Lighthouse - Euro-Zone Monitor - 2013-04

7/28/2019 Lighthouse - Euro-Zone Monitor - 2013-04

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Lighthouse Investment Management

Euro-Zone Monitor - April 2013 Page 1

Euro-Zone Monitor

April 2013

ContentsEuropean Equity Markets Diverge as Crisis Resumes ............................................................................... 2

A Walk Through the Euro-zone ................................................................................................................. 3

Nominal GDP: G6+1 .................................................................................................................................. 4

Nominal GDP: Europe ............................................................................................................................... 5

Real GDP.................................................................................................................................................... 6

Governments' Share of GDP ..................................................................................................................... 7

Government Revenue and Spending ........................................................................................................ 8

Cuts in Government Revenue and Spending ............................................................................................ 9

Trade Balances / Average Cost of Debt .................................................................................................. 10

Unemployment ....................................................................................................................................... 11

Debt-to-GDP, Primary Balance................................................................................................................ 12

House Prices, Unit Labor Costs ............................................................................................................... 13

Retail Sales, Industrial Production .......................................................................................................... 14

Deposits, Loans ....................................................................................................................................... 15

Summary ................................................................................................................................................. 16

Conclusions ............................................................................................................................................. 16


2/17



European Equity Markets Diverge as Crisis Resumes

As I was recently dining at a restaurant, the couple at the neighboring table kept complaining about

their food. The server tried to make things right, but eventually the manager had to intervene. Later, I

overheard the manager lecturing the server, explaining that "perception is reality".

And it's true. What does it matter if your bank deposits are safe as long as most customers believe they

are safe? The worst thing that can happen to a bank is pictures of long lines of customers trying to

withdraw money. Or, as in Cyprus, banks being closed, limited account access and "haircuts" to those

who believed their money to be safe.

Only then reality pierces perception, and depositors are suddenly reminded they are merely creditors.

From the bank's perspective, deposits are a liability, a source of funding for their assets. The bank

customer, of course, has no idea what kind of assets the bank acquires, and the risks taken. And he

shouldn't have to.

However, after the Troika (EU, ECB and IMF) seemingly didn't mind haircutting small depositors in

Cyprus, every depositor should be aware that the EU-wide deposit guarantee does not exist.

By confiscating deposits of those depositors, who had little to do with the demise of their bank, a new

frontier in the Euro-zone crisis has been reached. EuroGroup president Dijsselbloem made it clear theCypriot bail-in was a template for future bank rescues. Depositors in the Euro-zone periphery are on

high alert, and will likely not think twice before starting a bank run. Just as the Euro-zone crisis subsided,

politicians have succeeded in setting it on fire once more. A strong divergence of returns in European

equity markets since February (see chart) is a sign of increased trouble ahead.


3/17



A Walk Through the Euro-zone

Why has the Euro-zone fallen back into recession, and why can't it shake of its seemingly never-ending

crisis? Is there light at the end of the tunnel?It has been a while (Letter to Investors, March 2011) since we last looked into macro-economic

developments inside the Euro-zone.

A picture says more than a hundred words, so here are a few charts, with comments.


4/17



Nominal GDP: G6+1

Nominal GDP, with the year2000 set at 100.

You see that Spain was one of

the strongest performers

among the G6+1 (I took the

liberty to replace Canada with

Spain), while Germany was

one of the weakest.

This is an example how little

GDP actually says about thehealth of an economy.

Zooming in on the time

period since the 'great

recession' shows how

Germany fared better than

Italy and Spain (both never

reached their pre-crisis level

of nominal GDP).


5/17



Nominal GDP: Europe

Focusing on Europe, Cyprus

comes out on top in terms ofnominal GDP growth.

GDP is a flow value, meaning

each year it starts at zero. GDP

completely ignores level of

debt, and is therefore pretty

much useless.

If I ran a kingdom I could

double GDP by deficit spending

(but this wouldn't last verylong).

Here we zoom in on nominal

GDP since the 'great' recession,

showing dramatic declines in

Ireland and Greece.

