February 19, 2013
|Ken Orchard, portfolio manager and analyst of European sovereigns.|
What can we expect in 2013 from the ongoing European financial crisis? 2011 and 2012 were both characterized by periods of calm and stress. Although we should avoid the extremes of those years, swings in temperature are an integral part of the eurozone crisis. Periods of stress should also help to resolve the crisis eventually by forcing reform, integration, and mutualization. Ken Orchard, portfolio manager/analyst of European sovereigns, identifies eight themes to watch in 2013 that point to another mixed year for the eurozone.
A gradual, shallow recovery is likely—a robust rebound is not. Current consensus economic forecasts for 2013 may be too pessimistic. A mild recovery beginning in the second quarter seems likely.
Financial stress has plummeted since August, which should help confidence and be positive for growth. Although fiscal austerity will be a drag on the economy, it should not have the same pronounced impact as last year.
The eurozone will continue to face headwinds to growth from fiscal consolidation, high private sector debt, and banking sector deleveraging. Just like Japan during its lost decade, the eurozone is likely to experience recurring periods of negative gross domestic product (GDP) growth over the next few years. An acute phase has passed, but the crisis—and the impact on the economy—is not over.
There is evidence that the doctrine of fiscal austerity is weakening. The European Commission and European Central Bank (ECB) seem to be realizing that an endless recession will undermine public support for the eurozone and, ultimately, make solving the crisis more difficult. New politicians, particularly President Hollande of France, are not as willing to sacrifice economic growth in pursuit of fiscal sustainability, and German leadership appears willing to slow the pace of fiscal consolidation to support the broader economy ahead of German elections in September.
Fiscal policy will still tighten in 2013, but the easing of fiscal austerity targets will avoid an additional round of midyear fiscal tightening as occurred in mid-2012. This should give some breathing room to an incipient economic recovery.
Sovereign rating downgrades were abundant in 2011 and 2012. The (unweighted) average eurozone sovereign rating declined from AA- in December 2010 to A+ in December 2011 and then to A in December 2012, based on ratings by the three major credit rating agencies.
We expect few sovereign rating downgrades in 2013. The reasons are twofold. First, we believe that the action taken by the ECB and eurozone governments has, at least temporarily, stabilized the sovereign creditworthiness from a macro-financial perspective. The prospect of a "death spiral" of rising yields and falling GDP growth leading to liquidity crises is now unlikely, in our view. Second, we think that most sovereigns are currently fairly rated based on their fundamentals. Unlike in the past, there are no major differences between T. Rowe Price's internal credit research ratings and the rating agencies' ratings.
The major driver of social unrest in the eurozone is likely to be rising unemployment. Even though the region is expected to exit recession this year, growth is unlikely to be strong enough in the periphery to create jobs.
There are other potential causes of social unrest: labor market reforms that reduce protections for existing workers, pension and retirement reforms, higher taxes, and cuts to public services. All are necessary to solve the crisis long term, yet all will also exacerbate social stress in the short term.
The risks posed by social unrest should not be underestimated. Governments will need to be strong and determined to enact reforms in the face of widespread public opposition. If the reform process stalls, the eurozone could become trapped with high debt and no growth. A more serious risk is that governments try to ease the economic pain through unorthodox policies. Greece is most at risk of following this path in 2013.
The common perception that Greece is "solved" is too sanguine. There is still much potential for the situation to deteriorate again in 2013. The high and rising unemployment rate, combined with the cuts to pensions and public sector employment passed in November, could lead to a resurgence of public protests in the spring and summer. The Greek government is fragile and divided—its majority in parliament is eroding, and one of the coalition partners (Democratic Left) refused to support the International Monetary Fund-European Union (IMF-EU) package in November—and may not survive a concerted attack on its policies. Greece may once again rise up the market's list of concerns.
The most obvious candidate for an IMF-EU rescue program is Cyprus. Although Cyprus has a small economy, the market probably does not fully appreciate the nature of its problems—large insolvent banks, high government debt levels, and a collapsing economy. Cypriot banks need to be recapitalized, but lending the government the money to do so would push its debt/GDP limit to 160%. A rescue program, funded wholly by the eurozone, seems the most likely outcome, with debt restructuring deferred for several years.
The second candidate for an IMF-EU rescue program is Spain. We believe that Spain will be forced to request a contingent credit line from the European Stability Mechanism, thereby allowing the ECB to activate outright monetary transactions, the ECB's program to purchase government bonds of one- to three-year maturities subject to the requesting country meeting certain conditions. The fundamental situation in Spain continues to slowly deteriorate: The economy is mired in recession, the budget deficit and government debt are high, and the banking system and regions are under pressure. When another risk-off period rolls around, the market is likely to refocus on the fundamentals and push spreads higher again (although we do not expect it to be a traumatic event for financial markets).
The ECB is likely to take action to prevent a contraction of its balance sheet, following significant expansion in the past year, as it will want to avoid a tightening of liquidity conditions across the eurozone. Several options are available:
a. Cut the repo rate to 0.50% or 0.25%.
b. Reintroduce multiyear long-term refinancing operations, or LTROs, which provide low-cost financing to eurozone banks, including loans of 6-, 12-, and 36-month maturities. The aim is to maintain liquidity for banks holding illiquid assets.
c. Use the outright monetary transactions to reduce sovereign spreads (although this would require at least Spain, Ireland, or Portugal to make a formal request).
d. Buy financials sector assets, such as covered bonds, to try and keep the market for these instruments open to periphery banks.
e. Move the deposit rate into negative territory to encourage banks to lend and invest more. This would have unintended consequences and is likely to be used only as a last resort.
The eurozone has been characterized by a cycle of hope, disappointment, and crisis since the region's sovereign debt problems began. We are currently in the "hope" phase. "Disappointment" and "crisis" are likely to return again at some point, even if they are less pronounced than in the past.
The crisis will not be solved without new institutions and greater integration. Changes to the eurozone's structure are needed to minimize the collective action problem, transfer fiscal and financial risks from the national level to the eurozone level, and make the eurozone more like a federal state rather than a collection of individual states. These changes would make the eurozone more stable and more permanent, thereby significantly reducing the probability of a breakup and taking a major step toward solving the crisis.
The problem with new institutions and integration, however, is that there will be winners and losers. The transfer of risk, resources, and decision-making powers will benefit some countries while hurting others. The politicians in the losing countries can only justify the changes when financial stress is high enough that the transfer leaves them better off on a net basis.
The link between market stress and progress toward institution building and greater integration is fundamental to the crisis itself. A lack of stress leads to procrastination, which leads to crisis, which later leads to progress on institutions and integration. Market stress is a symptom of the crisis but should also drive the solution to the crisis. Although we will not see the ultimate solution in 2013, we think it should be a little bit closer by this time next year.