, but not enough to solve the problems. For U.S. investors, the European crisis has repeatedly threatened to boil over, but then put at low heat on the back burner (never taken off the stove). The crisis in Greece is once again approaching another breaking point – but this time we are closer to a real change rather than another postponement of the seemingly inevitable.
Following the results of the May 6 election, Greece was unable to cobble together a coalition to run the government. Another election is set for June 17. Polls show that most Greeks prefer to stay in the monetary union. However, polls also show that most Greeks reject the severe austerity imposed upon the country. They can’t have it both ways – and the June elections are expected to result in a more significant push away from austerity. Hence, the odds of a Greek exit from the euro have risen appreciably. At the same time, it’s not exactly clear that Greece will leave the euro, or even how it would leave the euro. European leaders are still signaling a strong commitment to keep Greece in the monetary union, and there’s no exit plan.
The consequences of a Greek exit would be severe, but at this point, the country seems likely to be just as doomed if it decides to stay in. Going back to the drachma would give the country a way out. With its own currency, a devaluation would provide a necessary adjustment to relative wages. Staying in the euro would require a fiscal union and a further write-down of Greek debt, steps that the rest of Europe may not be willing to take.
Of course, a Greek exit would also raise the threat of contagion. Greece’s problems are a lot different than those of the other troubled countries of Europe. However, Spain and Italy are much bigger economies, with much bigger banking systems that are connected to the rest of Europe. Greece has experienced a slow-motion run on its banks, which may be accelerating. The European Central Bank would provide liquidity to counter a significant bank run in Greece, but the ECB will likely have some limits especially if it looks like the country will exit the euro. More significant runs on the banks of Italy and Spain would be a much bigger problem for the ECB.
If this all sounds scary, it is. Just a few months ago, there was a broad consensus that Europe would experience only a mild recession. The euro area’s real GDP fell 0.3% (q/q) in 4Q11, and was reported as flat in the flash estimate for 1Q12. Amusingly (it’s important to retain a sense of humor in a financial crisis), the financial press trumpeted that the euro area had “avoided a recession.” However, 1) flash estimates are clearly subject to revision, 2) “two consecutive quarterly declines in GDP” is only a rule of thumb, not a proper definition of “recession,” 3) there is clearly a potential for things to get much worse, and 4) the troubled economies are doing a lot worse than others.
A lot of Europe’s problems stem from a misdiagnosis. This is commonly called a “sovereign debt crisis,” but budget deficits weren’t the catalyst. Spain and Ireland had budget surpluses before the crisis and, while debt levels were high in Italy, the debt-to-GDP ratio was falling. The crisis was set up by capital flows. On entry into the euro, countries suddenly had lower borrowing costs and the rest of Europe was happy to supply capital. Now, those capital flows have reversed. Recession boosted budget deficits as tax receipts declined and social spending increased. Growth helps reduce budget deficits, but the pace of economic recovery was gradual. Austerity, imposed too soon, weakens growth, worsening the budget situation. The challenge should be to provide support to the economy first, then address budget situations later on. Granted, this raises a risk that growth won’t recover fast enough. Stimulus has to be temporary, of course, but if insufficient, the too-early fading of stimulus will limit the pace of recovery. One should plan on over-shooting fiscal stimulus. If too large, fiscal stimulus could be later scaled back or countered with monetary policy. However, if insufficient, it’s just about impossible to get more.
Some have suggested a more radical response – a temporary increase in inflation. Professor Bernanke had offered this as a solution for Japan’s woes in the 1990s. Real (that is, inflation-adjusted) interest rates are what matters for the economy. With low inflation, real interest rates will be higher than they would be otherwise. A temporary increase in inflation would lower real rates, supporting economic growth. However, the danger is that the increase in inflation wouldn’t be temporary. Inflation expectations could rise, providing momentum to higher inflation beyond the desired time frame. Moreover, the political resistance to such a strategy in Europe, especially in Germany, would be extreme. In the U.S., Fed Chairman Bernanke is not keen to follow his earlier advice (unlike Japan, according to Bernanke, the U.S. acted early and is not experiencing deflation).
What does the European crisis mean for U.S. investors? The U.S. economic outlook is not much different than a month ago. However, the downside risks from Europe have increased significantly. The higher level of uncertainty is a negative for the equity markets. While Europe could come to a decision on Greece soon, the process of exit from the euro is a complete unknown. How badly will fears spread to Italy and Spain? How will the ECB and European leaders respond if things spin further out of control? Moreover, this may take years to play out.
Austerity – It’s All In The Timing
May 14 – May 18, 2012
During the financial crisis, most developed countries adopted expansionary fiscal policies, which limited the downside of a global recession. However, worries about the sustainability of large-scale budget deficits soon led to a reversal. Suddenly, countries had to immediately address their budget shortfalls. However, tightening policy too soon risked undermining fledgling recoveries. The punchbowl will have to be taken away eventually, but the trick is determining the right time to do so.
Expansionary fiscal policy as a response to recession is based on a simple notion. A large temporary increase in government spending can offset a large temporary decline in private-sector spending. Opponents of expansionary fiscal policy argue that temporary increases in government spending tend to become permanent, and eventually taxes will have to be raised to finance it. Some believe, incorrectly, that each dollar of government spending has to come out of private sector spending – people will anticipate higher taxes and adjust their spending accordingly, leaving no net stimulus. The large budget deficits that were run in the 1980s should have disproved that.
Fiscal stimulus can be tax cuts, increased spending, or as with the $800 billion American Recovery and Reinvestment Act of 2009, a combination of both. Temporary tax cuts, of course, are a poor form of stimulus – they are more likely to be saved than spent. While saving, or the paying down of existing debt, may help improve household balance sheets and pave the way for better spending down the line, they do little for the economy in the short term. Studies show that only about a quarter of the checks that were sent to senior citizens in the spring of 2009 were spent. To be effective, tax cuts should be permanent.