If your GDP falls 15% (and

unemployment skyrockets)

your fiscal deficit is going to

get worse, not better. Also, a

falling GDP makes the debt-to-

GDP ratio worse than it already

is.

Harsh austerity is the medicine

that kills the patient.


6/17



Real GDP

Moving on to real GDP, or

eliminating the effect of

inflation in order to get

changes in volume.

Look at Italy - worse off than

Japan. Yes, deflation actually

helps your real GDP, since it

makes real GDP higher than

nominal GDP.

However, I don't think Japanfeels really good about

deflation.

Zooming in on the past six

years, we observe that all

countries except Ireland and

Switzerland have dropped

back into recession.

Eurostat has apparently given

up on publishing numbers for

Greece, or is too

embarrassed to show how

Troika-prescribed severe

austerity destroyed the

economy.


7/17



Governments' Share of GDP

Which government is best at

'milking' its taxpayers? TheFrench!

More than 50% of GDP is

siphoned off by the French

government.

You also notice recent

attempts by Portugal and

Greece to extract more

money for the government.

Switzerland stands out aspositive example.

Government know one thing

best, and that is to spend all

available money (and then

some).

Not surprisingly, the Frenchgovernment is leading the

charts, followed by Greece.

Switzerland again stands out

by far.


8/17



Government Revenue and Spending

Compared with the level in

2000, the German

government had the lowest

increase in revenues,

followed by Switzerland.

Meanwhile in Cyprus,

working for the government

was great.

If governments only

remembered not to spend

more than they have!

Ireland is a special case, since

they had to bear the cost of

bailing out banks


9/17



Cuts in Government Revenue and Spending

Recessions rip holes into

government revenue, as tax

receipts decline.

Some countries quickly

recovered, while Ireland and

Spain clearly have problems.

How are those countries

coping with their loss of

revenues?

Ireland, Greece and, to lesser

extent Portugal, have

significantly cut spending (as

condition for receiving bail-

outs).

In Spain, however, little

attempts are seen at cutting

spending, a clear mismatch to

the decline in revenues.


10/17



Trade Balances / Average Cost of Debt

A negative trade balance

(more imports than exports)must be financed, usually

leading to external

indebtedness.

Recent improvements among

peripheral countries are

encouraging. However, not

every country can have a

positive trade balance; it's a

zero-sum game. Since neither

Germany or Netherlands

seem to give up any surplus,

imbalances must be popping

up elsewhere (Japan, USA,

other emerging markets).

An important chart, showing

the average cost of debt by

country. Everybody is

between 3% and 4% (even

Greece), despite huge

differences in debt

sustainability.

Many countries are

benefitting from the implicit

subsidy of being a member of

the Euro-zone.

While this is good for highly-

indebted countries, it doesnot impose fiscal discipline as

few countries have to pay the 'true' cost of their debt.


11/17



Unemployment

Now some ugly charts:

unemployment rates.

Germany is enjoying its time

in the sun, while other

economies are struggling.

Is this how an economically

unified zone looks like?

Language seems to be a

bigger barrier to free labor

movement than thought.

Youth unemployment is the

real drama, with rates of over

50% in Greece and Spain, and

rising sharply in other

countries (except Germany).

France saw social unrest with

"just" 25% youth

unemployment; I am

surprised how 'patient' young

unemployed Spaniards seem

to be.


12/17



Debt-to-GDP, Primary Balance

Finally coming to one of the

key areas of Euro-zone crisis:unsustainably high debt

levels.

The Greek 'haircut' brought

little relief, and Greece still

heads the ranking.

Eurocrats try to remedy a

debt problem by throwing

more debt at it. "Official"

(ECB/EU/IMF) creditors arecrowding out private ones,

and lead to higher haircuts in

the end.

The primary balance excludes

interest on debt.

Even if all debt was forgiven,

many countries would still

not have sustainable budgets.

The adjustment needed in

Spain is worryingly high,

probably too high (especially

given high unemployment).

