European Greece Fire Not Entirely Out


By Rob Edel

May was a good month for bonds.  Equities, not so much.

The S&P/TSX lost 1.0% while the S&P 500 retreated 1.4% and the Dow fell almost 2%.  Bond prices rallied, however, with 10-year U.S. Treasuries dipping below 3% for the first time this year.

Clearly, the economy in the U.S. has slowed.  Higher oil prices, a double-dipping housing market, disappointing job growth, supply chain disruptions from Japan, debt ceiling concerns… pick your poison.  All are playing their part in worrying investors.  Number one on the list, however, isn’t even a North American problem; it’s a European one, specifically Greece.

Greece?  Wasn’t that problem kicked down the road last year when the EU and the IMF agreed to bail Greece out with a €110-billion loan package?

Well, apparently they didn’t kick the can far enough, because Greece is in desperate need of another bailout, and soon.  Under the terms of the original loan package, Greece was required to show they have solid financing lined up for the next 12 months before receiving their next bailout installment.

Unfortunately, Greece is going to come up a little short, having fallen behind on their budget targets.  It is now estimated they face a funding shortfall of around €30-billion in 2012 and 2013.  Even without this short fall, Greece was going to have problems meeting its future financing commitments.

With €52-billion in bonds maturing in 2012 and another €44-billion maturing in 2013, it was always assumed Greece would need to return to the capital markets in 2012.  But with yields on 2-year Greek government debt blowing out to over 20%, this has become unrealistic.

The simplest solution would be for the EU and IMF to keep lending Greece more money.  Germany (and Finland), however, are under tremendous political pressure to have private bond holders share some of the pain and would like Greece’s debt restructured (aka default).

Simply writing another cheque and enforcing the notion that stronger European economies will continuously bail out weaker economies is unacceptable to most German voters.  At the very least, they would like a “re-profiling” of Greek debt whereby creditors would be asked to accept a longer maturity date on the bonds.  The ECB and IMF are dead set against this.

If Greece’s debt is restructured, it would no longer be acceptable as collateral for ECB loans.  Greek banks rely on these ECB loans and are already on the hook for €88-billion.  Their elimination would drive most Greek Banks into insolvency.  This would have implications for other European Banks that hold Greek Bank debt, as well as Greek government debt.

Nearly 70% of Greek government debt is held outside of Greece, with French and German banks having more than their fair share.  The ECB itself has an estimated €40-to-€50-billion in Greek debt and could require more capital if there was a restructuring. To make matters worse, the head of the IMF, a key participant in negotiations, was recently accused of sexually assaulting a maid in New York and forced to resign.  Poor judgment, poor timing.

If granted an additional bailout, Greece is willing to do their part.  New austerity measures will be proposed with higher taxes and a further crack down on public spending.  These will, of course, be met with more rioting and protests, at least until it’s time for summer holidays.

In addition, there are plans for a privatization agency that hopes to raise €50-billion through the sale of state-owned properties over the next few years.  The Hellenic Public Real Estate Corp., the government agency empowered with managing public property, has a list of 75,000 individual publicly owned properties.  Assets that might be sold include the government’s stake in the Mont Parnes Casino resort, hotels, and even a luxury golf course development.

If you had dreams of owning your own Greek Island this might be an opportunity of a lifetime.  However, if someone offers you a stake in a Greek Bank, we would recommend you pass.

Greece is not the only country in Europe that is under pressure.  Europe is increasingly becoming a continent of have and have not’s.  In Q1, the French and German economies grew at their fastest annual rate in the past three and a half years with Germany’s GDP expanding a blistering 4.9% on a year over year basis, the strongest annual growth rate since pan-German data began being collected in 1991.

Italy and Spain, on the other hand, grew less than expected and Portugal slumped back into recession.  We won’t even talk about Greece.  Overall, the Eurozone expanded 0.8% in Q1 versus Q4 2010 and 2.5% versus Q1 2010.  Not bad, but considering inflation hit a 30-year high of 2.8% in April, Euro-zone economic growth is actually negative in real terms.

Remarkably, tiny Switzerland grew 2.4% in Q1, driven by stronger exports.  It is remarkable because the Swiss franc has gained 24% against the U.S. dollar and 13% against the Euro in the past year.   How are the Swiss able to increase exports while their currency appreciates?  60% of Swiss exports are high quality products versus only 40% a decade ago.  The Swiss have adapted and restructured.

