Since European Central Bank President Mario Draghi’s
speech in late July promising to do “whatever it
takes” to preserve the euro, followed by the announcement
of an ECB program to buy short-dated peripheral government
bonds under some circumstances, euro area markets have rallied
and the single currency zone has faded as a source of concern
for markets in the U.S. and elsewhere. Investors who earlier in
the year were closely following the ins and outs of Greek
coalition politics have turned their focus to other topics, in
particular fiscal cliff negotiations in the U.S. While it no
longer represents an imminent threat to global risk assets,
however, the euro area crisis continues to unfold, and sooner
or later it will return to the headlines. Indeed, bad news
about euro area growth and renewed tension about Greece have
likely contributed at the margin to the U.S. equity market
sell-off in the past few weeks.
The coming months will likely bring a mixture of good and
bad news about the euro area. The improvement in financial
conditions achieved in recent months, if maintained, should
help generate somewhat stronger growth for the region in 2013.
That pickup in turn may represent part of a broader narrative
of improving business cycle conditions outside the U.S. By
contrast, the euro area’s institutional progress likely
will remain fitful at best, leaving the region vulnerable to
bouts of political disturbance and worsening sentiment.
For now, three moving parts within the euro area story
deserve investor attention:
Financial conditions have improved significantly, but
are now at risk. The ECB’s successive actions over
the past year — especially the LTROs and more recently the
yet-to-be-implemented OMT announcement — have by no means
solved the euro area crisis, but they have done much to ease
financial tension. Peripheral bond spreads have narrowed
significantly (Chart 1), and both the Italian and Spanish
governments have maintained their once-threatened access to the
primary market. Euro area equities climbed more than 20 percent
from late July to mid-September, though they did not quite
return to their March peak. As a whole, euro area stocks this
year have come close to matching the S&P500, though with
considerable divergence across specific markets in the region.
The German DAX, for example, has jumped more than 20 percent
thus far in 2012, while Spanish equities have shed about 10
percent in U.S. dollar terms. The euro currency itself rallied
against the dollar between July and September in response to
the ECB, reversing an earlier dip and taking it back close to
its end-2011 level. Equally importantly, capital flight from
the peripheral countries appears to have slowed. Bank deposits
have generally stabilized (Chart 2), and imbalances within the
euro area’s internal payments settling system (TARGET2)
have stopped worsening. Over time, these factors should help
reduce bank lending rates facing corporations and households in
peripheral countries, which have been slow to fall in response
to ECB rate cuts. With a lag of a few months, these declining
risk premia and borrowing rates should serve to lift euro area
growth, in particular by lessening downward pressure on the
peripheral economies.
Euro area peripheral bond spread and
equities
Source: Bloomberg, JPMAM; data as of November 19,
2012 |
Peripheral country bank deposits (Jan 2009 =
100)
Source: European Central Bank, Bank of Greece; data
as of September 2012 |
More recently, though, some of these gains have eroded. The
OMT has not yet become operational, mostly because Spain —
an obvious candidate for this type of assistance — has not
requested help, presumably because of the political risk
involved in accepting the associated conditionality. The ECB
appears ready to implement the OMT, whose fate thus appears to
depend largely on the Spanish government. More broadly,
progress on the institutional front, including the drive to
create a single banking system, has slowed. Spanish bond
spreads, which narrowed by about 375bp between July and
October, have widened about 85bp since. And euro area equities
participated in the global sell-off, slipping nearly 6 percent
from mid-October to the end of last week before bouncing
alongside the U.S. market. Failure to turn the OMT from
announcement to reality risks undermining its potential support
to euro area growth and would likely require the ECB to create
some other facility in an attempt to ease financial conditions
in the periphery.
