European procrastination a prelude to global stagflation?

Procrastination
Once again the theme of procrastination has emerged in the Eurozone crisis. This time it revolves around Spain and the tip of the iceberg is the rescue of ailing Bankia (= sum of the cajas).

Two long-standing pressure points stand out, that have consistently characterized Europe since the Greek crisis erupted.

First, lack of the proper institutional framework for dealing with crises is leading to lots of 'wasted time' and the associated escalation in uncertainty. These, in turn, have an impact on financial markets as well as the general health of economic activity.
There are calls for empowering the ESM to make direct recapitalizations and sever the existing link between banks and sovereigns to be when it comes to aid for banks in trouble.

It is worth pointing out that the ESM was conceived at the time as part of the 'solution' for tackling future crises.
Well, here we are...the future is now and now is the future, as the Greek crisis is very much alive and we are moving slowly (?) but surely to simply add more 'episodes' (e.g. Spain currently) along the way.

It is like throwing water on fire, when there is a variety of fire-fighting chemicals out there...But of course they have to be paid for. We are getting to the point when the fire is close to getting out of control and everybody is hoping that it is going to rain. The Europeans are dragging their feet once again.

Second, we continue to witness the ongoing 'clash' between different institutional sources of authority; usually it is the EU Commission vs. Germany, with the ECB standing in the middle...like an adult between two children fighting. No progress here either.

Indicative is the situation experienced around this time last year (May 2011), when Europeans were starting to warm up to the idea of a 'voluntary' agreement of Greece's private creditors on a 'haircut'. Chancellor Merkel started talking publicly about it, while France's stance was to categorically oppose the scenario of restructuring and the EU Commission half-heartedly suggested 'reprofiling' (i.e. just playing with words that essentially mean the same things) as a possibility..


Stagflation
Now, procrastination and indecision by the Europeans have been key factors depressing economic activity worldwide. Uncertainty freezes business decision-making, funding for SMEs remains scarce/unavailable, etc.

One can spot signals which suggest that the world economy may be entering a stage increasingly characterised by stagflation.

Extremely loose monetary policy in the developed world is set to persist/strengthen in the near/medium term. While not immediately translating to inflationary pressures, it is a very open question even to central bankers how there will be a successful 'mopping up' of all this liquidity without damaging growth prospects when the time comes. Authorities' profile of incentives on liquidity provision remains skewed/asymmetric, not least in order to avoid a debt-deflation spiral.

In the developing world, seeds of stagflation are becoming more evident.
India's GDP growth in Q1 2012 came in at an annualized 5.3%yoy (versus 9.2% in 2011), an eight-year low, with sharp declines in industrial production and exports being the norm recently.
Meanwhile, inflation remains elevated at 7.3%yoy despite a series of aggressive interest rate hikes by the RBI throughout 2011. The RBI has recently reversed course in order to stem the growth slowdown as the government tries to rein in its budget deficits. Foreign capital flows have all but dried out, the trade deficit has widened to a record, and the Indian Rupee has reached all-time lows versus the USD (a further fuel to inflationary pressures and expectations thereof). The RBI has tried to intervene in order to send a message to financial markets and stem the currency decline.



In fact, this is becoming a more general feature in the developing world recently, further evidence of stress in financial markets.

As Bloomberg reports:  
Just three months ago, emerging nations from the Philippines to Brazil were intervening in foreign exchange markets to make exports more competitive. Now they are selling dollars to stem currency declines and quell inflation. 

“Inflation is still an issue for a number of emerging- market countries,” said Callum Henderson, global head of currency research at Standard Chartered Plc in Singapore. “At the same time, growth is an increasing concern for those countries vulnerable to the European debt crisis. Policy makers have to try and strike a very careful balance.”

In Brazil, Banco Central do Brazil, with the government's 'blessings', has been slashing rates since mid 2011 in effort to boost growth (down to 2.7% in 2011 from 7.5% in 2010) and arrest the Real's strength (Brazil was among the small number of countries with positive real interest rates). Inflation is still high, but has been coming down recently.
Expectations out of Brazil are gradually converging with the reality of 'trouble' in the world, with the Bovespa index clearly reflecting this trend.

