U.S. public sector debt deleveraging conflicts with hopes of strong 2012-13 demand growth, and political leadership appears risk-averse in the run-up to next November’s elections. Meanwhile, European “leaders” continue to:
- Try and hold together Euroland membership
- Reject the notion that the euro is fundamentally flawed
- Resist the intra-European subsidy implications of a European superstate
- Deny the impossibility of adjusting grossly excessive Greek, Italian and Spanish labor costs down to a competitive level
Thus, the euro-crisis has plenty of scope to worsen. Additionally, Europe’s dominant power, Germany, is forcing the entire continent into a non-solution – that will make the debt problem worse – by embarking on major fiscal deflation. Therefore, the bottom line is not just disappointing growth in the US, with tepid year-on-year growth this year and another, even larger, deflationary dose in 2013, but also recession, in Europe for years.
European governments’ policies are obsessed with preserving the current euro structure by violent deflation of debtor countries. But the only hope for that structure to preserve without a deep and prolonged depression in the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) is acceptance by Germany of a combination of above-target inflation and sustained subsidies to the PIIGS for a decade or more. Meanwhile, French policy is torn apart by conflicting motives, as well as being paralyzed by general elections: the loss of its AAA rating makes it align with German austerity; but the need to keep the PIIGS in the euro, to hold down the euro’s exchange rate and preserve French cost competitiveness, argues for doing “whatever it takes” to subsidize the PIIGS. So Euroland staggers from crisis to crisis as it bounces between the opposite tactics of fiscal austerity versus monetary subsidies. In the short run, the result has been to flood the market with liquidity; but to little avail. The euro has weakened a little, but with the US sluggish, QE3 (a third bout quantitative easing by the U.S. Fed) may emerge to weaken the dollar too. And China is not about to let its yuan appreciate in these conditions. Thus, slowing and competitively depreciating Chinese and US markets will not be an offset for German exports. Nor will consumers rally to spend more. With savers’ interest income even more clearly to be negligible for a long while, they are more likely to spend less in response to a European Central Bank (ECB) liquidity flood. It may well help sustain the PIIGS government bonds for a while, but with little effect on aggregate economic demand.
Greece … Portugal … Spain … Italy – a possible exit queue. An extreme though possible outcome is Greek failure to come anywhere near achieving its fiscal targets, followed by no adequate recovery plan, and then later expulsion, or voluntary negotiated exit, from the euro. Austerity is damaging the finances, as the destruction of the economy outpaces any benefits of higher tax rates and spending cuts. Chancellor of Germany, Angela Merkel, needs to get the euro crisis out of the headlines in time for a decent run up to the big German elections in autumn 2013. Financial pressures could then lead to the exit of Portugal, and later Spain and Italy (in roughly that order). Between now and any such outcome, the weakness of China and potentially slow U.S. 2012 demand – as well as improved US cost-competitiveness – mean Euroland is likely to remain in or close to recession. So while European markets look cheap on a price/earnings basis, that is only appropriate, and their declines could be larger than the S&P’s as their earnings slide.
We expect housing numbers, as well as news out of Europe and China will add volatility to CEFs and the markets over the next few months.
Michael Ashley Schulman, CFA
Hollencrest Capital Management