GaveKal Ad Hoc Comment

GaveKal Ad-Hoc Comment Asset Allocation & Economic Research

Wednesday, September 14, 2011 Author: Charles Gave

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The Financial Implications of a European Recession

Milton Friedman used to say that the Euro would not survive the first European recession, yet the monetary union is still hobbling along even after the Global Financial Crisis. Clearly, Professor Friedman underestimated the willingness of the troika to put billions upon billions of Euros on the table to back the EMU. Yet we can say without any exaggeration that the Euro is still not in great shape (to say the least!). What if another imminent recession were to now hit the old continent? As most of our readers know, the European recovery has been very dependent on the externally-oriented Northern European economies. However, now that the US economy is also looking weaker, these export champions are also faltering. In the chart below, we compare two key leading indicators for Germany (the IFO and ZEW surveys) to EMU industrial production. Today, the sum of our two German leading indicators is more than one standard deviation below its historical mean. Every time this has occurred in the past, Eurozone industrial production fell -3% or more YoY.

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Meanwhile we have countries like France, that never really staged a post-global crisis recovery in the first place. The chart below tracks the relationship of a number of financial variables (Germany purchasing parity vs. the US, stock market index in France, real rates on German industrial bonds) against the 12-month variations in private sector GDP (French GDP minus general administration, health care, education and public transports). It is quite obvious that the rebound of the French private sector GDP has been quite meager after the 2008 carnage:

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Europe now faces the task of digging itself out of its debt problem even as global growth looks shakier.

Not only is a EMU recession very possibly on the waybut not since WWII have the risks associated with a recession been higher. After all, as we discussed in our recent Quarterly, the accumulated losses of the Euro experiment have only been partially written off. We still have, for instance, some 1,450bn in GIPSI debt that is held by private non-residents (including, of course, French and Germany banks). Until very recently, the hope was that Europe could muddle through, and that over time these losses could be slowly amortized through economic growth. Instead, Europe now faces the task of growing itself out of its debt problems even as global growth looks shakier. But with a) debt levels so high, b) losses still to be reckoned with and c) competiveness diminished, a number of European countries are clearly stuck in a debt trap from which the escape route is rapidly closing. This brings us back to the fact that the original Euro experiment epitomized the institutional folly and arrogance that Hayek identified as the fatal conceit. In 2002, I published a book in French called Lions led by Donkeys (currently only available in French) in which I argued that the Euro would lead to massive misallocation, with too many houses in Spain, too many factories in Germany and too many civil servants in France (and Greece, Italy, etc). The too many houses in Spain is inarguable, as is the too many civil servants in Greece. There are still hopes that France and Germany, as the two largest economies and most influential policymakers in the EMU, can orchestrate an EMU rescue. But in fact these two countries exemplify the growth risks facing the Eurozone.

1 Too Many Civil Servants in France (and Italy, etc.)

French government spending as a % of GDP since 2000 has increased by almost +10%. This public-sector splurge translated into stagnation of what one could call the non-communist part of the economy. After all, increased government spending means either a greater number of civil servants or higher social transfers, both of which are very conducive to reelections, but not very favorable to privatesector economic growth:

It is not just the little economies that will find this hard to do.

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Civil servants are not subject to international competition, but they do buy imports. So one result of expanding public sector is the emergence of an everwidening current account deficit. In a normal system (i.e., not in the Euro), this would lead to a falling exchange rate. In the Eurozone, of course, this is impossible. Instead, the country experiencing the public expansion becomes less and less competitive, as evidenced by the chart on the top of the next page.
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France and Italy have seen declines in industrial competitiveness.

As more and more of the domestic demand is serviced by the foreigners, domestic production shrinks, even if domestic consumption does not (at least initially). France of course is not the only EMU country to suffer from this phenomenon. From 1981 to 2000, Italian and German industrial production grew at the same rate, the Italian macroeconomic mis-management being compensated every three or four years by a Lira devaluation. However, since the introduction of the Euro, the IP growth rates of France and Italy have diverged as never before to the point that the Italian IP has actually declined in the last 11 years, while the German one has surged

This has undermined production, even as the effects of the Euro encouraged consumption.

France has also seen a deterioration in domestic production during the Euro years, and the coming recession will lead to a new deterioration of the primary deficit:

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In turn, a falling growth rate leads to weaker tax receipts and a rising budget deficit. Today, French government debt as a % of GDP is rising relentlessly:

As economic growth slows, so do tax receipts. Inevitably, budget deficits rise.

