6 June 2012

Macro Strategy Update

Policy Response Coming To The Rescue

Markets are panicking again after an initial calm. Spooked by fears of another Lehman-like event in Europe and a weak employment report in the US, investors sold equities en masse. A natural reaction would be to expect the worst. However, the situation is dire enough to change the manner in which European leaders will respond. The right policy moves can calm and move markets.

The situation in Spain is deteriorating everyday. Government bond yields are rising close to the 7% threshold where countries like Portugal and Greece found unsustainable. Around 100 billion euros, or 10% of its economy, left Spain in the first quarter of 2012, according to the Spanish central bank1. Plans to recapitalise Bankia, a failed banking institution, are in disarray as the Rajoy government tries to avoid a bailout. Not surprisingly, the Spanish prime minister has now called for centralized budget control, effectively ceding some sovereignty to Brussels, in exchange for help.

This is an important development for the Eurozone. For the past two years as the European crisis raged on, fiscal union has been touted as a permanent solution to the European problem. The fact that Spain has now supported this represents a change in the direction taken by European leaders2. European nations gave up monetary policy when they joined the Eurozone. Now they are about to give up fiscal policy as the crisis leaves them with no other choice.

Fiscal union is also what Europe's paymaster wants. In exchange for more funds, Germany has been insistent on budget controls. Now that Spain has given in, the ball is in Germany's court. It is likely that Germany would agree since they are too involved to walk away. A breakup of the Eurozone would cost the German export sector tremendously as the EU accounts for 60% of its exports. If the Euro zone were to break up, not only would Europe suffer a deep recession, but the Deutsche mark would soar in relation to other European currencies, therefore further compounding the problems of German exporters. From an economic perspective, it would be suicidal for Germany to walk away from the Euro. German banks are also deeply involved in the Eurozone. The Bundesbank is owed some 500 billion euros through the ECB's Target 2 payment system3, a result of Germany financing the peripheral Europeans.

Another important development is German chancellor Angela Merkel's backing for a banking union, a precursor to fiscal union4. A banking union requires fiscal support for individual banks. Recapitalisation, resolutions and deposit insurance schemes will have to be considered and implemented to stabilise Europe's shaky banking sector and restore trust in the peripheral banks. With a bank union, the odds that the European Stability Mechanism is used to recapitalise banks directly are high. This potentially lowers the cost of funding given how little Germany pays to borrow5.

Greater fiscal union also gives the ECB more room to act. The ECB president has been calling for more action from political leaders to resolve the crisis. Now that policy making is more pro-active, it gives the ECB legitimate reason to stabilise markets while policy change occurs (which takes a long time in market terms). As the only institution capable of acting quickly enough to stabilise markets (via interest rate cuts, buying government bonds or more refinancing operations), the ECB acts as a temporary solution to Europe's problem even as political leaders cobble up a permanent solution.

Slowly but surely, the pieces are falling into place to restore some stability to Europe. Markets will begin to react to these measures. Investors need to watch out for positive news flow emanating out of Europe. So long as Europe is heading towards the right direction, i.e. banking union and greater fiscal integration, investors will begin to realise that their worst fears are unlikely to become a reality.

Before summarising, a look at the US economy shows that the risk of recession remains low despite a poor employment report. Profitability in the US is at an all time high. First quarter profits of non-financial businesses (including listed and unlisted corporations) surged. It is difficult to envisage how an economy might slow down significantly in the face of such high profitability.

Figure 1: Profits at non-financial businesses still rising.

Conclusion and Portfolio Positions

Markets are volatile and the media is lapping up the bad news. However, the risk of a strong policy response is high as the strains in Europe become unbearable. Under such conditions, policy makers have the power to move markets, especially given how oversold markets have become. Stay invested. We have sent out a rebalancing recommendation earlier. Please speak to your adviser if necessary if you have questions.

1. Spain reveals 100-billion-euro capital flight. 1 June 2012. CNN
2. Spain seeks centralised budget control. June 3 2012. Financial Times
3. The Hidden Risks Lurk in ECB's Accounts. 26 March 2012. Des Spiegel
4. Merkel open to idea of European banking union. 4 June 2012. Businessweek
5. German 2-Year Yield Drops Below Zero as Crisis Deepens. 2 June 2012. Businessweek

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