At some point, social stability

becomes a factor (and the

potential for political

extremism).


13/17



House Prices, Unit Labor Costs

Housing markets are booming

in Scandinavia, while Spainlooks dreadful. This will rip

more holes in the balance

sheets of Spanish banks.

The Netherlands is also

showing some signs of

deterioration.

German employees showed

wage restraint while workers

in other countries enjoyed

salary increases. Used to fight

regular currency devaluations

of its European tradepartners, German companies

are constantly improving

productivity.

While the price of labor

(salaries) is only flexible in

one direction (up),

adjustments in the other

direction usually fall onto the

number of workers

(unemployment).


14/17



Retail Sales, Industrial Production

While retail sales are

stagnating in Germany, theyare shrinking dramatically in

countries that had to be

bailed out.

The Netherlands are again a

surprise, with similar

development as in Hungary.

In Germany and France,

industrial production peaked

in early 2011. Other countries

(Greece, Spain, Portugal)

never really recovered.


15/17



Deposits, Loans

Finally, a look at the banking

sector. Deposits in Spain and

Portugal are bleeding with

annual rates of 10%.

This, together with rising non-

performing loans and

increased capital

requirements will make banks

reduce their lending, choking

small and medium-sizedcompanies.

This is reflected in declining

loans by financial institutions

in the PIIGS (with the

exception of Italy - for now).


16/17



Summary

1. GDP is pretty useless as indicator of economic strength, as it ignores debt accumulated by the

largest contributor to GDP (governments).2. If one thing can be gained from looking at real GDP it is the fact that, over the past 12 years, Italy's

growth has been inferior to that of Japan. Without any grow, even otherwise (borderline)

sustainable debt levels become too much of a burden on the economy.

3. Even in times of rapidly declining revenue, governments are unwilling or unable to cut spending

unless forced to do so by EU/ECB/IMF. This is the reason why most countries try to resist any

bailouts until it is too late (usually when the capital market refuses to further finance its debt).

4. Governments do not have any cash reserves; insolvency is only a failed debt auction away and can

happen at any time.

5. Trade imbalances of the PIIGS are on the mend (but without the major beneficiaries, Germany and

Netherlands, giving up any of their surpluses).6. The average interest paid on government debt is surprisingly uniform (3-4%); the subsidy of being

member in the Euro zone does not enforce fiscal discipline.

7. Unemployment, and especially youth unemployment provides for potentially explosive social

tensions and/or radical political movements, making governing more difficult.

8. Debt-to-GDP ratios continue to rise as required fiscal adjustments are too large and recessionary

trends take their toll on government finances.

9. Despite recent improvements, Germany has still a large advantage in unit labor costs.

10.Declining house prices in Spain and Portugal will continue to weigh on banks.

11.Collapsing retail sales and industrial production in the PIIGS continue to erode the tax base.

12. In Spain and Portugal, trends in deposits look to undermine the banking system and choking smalland medium-sized companies.

Conclusions

Developments in Spain and Italy will lead to further deficits and increase in debt levels.

At some point, capital markets will refuse to absorb new debt.

ECB/EU/IMF will be forced to step in, as local banking systems are loaded with government bonds.

Any government bond restructuring would also impair the banking system.

Rumors regarding the solvency of banking systems could trigger bank runs, as depositors are warned

by the Cypriot example.

Many years of further austerity seem to be the inevitable result, with potential political and social

instability sprinkled in.

Central banks might be able to paper over (literally) a collapse of the Euro-zone, but still won't be

able to prevent stock markets from reacting negatively to recurring crises.


17/17



Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be

taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or

endorsement to buy or sell any security or other financial instrument. You shouldn't be surprised that

accounts managed by Lighthouse Investment Management or the author may have financial interests in any

instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and

we might not necessarily disclose updated information should we discover a fault with our analysis. The

author has no obligation to update any information posted here. We reserve the right to make investment

decisions inconsistent with the views expressed here. We can't make any representations or warranties as to

the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions,

misinterpretation or misuse of any information posted is excluded.

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