Author: DrWilliamWilder

Political Activist, Director of Economics, Author

EU Differentiation… The Key Points you should know…

“United we stand; divided we fall” Aesop (Ancient Greek Fabulist and Author of a collection of Greek fables. 620 BC-560 BC)

The problem with the “EU” banner is that it links together economies that are quite different from each other. Much press has been dedicated to the fate of the PIIGS – Portugal, Italy, Ireland, Greece and Spain but it is interesting to compare journalistic exposure with economic impact. Greece Ireland and Portugal account for less than 5% of EU GDP. To save you shifting through pages of research – here are the key pertinent points for each economy… The structure follows that of my earlier assessment of the futility of EU bailout mechanisms–

  1. FLAWED LOGIC – what are the real issues?
  2. NOT SOLVING THE PROBLEM – will the economy in question be able to grow enough / will the debt burden be manageable enough so that it will fall as a % of GDP?
  3. UNCERTAINTY – what are the political issues?

Source: "Belgium Joins The PIIGS: And Then They Were Six" - Gavan Nolan, Econotwist The Swapper - learning and understanding the increasingly complex financial world.

Portugal – A Disappointing Deficit, Dipping Back Into Recession

  1. DISAPPOINTING DEFICIT and FOREIGN PRESSURE – Disappointed the market with its deficit reduction plan for this year, amounting to a value for the first 10 months of 2010 which was than for the whole of 2009 and forecasted to exceed the EU limit until at least 2012. Exposed to more foreign pressure with around 70% of its debt is held abroad
  2. LOW GROWTH – estimated to only amount to 1.3% for 2010 for an economy expected to fall into recession next yr
  3. POTENTIAL SOCIAL UNREST – planning to reduce its public workforce

Italy – Saved by its Savings, Economic Exposure but Debt Isolation

  1. TOO BIG TO BAIL OUT – second largest debt burden after Greece (public debt equates to 120% of GDP)
  2. LOW GROWTH

  • HOWEVER: High savings rate, exposure to German and Emerging Market economies, less dependant on foreign creditors and therefore more flexible

Ireland – The Public Prefers a Default

  1. HUGE BAILOUT – amounting to 60% of GDP vs. “only” 47% for Greece
  2. POTENTIAL FOR DEFAULT – 57% of the public believe the country will not be able to support the annual interest payments involved with this debt burden (€5bn over 9 years) and would prefer the government to DEFAULT on its commitments
  3. PROTEST and INTERNATIONAL IMPACT – 50,000 took to streets to protest against the Government’s plan to cut the budget deficit. The UK has £140bn exposure to Irish banks

Greece – Flirting with Insolvency

  1. STRUCTURAL LIMITATIONS“overblown state sector”, “uncompetitive and relatively closed economy”
  2. SOLVENCY – It has been argued that the bailout package will only prevent Greece from insolvency for ~a year
  3. CIVIL UNREST – has been seen in response to social program cutbacks

Spain – Pulling a “Sickie”

  1. UNEMPLOYMENT and a potential for DEFAULT – the highest in the EU at around 20% of the population. A third of private sector debt (€0.6tn) was generated from the housing boom and liable to default.
  2. INTEREST PAYMENTS HAVE JUMPED – Since Oct, yields have jumped from 4% to 5% leading to a larger debt burden as a percentage of GDP
  3. SOCIAL UNREST – Just the other week we saw one of the largest “sickies” thrown by their air traffic workers

Hungary – The Government Can’t Win

Although not within the PIIGS acronym – it is important nonetheless to mention this economy at this point and a great example of the potential impacts to investment. It’s a case that highlights the Government can’t win – if it decides that instead of implementing austerity programs eliciting social unrest, it will instead employ more crowd-pleasing reforms, it will get punished nonetheless….

  • DOWNGRADED – Moody’s has downgraded its debt to the lowest investment grade status. One more downgrade and it changes classification and those restricted to investing in Investment Grade debt only will be forced to sell, regardless of any other factors. Great opportunity to pick up dent at a discount (whilst watching the quality of the issuer!)
  • REASON – Short term (less antagonistic) measures are not sustainable – special taxes and utilising private pension schemes to fill holes! The Government is relying on future growth to afford its pension liability in the future and anyone not transferring to a state pension by end Jan may lose 70% of their pension value.

Contrast with the Core

Just to contast these economies with the one seeming to be driving force behind the union – Germany’s deficit could potentially fall to the 3% EU limit next year

INVESTMENT INSIGHT: When investing in the EU – differentiate between countries!

European “Financial Mechanisms” – Can they solve the EU’s problems? And how can I make money from the concern?

World unity is the wish of the hopeful, the goal of the idealist and the dream of the romantic. Yet it is folly to the realist and a lie to the innocent – Don Williams, Jr  (American , b.1968)

There has been much in the news lately on the outlook for the European Union. In May, Greece was offered €120bn in EU government and IMF loans over 3 years to replace the need for new borrowing at exorbitant market rates – the “first bailout of a Eurozone country and the biggest bailout of any country”.  Just last month Ireland joined the queue and received a €85bn injection plan. The flame of contagion was burning bright as investors worried Spain, Portugal and Italy were to follow suit quickly (The other members of the PIIGS acronym – and we’ve been advised what risks lie in an acronym!). Then just as markets calmed after the ECB staged their largest intervention and purchased mainly Portuguese and Irish bonds on Friday, the rating agency Moody’s announced it was downgrading Hungary’s debt by not one but two notches!  This country isn’t even in the periphery of the EU, it’s outside of it entirely… and so the contagion spreads….

Source: Bloomberg. The premium investors demand for investing in Irish government bonds over German bunds remains elevated (indicating a perceived heightened risk)

Why won’t the EU bailouts solve everything?

1. FLAWED LOGIC: attempting to solve the problem of debt with more debt

2. NOT SOLVING PROBLEM: without growth, the debt burden as a share of GDP will continue to rise. The latest European Financial Mechanism only covers maters until 2013,  if Debt/GDP has not reduced significantly then bond holders start sharing the pain

3. UNCERTAINTY: ministers keep changing their minds! (“no bail out” to “bailout”, “no pain for creditors” to “sharing the burden”) – markets don’t like uncertainty!

The key discrepancy –

What the ECB wants EU countries to do: Be prepared to increase the size of emergency bailouts, consolidate budgets and reform (implement austerity measures and assume national responsibility so the ECB can avoid being a bailout tool)

What EU country economies need: COMPETITIVENESS AND GROWTH

Market Impacts

  • YIELDS may have fallen sharply for some periphery debt but as the chart before shows, they remain at elevated levels.
  • FORCED SELLING – Pension funds, insurance cos and ETFs which are focused on matching the liabilities to their assets may have to sell certain debt when its credit rating is cut

How can you exploit this?

“Europe is difficult to understand for markets. They work in an irrational way sometimes,” Christine Lagarde, French economy minister

  1. Companies located in an EU periphery country, with strong balance sheets and demand insulated from worries about their homeland (i.e. international exposure and demand for their products from the east etc) making it a sound investment choice, may suffer from illogical moves in the markets that punish anything connected to the country regardless. This debt can be picked up cheaply.
  2. In addition, a downgrade in a country’s government debt may trigger a wave of forced sellers (the pension funds etc. mentioned above) that are restricted in holding this level of debt. If this is just an automatic trade, these distressed sellers may be exploited with the purchasing power in your hands