This is what Greece and the Club Med economies need to do.  Bailouts are not solving the problem, only kicking it down the road.  I’m not suggesting we will all be wearing Greek watches in a few years, but Greece has got to find a way to become more competitive in the global economy.  If they can’t become more like the Germans (or the Swiss), it doesn’t make sense that they share the same currency.

Asia is also having their issues. Japanese Minister for Economic and Fiscal Policy, Kaoru Yosano believes the earthquake-tsunami-nuclear disaster triple play will shave 1% off GDP growth this year and cost the government US$124-billion in reconstruction costs.  This has the debt rating agencies worried, with S&P recently downgrading Japan’s long-term sovereign debt one level to AA minus.

What should make debt-holders happier is Yosano also hinted that higher taxes, as well as tax and welfare reform, are also in the cards.  Japanese GDP actually fell 3.7% in Q1 and some feel it may fall 5.5% to 5.9% in Q2 before recovering in the second half.

  

One of the reasons Japan is confident growth will recover in the second half of the year, is that the rest of the World’s economy is growing, especially in China.  China is not immune to corrections, however.

Real estate has been the main driver of economic growth in China over the past two decades.  Such that many, including the World Bank, fear a bubble maybe forming and could, in fact, already be in the process of deflating.

In April, prices declined 4.9% year-over-year in nine major cities versus price increases of over 20% the year before.  Sales are also off 50% since the beginning of the year.  Standard Chartered Bank estimates some second tier cities may end the year with upwards of 20 months of inventory, putting additional downward pressure on prices.

Another barrier for future economic growth in China is their authoritative and oligarchic governmental structure.  Business school INSEAD recently reported evidence that economies without good institutions, such as equitably enforced laws and universal property rights, tend to hit “The Great Wall” of $10,000 to $15,000 (US$) net income per capita.

Unfortunately, good governance tends to coincide with political freedom, which usually only comes about with upheaval and revolution.  China’s income per capita is well below the $15,000 wall, so they have time to reform and improve their governance before economic growth stalls.  In order to break through this barrier like South Korea has, however, they will need to make some changes.

The U.S. Economy

 

Economic growth in the U.S. has definitely slowed.  GDP growth in Q1 was unchanged from the previously estimated 1.8% growth and leading indicators disturbingly turned lower in April.

Manufacturing – which had been the star of the “economic growth show” – experienced a bit of a “Charlie Sheen moment” with industrial production flat in April and durable good sales declining nearly 4%.  In May, the ISM Manufacturing index suffered its largest one month decline since 1984 and fell to its lowest level since September 2009.

Certainly the impact from the Japanese earthquake/tsunami is contributing to the weakness, as is the poor weather in the U.S. with flooding and tornados creating havoc, but these should be temporary and unlikely to result in a double dip recession.  The persistently high unemployment rate and deteriorating housing market are another issue.

Bloomberg’s Caroline Baum points to the steepness of the yield curve as further evidence that another recession is not in our near-term future.

As Baum explains it, “The term structure of interest rates isn’t some mystical talisman with omniscient powers.  It derives its prognosticating ability from the simple fact that one rate is artificially pegged by the central bank while the other is determined by the market.  The time to worry about recession is when the Fed raises the funds rate to the point where the yield curve inverts.  Within a year or two, it’s curtains for the economy.”

In layman’s terms, Baum is arguing that the economy is unlikely to contract while monetary policy is accommodative.  While we don’t see a new quantitative easing program (QE III) taking over when the current one (QE II) expires in June, we also don’t see the Fed increasing rates anytime soon.  The economy might not break any high growth records, but a recession is not in the cards… so far.

 

May was a disappointing month for the job market.  Not only was job growth a paltry 54,000  and more than 100,000 lower than expectations, but March and April’s gains were revised 39,000 lower.

At 83,000, the private sector added the fewest number of jobs since June 2010. The manufacturing sector actually lost 7,000 jobs, posing its first decline in seven months.  Depressingly, we are two years into the economic recovery and the percentage of the U.S. population working is only 58.4%, over 4% below the participation rate at the start of the recession.

While the U.S. has created jobs, it’s barely been enough to keep pace with population growth.