However, the stakes are getting higher, and the associated fragility harder to handle the longer such an approach remains in place.
As Beyondbrics reports: 
Moody’s Latin America director Alfredo Coutiño, had this to say:

After today’s decision, monetary conditions have fallen below neutrality, since the nominal policy rate is lower than the neutral 9 per cent. If economic activity remains weak and advances slowly, monetary conditions will need to be pushed further into expansionary territory in coming months. Lower interest rates will restore the currency competitiveness and will help the national industry to quit recession.

The danger lies with potential un-anchoring of inflation expectations as the economy appears to respond to stimulus. Furthermore, political 'suasion' on the central bank has been steadily rising in Brazil and could have an impact of foreign investors' confidence.

China has so far managed to contain inflation through drastic intervention in the property market. Growth has been slowing, so the tipping point for a shift in the authorities' stance may be getting closer. Also, it is interesting to think about what the effect of 'rebalancing' (towards more domestic consumption, less investment, less reliance on exports for growth and some financial system liberalization) will be on the growth/inflation mix going forward.

Anthony Boeckh puts it well in a recent note (3/5/2012):

"Price inflation has softened recently in a number of countries.  Headline price inflation in the U.S. has slipped from 4% p.a. to a little under 3%, in the eurozone from 3% to 2.7% and in the UK from over 5% to 3.4%.  China’s non-food and producer price changes have actually moved into negative territory.  India and Russian inflation numbers show a decline from recent peaks of around 15% to the 6%-8% range.  Agricultural and industrial metal prices have dropped about 20% from the peaks of a year or so ago.  So, from a close up snapshot, one could ask, “Where is the inflation problem?”  However, that misses the point.  Price inflation is all about excessive money, credit and fiscal deficits.  When they work their way through the system, prices go up.  The key variable is the time lag."

I am not claiming that stagflation on a global scale is imminent. However, it is important to keep track of what is going on below the radar at a time that everybody is thinking about Greece, Spain, banking unions, etc. Not least because developments in Europe have been and will continue to be a key input of authorities' reaction functions in the rest of the world.

Is Europe really the biggest risk out there?

I am not going to suggest that Europe does not lie at the top of the list when it comes to macro risk these days. A euro 'accident' would have severe consequences for financial markets and the real economy across the globe. A great number of analyses in the press have covered pretty much every angle there is on this issue.

It is also the consensus view that the US is 'ahead' of Europe in many respects, and righly so; for example, the US has a more flexible/proactive central bank and has been more decisive in recapitalizing its banks.

However, it is often the case that taking a longer-term perspective can yield counterintuitive (or contrarian) insights. 

This 'principle' came to mind after watching a brief interview of economic historian (and widely regarded as a 'bear') Russell Napier on FT.com.

Napier argues that, from a long-term valuation angle, Europe is the most promising region when it comes to prospective returns from equities for the next 10 years, esp. with many markets now back at valuations last seen in the early 1980s.

While not as useful a guide for the short-term, metrics such as the 10-year cyclically-adjusted PE ratio (or, 'Shiller PE' ratio) suggest the risk/reward for the long-term investor appears pretty attractive.

According to Napier, European equities currently seem to already reflect/discount a 'great deal of pain'. Notwithstanding the scenario of a euro breakup, Napier's argument is that the ECB (or, should the euro disintegrate, the resulting national central banks) will try to reflate/turn on the printing presses, in an effort to arrest deflationary economic pressures, thus acting as a trigger for higher equity valuations.

Under this rationale, it would make sense to look for good companies in the most distressed markets and make a bet for the next 10 years. Greece has its own 'gems', a number of companies with good management, considerably extrovert and currently trading at valuations that discount near-bankruptcy (e.g. MOH GA, MYTIL GA, EEEK GA), as investors are fleeing any sort of asset related to Greece (for example, this is indicative)

This is not meant to suggest 'go and buy tomorrow', as the euro exit scenario is very much real and it is nearly impossible to time market bottoms anyway. It is  intended to stress the importance of being able (and willing) to adopt a longer-term, contrarian mindset when one feels we may be getting closer to an inflection point.

Napier goes on to talk about the US. His argument is that, fundamentally, the biggest and most systemically-important risk out there revolves around the ability of the US government to finance itself going forward.
The foreigners that hold around 45% of US sovereign debt have been quite 'patient' thus far with all the money-printing by the Fed. However, 'the king has no clothes on' and the most likely catalyst for this to get the market's attention wil be when the Chinese renminbi depreciates, hits the bottom of its trading bound and leads on to the selling of Treasuries by the PBOC.