Interestingly, the Bush-era tax cuts were set to have a ten-year lifespan. However, most people felt that they would become permanent. At the same time, the Bush-era tax cuts, without a corresponding reduction in spending, created a structural budget deficit, seen by some as irresponsible given the pending strains in government finances due to the retirement of the baby-boom generation. Additionally, structural budget deficits would leave us with less scope for expansionary fiscal policies if needed.
ARRA continues to be criticized from both sides. Some view the stimulus as ineffective. After all, while improving, the economy remains relatively soft. However, the stimulus surely prevented the economy from weakening more than it did. Others suggest that, since the downturn was expected to be severe and the recovery very gradual, the stimulus should have been much larger and longer-lasting. Indeed, the fading of the stimulus has subtracted from GDP growth in recent quarters.
About a third of the federal fiscal stimulus was aid to the states, but that did not fully offset the shortfalls that state governments were facing. With federal support fading, state and local budget pressures led to increased job losses over the last year. About a fifth of the stimulus was infrastructure spending, but that largely replaced projects that would have been cut by the states.
The fiscal stimulus also became political. No Republican in the House voted for it and the few Republican senators who voted for it had to be enticed by less spending and more (temporary) tax cuts. The stimulus plan was not much different from one that would likely have been proposed if John McCain had won the White House. Mark Zandi, an economic advisor to McCain, credits ARRA for preventing the downturn from being a lot worse.
One problem with designing fiscal stimulus is determining how rapidly to move back toward fiscal balance. The U.S. economy has already faced some degree of austerity. According to the National Income and Product Accounts, government consumption and investment subtracted 0.6 percentage point from GDP growth over the last six quarters, where in normal times, it would have added about 0.3 percentage point (consistent with population growth). Real GDP averaged 1.8% growth over the last six quarters. It would have been nearly a full percentage point higher if not for the contraction in government.
The scary part of the federal budget outlook is not the large deficits we’ve been running recently. Rather, it’s the strains, mostly in Medicare spending, that are set to hit in 10 to 20 years. We are on an unsustainable budget trajectory and we’ve know about that for decades. Lawmakers will eventually address the problem, largely because they’ll have to. Absent a significant containment of healthcare costs, we’ll have to see higher taxes or a significant reduction in benefits, or some combination.
Of more immediate concern is the “fiscal cliff.” The Bush tax cuts are set to expire at the end of the year, the 2% reduction in payroll taxes will go away, and automatic spending cuts are set to kick in. Added up, these changes are expected to subtract at least 4% from GDP growth – enough to push us back into a recession. Most likely, the pain will be postponed. It would only take a few Democrats in the Senate to go along with another extension of the Bush tax cuts and Obama (if re-elected) would likely go along with that. However, no action is expected until after the election. Uncertainty could be a negative for the stock market until then.
In Europe, excessive budget deficits were not the cause of the region’s troubles. So, austerity cannot be the solution. Europe’s problems were due to excessive capital inflows, and their ensuing outflows, and the collapse of housing bubbles (Ireland, Spain). Austerity must be a critical long-term goal, but policies to promote growth are much more important in the near term.
The Labor Market Outlook
May 7 – May 11, 2012
The April Employment Report disappointed stock market participants. However, it really wasn’t a bad report. Private-sector job growth has been moderately strong this year. The Household Survey data suggest that the economic expansion has been strong enough to absorb the growth in the working-age population, but not enough to take up much of the labor market slack that was generated during the downturn. These figures tell us nothing about where the labor market is headed. Job growth over the next six months will have important implications for investors and for the November election.
One should never put too much weight on any one month of employment data. These figures are subject to revision, and further revision. However, the recent employment reports have painted a consistent story. This was an unusually mild winter. As a consequence, the December-to-January decline in unadjusted payrolls was lower than usual and the February payroll gain was higher than usual. The seasonal adjustment turned these into outsized gains in January and February. The March and April payroll gains, in turn, were biased lower.
Seasonally adjusted private-sector payrolls averaged a 207,000 monthly gain over the first four months of the year (and a 199,000 average over the last eight months). We’d like to see payrolls rising by 250,000 to 300,000 per month over three or four years to return to full employment, but the recent pace has been respectable. State and local government payrolls fell by 11,000 in April, reflecting continued budget strains, but the pace of job losses is less than in 2011.
The unemployment rate, having peaked at a little over 10% in October 2009, has continued to trend lower. However, that’s partly due to decreased labor force participation. There are two issues here. One is demographics. Participation will trend lower as the baby-boom generation moves into retirement (and the soft economy likely contributed to earlier retirements). The other is discouraged workers. As individuals exhaust their unemployment benefits, they have a tendency to stop looking and are therefore no longer classified as “unemployed.” The employment/population ratio, a better measure of slack in the labor market, has been relatively flat over the last two years.
The April Employment Report tells us nothing about the likely pace of job growth over the next several months. However, the outlook for moderate job growth this year should be relatively unfazed by the recent job numbers. Many of the recovery headwinds are still with us (housing, state and local government budget strains), but their impact on growth should be decreasing over time. Bank lending to consumers and small businesses is gradually getting easier. A recession in Europe will mean slower U.S. exports, but that’s not enough to seriously slow overall economic growth. The bigger factor in the short term may be gasoline. Higher gasoline prices dampened consumer spending and business hiring in the late spring and summer of last year. It looked like we were in store for a repeat this year, but gasoline prices have begun to back down. A sharper decline in gasoline prices could help fuel economic growth this summer.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