 

Inflation continued its steady march higher in April, predictably driven by food and energy prices. While normally we may be a little more alarmed, disappointing economic growth leads us to believe inflationary expectations are unlikely to accelerate, especially if the employment picture continues to darken.

Higher prices also tend to curtail demand.  Already higher gasoline prices are starting to have a material impact on driving habits as well as consumer spending in general.  However, lower gasoline demand in the U.S. this summer is likely to be offset by higher oil demand in China as dangerously low water storage levels mean hydroelectric power will be in short demand and oil fired generators will be needed to take up the slack.

Even in a weak economy, oil prices may stay strong and help keep inflation high.

Nothing hurts consumer confidence more than high unemployment and higher food and gasoline prices.  Predictably, the Conference Board consumer confidence index plunged to its lowest level in six months. Strangely, the University of Michigan report is indicating consumers are not as concerned.

Retail sales were somewhat mixed last month. Lower end stores, like Wal-Mart, have been impacted by higher gasoline prices as consumers think twice before heading out in their gas guzzling SUV’s to shop.  Luxury retailers and higher end department stores, however, have fared better.

As Nick Carraway says in F. Scott Fitzgerald’s The Great Gatsby, “the rich are different than you and me.”

Affluent shoppers are not as concerned with higher fuel costs or high unemployment.  While most Americans have reigned in their spending habits, the rich are still living the dream.  In fact, according to Moody Analytics’ Mark Zandi, the top 5% of earners in the U.S. presently account for 35.5% of spending versus only 25% before the recession.  They also have the lowest savings rate, squirreling away a modest 1.4% versus 8-10% for the rest of the population.

That’s not to say they haven’t changed their spending habits at all.  A survey by Harrison Group found 38% of consumers earning over $275,000 now wait for items to go on sale versus only 31% in 2010.  More are also using coupons and buying less expensive brands.

If there is one retail trend that has so far proved recession resilient, it is cellular phones; or more specifically, the increasing popularity of smart phones.

Most consumers can’t live without their cell phones and they would be one of the last items they give up.  Now, most are trading up to smart phones in order to take advantage of applications that they never thought they needed or even knew existed only months ago.

Given the recent submission by a panel of international scientists that radio frequency electromagnetic fields possibly cause malignant brain tumors, it will be interesting to see if consumers use this as an excuse to cut back spending in this area as well.

Probably not, but I really like this cartoon and was looking for an excuse to include it.

New home prices and sales moved encouragingly higher in April, but by far the larger and more important existing home market continued to signal a double dip in the housing sector.

According to the Case/Shiller price indexes, home prices retreated all the way back to 2002 levels and are down 33% from their 2006 peak.  Some cities are even below 2000 levels.

A recent Harris Interactive poll found 54% of respondents don’t expect the housing market to recover until 2014 or later.  Last November, only 33% were this pessimistic.

Distressed sales are the main problem.  Corelogic estimates that while overall home prices (new and existing) declined 7.5% in April versus last year, if one excludes distressed sales, prices would have dropped only 0.5%.

The problem is there is still a very large inventory of distressed homes that haven’t even hit the market.  RealtyTrac estimates Banks hold title on more than 872,000 foreclosed homes which could take three years to sell off.  Moody’s estimates this could result in prices falling another 5% by the end of 2011 before rising marginally next year.

Even worse, Corelogic estimates there were about 10.9 million homes under water (worth less than the current outstanding mortgage) at the end of Q1.  While this is down from 11.1 million at the end of Q4, most of the decline was due to foreclosure.

Other than the increase in new home sales, the only good thing that you can say about the housing market is that it is cheap.  According to Moody’s Analytics, the ratio of home prices to income is now 20.9% lower than the 15-year average.

With building at a virtual standstill and demographic indicators such as household formation turning positive, prices could start moving higher sooner than people think.  We can hardly wait.  The housing market is a major driver of consumer spending and economic growth in the U.S. economy.

The trade deficit increased to a nine month high in March, mainly due to higher oil prices.   The non-petroleum deficit, however, declined to $16.9-billion versus $20.0-billion the previous month. If the price of oil declines, which it has at the margin, the trade deficit should move lower.