The vicious cycle of the debt trap is hard to escape.

Part or all of the debt issued by France and the rest of the current account-deficit countries in Europe was bought by non-resident savers. Eventually, unless one enjoys the exorbitant privilege of being the worlds reserve currency, this will lead to concerns over sovereign risk and a rising cost of capital, making growth even harder to achieve. Moreover, accumulated past deficits are likely to explode as a proportion of GDP. This is the classic debt trap situation, of which Italy has been particularly associated with in recent years:

How can Germany pay if so many of its export customers are in this situation?

And as the fear of default is now spreading from the fringe EMU countries to any potential debt trap victims in the EMU, interest rates start to move up generally, which in turn kills off growth and guarantees an eventual default. This is where the Germany will pay refrain is usually heard. But Germany may not be in as great a position to pay as is often assumed. And the next leg of the Euro misallocation tells us why.

2 ...And Too Many Factories in Germany

In order to follow a mercantilist path, Germany had to provide vendors financing to its customers. In other words, if Germany wanted to keep accumulating current account surpluses against its EMU partners, it had to accept IOUs issued by these countries as payment. As a result, Germany has accumulated close to 1 trillion of debt issued by the likes of France, Italy, Spain, Greece, Ireland, Portugal, etc. And, as we all know now, these countries may now be unable to repay their debts. As such, fears that the German financial system will have to write off a large chunk of its 1 trillion in EMU sovereign debt have long plagued the German financial system. Indeed, it shows that the so-called German miracle of the last few years was nothing but a mirage. The profits made by German companies selling in the
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Germanys sovereign debt holdings can essentially be seen as the amount of export financing provided to its trading partners.

Euroland may very well be cancelled by the losses incurred by the German financial system. As Bastiat would have said: The Germans could have put their goods on a boat and sunk it in the Atlantic, the results would have been the same But another key risk has gotten much less attention. Just as too many houses were built in Spain, too many factories were built in Germany. We are now left with overcapacity in the German production system, since demand from the GIPSI countries plus France together make up nearly 25% of the German export market. Exports to these countries now makes up more than 9% of GDP:

As Bastiat might say:

they could have sunk goods in the Atlantic, the results would have been the same.
The only solution would be for Germany to continue its vendors financing, producing goods which they would continue to sell at a lossin Eurospeak, this is called mutualisation or federalization of the debt. But due to the sheer size of the debt, it may be too much to swallow even for Germany. This situation also dashes hopes that German demand could pull the weaker EMU countries out of their malaise. If a lot of spare capacity were to appear in Germany, it is hard to see why the Germans should buy foreign goods rather than German ones. In fact, the most likely scenario given the coming decline of German exports to the weak countries is a decline in German imports, the capacity to service whatever is left of the German demand reappearing in countrys unused capacity. This is confirmed by the next chart which shows that every time in the past, when the German economy has slowed, German imports slowed even more:
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Demand will collapse when the lenders refuse to lend anymore, spreading the disaster from the current-account deficit countries to the surplus countries.

If the first act of this tragedy was too many houses, this has more or less been played out. With the debt trap noose tightening on countries with too many civil servants such as Italy and France, we are in the middle of the second act. The third one is still to come (although the German stock market has started to sniff it out) as the realization that a massive amount of capital has been invested in Germany at a loss.

3- Investment Conclusions...
Perhaps we should have titled this section, how to make rational investments decisions in an asylum? We have arrived at the current misery because the Euro is an artificial construction which has caused a massive misallocation of capital. A large part of the demand (how large is anybodys guess) has not been bought with earned money but with money borrowed at a false cost of capital. Demand will collapse when the lenders refuse to lend anymore, spreading the disaster from the C/A deficit countries to the surplus countries. The conclusion is inescapable: Keep avoiding the financials (our recommendation since the beginning of the Greek crisis at least) Avoid the bond marketsincluding now the Bund Concentrate holdings in the shares of companies which derive their revenues from outside the Eurozone. In short, do not have anything in Europe except if one has to. And do not believe a second the fellows who tell you that the European markets are now cheap! If we take the French stock market vs. the US stock market (total return, including dividends in one currency) as an example, the US current account is still improving and the French stock market has another 50% to fall before becoming very attractive on a valuation basis vs. its US counterpart. The time will come to buy European equities, but it is certainly not now.

We have arrived at the current misery because the Euro is an artificial construction which has caused a massive misallocation of capital.

Do not have anything in Europe unless one has to...

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