I’m feeling very bearish. Lots of bad things happened on Friday night.
China tightened reserve requirements, the EU is on the verge of a double dip, bad Greek data and negative revisions are probably going to see them downgraded again (which makes a fiscal meltdown still more likely), even if the EU can avoid a double dip, the the fiscal consolidation that’s required to prevent a sovereign debt crisis will keep growth sub trend for years, and Dubai is (again) talking about a debt standstill ( this saw CDS out to 660bps, and 2014s off 2 cash points).
Following the tepid EU Q4 GDP report, it seems Europe is on the edge of a double dip recession. Private demand is weak, and the parlous fiscal situation means that fiscal consolidation cannot be put off. If the snow hasn’t already done it, there’s a good chance that the necessary fiscal consolidation will pull the EU back into recession.
The EA16 and EU27 expanded by only 0.1%q/q (mkt +0.3%). The states with the largest sovereign debt problems had the worst performance – Greece was -0.8%q/q, with negative revisions putting GDP 100bps below expectations (-2.6%y/y); Spain was -0.1%q/q; Italy -0.2%q/q, and Portugal 0%q/q. Germany disappointed (0.1% v. mkt +0.3%), and though France was a little better than expected (Q4 GDP +0.6%q/q v. mkt +0.5%), but employment was weaker than expected (-0.4% v. mkt -0.3%q/q).
The disappointment and negative revision for Greece mean that they are likely to have their sovereign rating cut again by both of the major agencies. The budget deficit for 2009 is likely to be more like 14% (up from 13%), and the mathematics of base effects means it’s unlikely the Government’s -0.3%y/y forecast for 2010 will be achieved.
S&P will most probably act on their negative outlook, and drop Greece another notch (from BBB+). I also expect that Moody’s act on their recent statement, and will drop Greece to A3. Both are likely to retain their negative outlook. Recall that Moody’s said that A3 would occur if Greece managed to implement most of its budget plans but fell just short of meeting its pledges. Ending 2009 100bps worse than expected should do the trick.
This is a big issue, as from the start of 2011, the ECB will not accept bonds rated below A- (roughly A3 for Moody’s) by major ratings agencies. The current minimum is BBB-, and if I’m right about Greece being cut again due to their bad 2009, this will put them only two notches away from unacceptable on current rules (and two notches from being acceptable in 2011).
On my calculations, Greece is at the limit of fiscal sustainability, and if it gets cut debt servicing costs will rise, and the interest burden will exceed nominal GDP growth by a few percentage points. This would precipitate something of a meltdown.
As nominal GDP numbers have not yet been released, in the below I fudge it and assume nominal YoY is equal to real (a serviceable assumption, given that GDP deflators are likely to be flattish). I’m using the Economist for deficit numbers, and Eurostat for debt to GDP in 2008.
Based on these numbers, and some generous assumptions about fiscal consolidation, i came up with the following path for debt to GDP ratios in Europe (see above chart, or the table below).
My back of the envelope calculations suggest Greece is already in meltdown territory. Making generous assumptions, I expect that their debt to GDP ratio will stabilise somewhere around 155% of GDP in 2015 – if they are lucky.
Greece will be lucky if it stabilises, because by 2015, the interest burden of their debt will approach 7% of nominal GDP – which is about as good a growth of nominal GDP as they could reasonably expect. That is, by the time debt to GDP has stabilised, interest on the outstanding debt will grow as quickly as GDP – this is the entree to a fiscal meltdown. Very savage budget cuts are required to make the gains I have assumed, as the rising interest burden will eats more of GDP each year.
Euro wide fiscal drag implied by the above numbers is a little over 2ppts of GDP in the first year, and a little over 1.25ppts of GDP per year thereafter. This is required just to stabilise debt to GDP ratios. In a good year, the EU might deliver 3% growth – so these are very severe fiscal adjustments.
Europe has the choice between a sovereign debt crisis, or a long period of austerity and very slow growth.
Even before fiscal austerity has began, the fade of fiscal stimulus measures and the exhaustion of the inventory cycles appears to have delivered Europe to the edge of a double dip. Heavy snow in Q1 snow is probably sufficient to make Q1’10 negative. Private demand simply isn’t recovering. Retail sales (-0.1%m/m in Dec) and IP (-1.7%m/m in Dec) both continue to decline. This isn’t just in the Euro area, Japan is suffering too – but it’s most obvious in Europe.
If not double dip and austerity it’s going to be crisis. Certainly, there are hints of September 2008 just now – especially the now-you-see-me, now-you-don’t pantomine that surrounded the EU’s Greek commitment on Thursday morning.
Dubai is playing the part of Bear (complete with the rich sponsor who saves the day at the last minute?), and Greece is playing Lehman. This story in the FT casts Angela Merkel in the part of Bernanke – insisting that there is no legal basis for a Greek bailout. Will it be the UK that plays the part of Merrill Lynch?
The Dubai story come back on Friday night – cash bonds sold off 2 cash points and CDS hit 660bps as reuters reported that an article in al-Ittihad newspaper said well placed sources had informed them that Dubai World would ask creditors for a six-month debt standstill.
Note that Stiglitz has popped up again – he’s been advising the Greek government.
The man is the academic equivalent of Merrill Lynch – where there’s money to be lost, he’s involved. For those who had forgotten, Stiglitz and Orszag (now Obama’s director of the office of management and budget) wrote this little beauty – which concluded that the GSE’s would never cost the taxpayer a dime.
S&O put the GSEs through “millions of potential future scenarios”, constituting a “severe” test; they concluded that the probability of a default was found to be “so small that it is difficult to detect.”
So far, Fannie has cost 60bn, and Freddie 50bn. And just recently, given ever-rising default rates, congress amended the terms of their bailout such that the 200bn cap was removed (the taxpayer is now on the hook for whatever it takes to keep their net worth positive). See the RBA’s summary from their excellent SOMP here.
You should short any nation or company with which Stiglitz is involved.