Weaker global growth, however, could derail export growth, despite the recent U.S. dollar weakness.  The impact on overall economic growth would be minor, as Economist Michael Gapen estimates exports represent only about 13% of the U.S. economy.  Even a 10% drop in the U.S. dollar would boost GDP growth a mere 0.4 percent.

 

 The Canadian Economy

     

More than making up for a weak showing in February, GDP increased 0.3% in March to finish Q1 up a robust 3.9%.

Sharply higher energy and automotive production were the main contributors.  In contrast to the U.S., leading indicators and manufacturing indexes are pointing towards continued expansion in Canada.  Given the slowdown in the U.S., however, we don’t think another 3.9% GDP increase in Q2 is realistic.  Most suspect 1.5% is more likely.

Another area where Canada is outperforming the U.S. is in deficit reduction.  According to the Fiscal Monitor, Canada’s deficit for fiscal 2011 is estimated to come in nearly $6-million below the $40.5-billion estimate.  Even better, the Conservative government is forecasting Canada should eliminate its budget deficit by 2014-2015, a year earlier than previously forecast.

With a majority Conservative government, Canada has what few other countries around the World have: a government committed to getting the deficit under control and the mandate to do it.

At least for the next five years or so.

A decent month for the Canadian job market.  The unemployment rate fell to 7.4%, its lowest level since January 2009, though this was partially due to an estimated 28,000 giving up looking for work.  The labour participation rate, at 66.8%, is actually lower than a year ago.

Also contributing was the fact that Canada created 32,700 full-time jobs while losing 10,400 part-time jobs.  Most of the full-time jobs were lower quality self-employed positions, but still a pretty good result.

Inflation was virtually unchanged from March with food and energy driving most of the growth.  While still under the 2% target level, inflation is on the Bank of Canada’s radar screen, especially with the strong housing market.

On May 31st, however, the Bank of Canada decided to leave the Bank Rate unchanged at 1.0%, but hinted at future increases by stating “stimulus will eventually be withdrawn.”  Most are looking towards September for the next rate increase.

Despite strong economic growth, Canadian consumers have turned downright frugal.  Bank of Canada Governor Mark Carney has been warning Canadians for months against the perils of over leveraging and it looks like we have been listening.

Retail sales were flat in March and up less than a percent versus last year.  According to the Boston Consulting Group, even though Canadians feel relatively optimistic about the economy, they are adopting the frugal shopping habits they learned during the recession.  Bargain hunting and buying fewer non-discretionary items are becoming more and more the norm.

In fact, when ranking consumers from 19 countries on their propensity to buy products “on deal,” Canada took the silver medal while the U.S. came in fourth.  When the same study ranked countries by optimism towards the future economy, Canada again came in second (Turkey took the gold) while the U.S. came in a disappointing 13th.

Home sales have retreated from their blistering pace, but prices continue to march higher, increasing 8% in April over the previous year for the third month in a row.

While Asian investment in the Vancouver’s residential housing market has certainly skewed the national average higher, Toronto is also seeing its share of foreign capital.  Stricter mortgage rules that took effect on April 19th have dampened sales across the country, but higher-end homes in Vancouver and Toronto experienced their best month ever.

Urbanation Inc. estimates more than 50% of condo purchases in Toronto last year were made by investors who plan to rent them rather than occupy them.

So is the Canadian housing market in a bubble?  Certainly from an affordability perspective prices in Vancouver don’t make sense.  The Royal Bank estimates homeowners must now allocate 72% of their household income to pay their mortgage versus only 47.5% in Toronto.

With the exception of Vancouver, however, the Royal Bank believes that housing remains affordable.  Also comforting is the fact the Canadian Association of Accredited Mortgage Professionals believes Canadians, on average, have a loan-to-value ratio on their homes of only 44% and $222,000 in home equity.

Of the 9.5 million homeowners in Canada, approximately 3.75 million don’t have a mortgage at all.  The average mortgage outstanding is $150,000 with 60% choosing a fixed rate mortgage.

Doesn’t feel that much like a bubble to me.

Canada’s trade surplus improved marginally versus February as energy and industrial exports more than made up for stronger automotive imports.  The strong Canadian dollar continues to provide a headwind for exporters, especially in the manufacturing industry.

Overall, Canada remains on track.  If only the U.S. economy would get their act together.

What are your thoughts on the economy’s activity in May?  Let us know in the comments below!