We can take a bearish or bullish view of the world today. The bearish one expects continued sovereign debt crises spreading globally, but focused in Europe for the moment, and global deleveraging by governments, households and banks.
The bullish one expects that tidal waves of central bank liquidity will drown such fundamentals and that US consumers will releverage. Another important driver of the bullish case is that as credit crises enter successive stages, their marginal impact on economies and markets lessens; the unknown unknowns become known unknowns.
Perhaps financial markets will just get tired of continual crises. The eurozone will struggle on, Europe will be in recession and global economic growth will be weak but governments and central banks will muddle through. Without the European Central Bank’s liquidity injections through Long-Term Refinancing Operations (LTROs) and other ECB funding, Europe’s banking sector would have collapsed this year. Bankers don’t have an appetite to buy much more long-term sovereign debt. And bank deleveraging might continue and cause credit to shrink.
The credit rating agencies’ downgradings of sovereign debt ratings will exacerbate this problem. By differentiating between Germany on the one hand and France and Austria on the other, contagion is imported to the EMU core. European Financial Stability Facility funding capacity is effectively either curtailed by around one-fifth or moves to a lower credit rating and more expensive money. This will force the political debate on extending the EFSF funding in parallel with the new European Stability Mechanism funding. That is going to be a messy political battle between France and Germany.
All this won’t help Europe get out of its current mild recession. Eurozone growth has already fallen below the fail-safe rate beyond which austerity simply makes sovereign debt sustainability harder to achieve. And the UK is going to be dragged into the EMU storm by dint of its weak domestic economy and a worsening impact from its financial and trade (40% of exports) linkages to the eurozone.
| US household debt and debt |
| Servicing costs to personal disposable income |
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| Source: Datastream, Independent Strategy |
The US consumer has reduced debt to below the trend line of those debts to income. And the servicing cost of that debt is also way down. So releveraging there might provide a boost to US consumption and GDP. However, the trend line of US household leverage reflects the successive credit bubbles of the past 25 years and is still too high. And households might save more to offset excessive US deficits and debts, where nothing good is happening. In any case, a reduction in household thrift (the savings rate has already fallen to 3.5% of disposable income from over 6%) is hardly a return to healthy balanced growth, even if the market would rejoice at the prospect.
China will try to drown its banking sorrows in liquidity like the rest of us. Given the naivety of its audience and the concupiscence of the investment banking analysts who are well trained to kowtow to any of Beijing’s policy antics, the market could grant this credibility for a while. But China’s shadow banking system might absorb all monetary easing without much flow through to the real economy. Such is the scale of the credit problem (hidden bad debts are about 25% of GDP). And, of course, this makes growth elusive because households are the financers of China’s shadow banking system, having bought their homes at inflated prices from the real estate developers who are the principal borrowers from it.
Printing money
The bullish case rests on the fact that all the world’s central bankers are printing money in one way or another. Also, different outcomes could arise in different places at the same time: the bearish one in Europe and the bullish liquidity story in the US (for example, another round of quantitative easing focused on housing) and US household releveraging.
Or alternatively, confidence in the ECB’s de facto quantitative easing could bolster EMU assets until the limitations of LTRO become evident. That could spill over into greater confidence in emerging markets in general. China’s ability to export more and drown its bad debts in liquidity and growth would inspire greater confidence.
The US looks better set to grow than Europe. And growth is now the rarest investment commodity in the world. I remain a cautious bull.
David Roche is president of Independent Strategy Ltd, a London-based research firm.