Nassim Taleb (see here) also thinks the biggest concern involves US fundamentals going forward, rather than the European situation.

“We have zero interest rates,” Taleb said. “If interest rates go up in the United States, you can imagine what the deficit would be. Europe is like someone who is ill but is conscious of it. In the United States we are ill, but we don’t know it. We don’t talk about it.” 

Interesting stuff...

Greece

Greece can be seen as the 'sovereign' analogy to Lehman Brothers; small, but with huge implications: risk of contagion, financial market panic and then a sudden urgency to “put one's house in order”.

Everyone agrees in the need for a 'firewall'. But can there be a firewall that is robust enough? Furthermore, given the poor ‘performance' of Europeans on such matters, can one be confident that such a firewall will be sufficient? 

Experience has not been encouraging. Unlike the US and UK, where there has been good progress in recapitalizing the banks, minimal steps have been taken in Europe. In addition, political leadership has been scarce and inconsistent, lacking the vision necessary to address problems which themselves involve a product born out of a 'vision' (the Euro).

What is more, 'hard-line' statements (e.g. 'no' to restructuring of Greek debt) have been (predictably) abandoned during the course of the crisis, with consistent denial to accept that the problem is crucially one of 'solvency'.  
The FT reports today that "Germany rules out common euro bonds"..could this be the next one?

Ironically, the more rigid a stance, the harder the 'backtracking' is going to be once circumstances force themselves, a theme we have seen creep up since 2010.

Importantly, as has so far been the case in every instance of 'resolution' / buying of time / 'can-kicking', it is the ECB that takes the wheel and steers the ship (see SMP, LTRO, etc.), treading around the edges of its mandate. There is even a timeline of the financial crisis on the ECB's website...which ironically bears proof to this statement.

The ever critical role of the ECB at present is well-highlighted by several commentators (see, for example, this comment by Andreas Koutras). 

It is also a point made by Jean Pisany-Ferry in the FT; he correctly points out that the credibility of a hard-line stance needs to be backed by concrete initiatives that will 'beef up' the necessary firewall and make it work.

The bottom line is this, in my view. 

First, Europeans do have a red line; a world with Greece out of the eurozone can exist tomorrow, however large the contemplated cost will be (in monetary terms as well as in terms of political capital) in the short term. 

Dangerous populists like the leader of 'Syriza' should acknowledge this and think/act accordingly (I doubt they have ever tried to). His party ranks second, with 16% of the vote: yes, a huge leap from 5%, yet less than the collective 18% of all parties who did not manage to elect MPs...But he walks around as if his party got 30% or 40%, insulting people’s mentality with his anachronistic, delusional and inconsistent rhetoric.

Greece has wasted a great amount of time and negotiating ammunition since the start of the crisis, haunted by an 'endogenous' lack of political cohesion and leadership. 

Nodoby is asking Greek politicians to adopt a 'nordic' mentality towards the common good overnight, but it is sad to see a bunch of 'followers' who cannot even talk straight to themselves (let alone each other) exhibit a uniquely unconstructive type of 'selective myopia' in their rhetoric (and lack of action). 

Maybe the state of Greek society has deteriorated so much (and for so long) that it has come to deserve this kind of leadership (or lack of it.)

Second, it is important to note that so far (and, unfortunately, this seems set to continue) initiatives in Europe have been taken after tremendous pressure, be it markets pushing sovereign yields higher or ''disturbing''' (but fully expected) election results unnerving investors. And even when things start to move, it is not politicians at the forefront, but the ECB.  But the capacity of central banks to 'do the work' for governments is not without bounds. Yes, Draghi has been more 'pragmatic' than Trichet, but my sense is we are now getting closer to the limits...with clearly destabilizing implications.

It makes one wonder if it will take another Lehman, this time on the sovereign side, in order to get Europe to realize if and how it has what it takes to move towards its desired (in words, but not deeds) direction. 


Below, Daniel Gros talks on Bloomberg about Eurobonds and the situation in Europe.

Where we stand: the Fed in delicate balance

It is now two weeks since the election results in Europe gave markets a pause and investors a reason to reconsider risk exposures from new, lower levels.