Nothing doing yet on the growth front. While our
forecast includes improvement in euro area growth during 2013
— with GDP gains averaging just over 1 percent through the
course of the year — no obvious sign of improvement has
yet appeared. GDP contracted 0.2 percent Q/Q, SAAR in the third
quarter, following a 0.7 percent dip in the second quarter of
2012. Neither did the monthly data flow improve during the
course of the quarter. Perhaps more worrisome is that surveys
are not showing any improvement in business or consumer
confidence thus far, even though these indicators might be
expected to reflect the improved financial environment quite
quickly. To take two examples, both the overall EC Survey
measure of economic sentiment and the Germany-specific IFO
business survey continued to weaken through November, though
the IFO’s expectations component did at least stabilize at
a weak level (chart 3). For now, the euro area continues to
struggle under the weight of ongoing fiscal austerity, an
impaired financial system, and lower but still significant risk
premia. With economic activity already at a weak level, the
region is not experiencing a severe recession. But the roughly
zero growth environment for now implies an ongoing increase in
the euro area unemployment rate, weak corporate profit growth,
and limited popular support for governments.
Euro area confidence surveys
Source: JPMSI; data as of October 2012 |
The forecast of somewhat stronger growth in 2013 depends
most crucially on easier financial conditions, making
successful implementation of the OMT program paramount. At the
margin, slightly less fiscal tightening than in 2012 and a
pickup in Asia, benefiting European exports, should also help.
Signs of an inflection point will likely appear in monthly bank
lending data as well as the various national business surveys.
If growth is indeed to move into positive territory already in
the first quarter of next year, business surveys need to
display a convincing uptrend by December.
Shaky institutional progress, with Greece back in
focus. While euro area leaders continue to support further
integration rhetorically, actual institution-building is moving
ahead very slowly. Most obviously, progress toward a banking
union is unfolding at a glacial pace, with as yet little
agreement on the division of labor between regional and
national regulators and no facility yet in place to support
pooled deposit insurance. More concerning in the short run,
though, is the ongoing plight of Greece.
In partnership with the IMF, Greece’s euro area
partners are funding the country, via the EFSF, while Greece
carries out its large fiscal adjustment. The hope is that
Greece’s efforts will eventually result in regained access
to the primary market. The lenders’ current review of
Greece’s progress, ahead of the next aid disbursement,
resulted in fresh demands for more austerity measures, which
precipitated a brief crisis within the Greek parliament.
Ultimately, lawmakers approved the new round of cuts as well as
the full 2013 budget. But new projections prepared as part of
the review process highlight the debt burden, which remains
crushing even after last year’s write-down of privately
held bonds. With the economy mired in recession, the Greek
public debt ratio seems unlikely to drop to 120%/GDP — a
level adopted by the official lenders as a benchmark at which
the country might be able to return to private debt markets
— within the next 10 years (chart 4), even assuming
herculean and sustained austerity efforts by the local
authorities and a return to economic growth by 2015.
Greece public debt/GDP projection (%)
Source: JPMSI, European Commission; data and
forecasts as of November 2012 |
This outlook for Greek debt generates an unappealing set of
options for its official lenders: (1) Continue funding Greece
indefinitely, in the knowledge that the country may never
succeed in weaning itself off of this assistance; (2) Accept a
write-down of official claims, either those held by the ECB or
directly by euro area governments or both; (3) Precipitate
Greece’s expulsion from the euro area. Euro area leaders
likely do not want to bear the risks associated with a Greek
exit, nor do they seem politically ready yet to take a
reduction in their own claims on Greece. Keeping the dance
going for now seems the least-bad option. The problem is that
the IMF, which only lends when it does not expect an eventual
financing gap of the kind that exists now in Greece, may
withdraw its own participation, forcing euro area governments
to step up their own contribution, another politically
challenging step.
With little appetite for returning to existential-crisis
mode, euro area governments will probably continue disbursing
loans to Greece, with or without IMF support. Having won
approval for the 2013 budget, the government seems unlikely to
fall in coming months. But ongoing debate within the country as
well as among the euro area lenders about the long-term
sustainability of the current process will keep Greece close to
the headlines, until the official lenders decide either to
write down their claims or force Greece out of the single
currency. The possibility of the latter move, however small,
makes it unlikely that currency and convertibility risk premia
will disappear entirely from the euro area periphery.