European Market Insight
AMSTERDAM—The Euro Stoxx equity index had the worst week of 2012 so far, losing 3.18 percent and falling below 2,500 before recovering to close at 2,525 last Friday.
The euro currency gained a modest 0.71 percent, closing at $ 1.33 for the week. Again, the small gain masks the volatility, which haunted traders during the week. The Wednesday high of $1.33 was followed by a crash to $1.31 and the recovery into the close on Friday.
The Greek CDS auction settled without interruption last Monday, with a price of 21.5 percent of par. This means that investors who bought Greek government bonds at par lost 78.5 percent of their money (disregarding any coupon payments).
This is the biggest discount on sovereign debt in history. Despite the smooth transition here, there is still the question of hedge fund litigation and U.K.-law bonds. Reporting on this matter was rather quiet this week, but the chance is high that something will happen when people least expect it.
The market, however, is most likely pricing in another Greek default, as the “new” Greek bonds yielded more than 20 percent last Thursday.
Despite the already low expectations, PMIs for the eurozone managed to disappoint as a whole, painting a relatively bleak picture for the economic prospects of the 17 countries that share the euro currency. The composite PMI, which gauges purchasing managers activity, for March fell to 48.7 on expectations of 49.6. A reading below 50 indicates contraction of economic activity. Among single countries, Germany’s PMI fell to below 50 for the first time this year.
Some Stress in Peripheral Markets
Yields of Italian and Spanish bonds were on the rise again for most of last week as underlying fears crept back into traders’ minds that were previously alleviated by the success of the European Central Bank’s Long Term Refinancing Operations (LTRO).
Citigroup’s chief economist Willem Buiter was on Bloomberg radio last Wednesday saying, “Spain is the key country about which I’m most worried.” Spain had a pretty good starting position before the crisis and still has a lower debt to GDP ratio compared to both the United State and Germany at 68.2 percent at the end of 2011.
This, however, masks the underlying problems of a devastated housing market, which according to the Bank of Spain is trading 29 percent below 2007 peaks. Similar to the U.S. subprime crisis, the crash in housing led to bad bank loans, which mostly have not been written down. Therefore, implicit in the Spanish government debt is the Spanish bank debt for which the government will have to assume total responsibility if it wants to avoid a complete economic collapse.
Irish GDP also disappointed heavily, decreasing 0.2 percent in the fourth quarter of 2011 on expectations of a 1 percent gain. Ireland previously has been lauded as the best in class of the peripheral economies, as the country really managed to implement economic reforms and slash the budget deficit.
Low Credit Demand Indicates Balance Sheet Recession
Apart from problems in Spain and Ireland, there are other worries that plague the eurozone as it was seen in the poor showing of the PMIs last week.
Despite the record amount of liquidity injected in the markets during the two LTRO (Long-term refinancing operation) programs, credit growth in the real economy especially in the corporate sector remains subdued. Research by Morgan Stanley indicates that demand from small and large companies for bank loans has fallen since the beginning of 2011. At the same time, bank-lending standards have tightened.
Richard Koo, an economist at Nomura who first coined the term “balance sheet” recession as an economic phenomenon where companies and consumers do not follow the neo-classical economic paradigm of profit maximization. Instead, they focus on debt minimization, which greatly reduces the effect of fiscal and monetary stimulus.
This phenomenon was widely acknowledged in the two “lost decades” of Japan and has gained traction after the recent crisis in the United States. The recent data from Morgan Stanley shows that Europe is now showing the same symptoms.
The Week Ahead
Germany will report the IFO business confidence indicators as well as consumer prices and the unemployment rate.
After suffering under hyperinflation in the 1920s, Germans have notoriously been inflation hawks especially after the Deutsche mark was introduced in 1949. Other than that, it will be a quiet week in terms of scheduled releases. It is very well possible that we will see a third week in a row where the eurozone does not dictate worldwide stock market movements, something quite unheard of since the summer of 2011.