Notwithstanding the worries out of Europe, the US economy appears to have entered a period of slow, but steady improvement. 
Certainly the performance of US banking sector stocks seems to be reflecting this, up more than 10% ytd in absolute terms (as well as versus the SPX), despite the recent market selloff and JPM story impact. And with relatively healthy behavior from the banks, it would seem unlikely that the overall market is set to tank.

On the policy front, the Fed finds itself in delicate balance. On the one hand, there is still lack of confidence regarding the sustainability of the recovery, coupled with the real possibility of significant fiscal drag kicking in towards year-end.

Meanwhile, measures of inflation and inflation expectations have been trending lower, giving the ‘doves’ room to argue for additional easing measures.

Bloomberg reports:

With six weeks left before the end of the Fed’s $400 billion swap of short-term debt for longer-term securities in a program known as Operation Twist, everything from yields on securities that protect against rising consumer prices to a measure of the outlook for inflation in the forwards market show diminished concerns. Traders are pricing in a 55 percent chance that the central bank will begin new efforts to spur economic growth, Bank of America Corp. says.

For first time since it announced Operation Twist in September, the Fed’s preferred gauge of measuring traders’ inflation expectations is poised to fall for a second straight month.

“Growth concerns have increased, and with the drop in commodity prices inflation concerns have decreased which has kept the environment friendly for low rates,” said Michael Pond, co-head of interest-rate strategy in New York at Barclays Plc, one of the Fed’s 21 primary dealers. “If growth stalls, the employment rate stops falling and inflation remains no concern, it won’t take much for another round of stimulus.”

The difference in yields between 10-year notes and Treasury Inflation Protected Securities, or TIPS, which represents traders’ expectations for the rate of inflation over the life of the bonds, fell to 2.04 percentage points on May 17. That’s the least since Jan. 23, and down from the high this year of 2.45 percentage points on March 20.

“We’ll probably have to go below 2 percent on 10-year break-evens for the Fed to say there’s a higher chance of deflation priced in,” Priya Misra, head of U.S. rates strategy at primary dealer Bank of America Merrill Lynch in New York, said in a May 14 telephone interview. ”This paves the way for more stimulus, but we’re not there yet.”

Adding to the debate on the desirability of further monetary stimulus is the risk of political backlash, especially from the Republicans.

What is more, there are voices within the Fed that have long expressed their unease with additional rounds of accommodation. Most notably, Dallas Fed president Richard Fisher, highlighting the associated ‘moral hazard’ issue vis-à-vis the fiscal authorities.

Back in September 2011, Bloomberg reported:

“If I believe further accommodation or some jujitsu with the yield curve will do the trick and ignite sustainable aggregate demand, I will support it,” Fisher said today in a speech in Dallas. “But the bar for such action remains very high for me until the fiscal authorities do their job, just as we have done ours. And if they do, further monetary accommodation may not even be necessary.”

                                                   

“I am wary of adopting any policy that might have the unintended consequence of becoming a veterinary fix rather than a more salutary repairing of the ability to propagate jobs,” he said.

A similar line of argument has been echoed by Philadelphia Fed president Charles Plosser in his article in the Financial Times, citing the issue of central bank independence. 

Today, Atlanta Fed president Lockhart also set the bar 'high' for additional asset purchases by the Fed.

My view is that the Fed, led by Bernanke, remains fundamentally open to further stimulus and alert should the economy take a turn for the worse. Certainly, the fact that measures of inflation and inflation expectations have been moving lower also renders potential Fed action more ‘justifiable’.

In addition, the risk of a ‘Euro accident’ may force the Fed’s hand in order to ‘fight’ the upward pressure on the dollar. 

Danger of a euro collapse, albeit temporary, is clearly on the minds of most central bankers nowadays; Mervyn King’s response during the recent Quarterly Inflation Report Q&A session is indicative:

Journalist:  …you did say then that there's substantial devaluation of rates. But what happens – we know markets tend to overreact. Supposing the pound just goes on up and up and up? Is your policy to continue to be one of non-intervention?

Mervyn King: Well, that's a question which is a perfectly reasonable question to ask, but it's one I will answer if and when it happens and not as a hypothetical question. But I'm very pleased to see someone here who remembers the days of trade deficits and the problems that can result from that.

Extreme circumstances open the door for extreme measures.