The perils of misplaced optimism
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The perils of misplaced optimism

Markets have taken some comfort from the better-than-expected run of data seen in the early part of the year, the most recent being yesterday’s provisional PMI data in Europe.   But are we heading for a repeat of the last two years?

Both data sets saw a strong tendency for upside surprises in the early part, to be followed on by a raft of weaker data. Whilst for the US there may be some basis for the better tone, in Europe it’s decidedly more fragile.

The IMF yesterday said that the eurozone may enter a mild recession this year, but the economic divergence being seen will mean that this entails decidedly different things for different countries, not least owing to the fiscal tightening being imposed in many non-core nations. It’s not a case of raining on Europe’s parade, just a warning not to lose sight of the fact that we remain in the eye of a sovereign crisis storm from which the escape route has yet to be mapped out.

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More strain in Spain. Spain is in a very knotty financial situation currently, one that will take a desperately long time to rectify. Not helping its predicament are signs that the economy is back in recession. According to the Bank of Spain, growth will contract by 1.5% this year. For those ministers responsible for putting Spain back onto a more solid fiscal footing, their task is rendered even more difficult by the fact that achieving a deficit target for this year of 4.4% of GDP is almost impossible given the 8% shortfall recorded in 2011. Although Prime Minister Rajoy has already announced a package of measures worth EUR 15bln, we will need to wait for another couple of months before a comprehensive budget is presented. Worryingly, it would appear that there is already some friction between the two ministers charged with righting the government’s parlous balance sheet. Last week Budget Minister Montoro called for the EU to relax the 4.4% deficit target for 2012, arguing that it was unrealistic. However, yesterday we had the Economy Minister, de Guindos, claiming that the new government had a very strong commitment to austerity. Last week, Deputy Prime Minister, Saenz de Santamaria, declared that Spain was determined to achieve the existing target.   It is just possible that these are not conflicting positions. Spain’s new government does appear quite committed to fiscal consolidation, but there is a growing recognition that it cannot pull back too sharply or it risks sending the economy into a death-spiral not unlike Greece. Europe should cut Spain a little slack.

Some basis for ECB optimism. The provisional PMI data for Germany, France and the eurozone as a whole suggest that the modest optimism expressed by the ECB earlier this month is not wholly without substance. At the January press conference, Draghi noted that “there are tentative signs of a stabilisation in activity at low levels” and for the two largest economies and the eurozone as a whole at least; yesterday’s data add some weight to this view. The increase in the manufacturing balance for Germany takes it back above 50 and to a level last seen in August of 2011 (at 50.9), whilst the services series showed even more vigour at 54.5. Although manufacturing in France fell, services recovered and, for the eurozone as a whole, the balance was back above 50 (again for the first time since August). This is in contrast with the recent trend of forecasting a mild upcoming recession in the eurozone, the most recent warnings coming from the IMF ahead of the publication of its latest round of forecasts. The pattern of the data does more to back up the view that any such recession is likely to be mild, but within this the stand-out factor is the increasing economic divergence between Germany and (to varying degrees) the rest of the eurozone. All well and good from one perspective, but the structure and basis of the single currency was economic convergence, something which the current crisis has blown apart.

The problem for Athens.  The longer the stalemate goes on with the private sector bondholders, the more the power lies with the private sector bond-holders because there’s no moving the March deadline for redemption of EUR 14.5bln (just over EUR 15bln with final coupon payment). Greece can’t afford to pay this and Germany ruled out giving Greece a bridging loan should a deal not be agreed by then. On this basis, holding out for a forced restructuring could be in the Greek’s interests, as it would involve those bonds not covered by the PSI deal sharing the burden (the estimated EUR 55bln held by the ECB and other central banks). As such, there comes a point where Greece could be better off under a forced, rather than voluntary deal. Furthermore, for those bond-holders hedged (either fully or partially) via CDS contracts, they will benefit from the payout. So, as every day ticks by, the power shifts away from the EU and towards the private sector bond-holders who have an ever larger gun held to the head of the EU. The end game is not going to be pretty.

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