Lighthouse Investment Management

Euro-Zone Monitor
April 2013

Contents
European 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

Euro-Zone Monitor - April 2013

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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 the Cypriot 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.

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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.

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Nominal GDP: G6+1

Nominal GDP, with the year 2000 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 the health 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).

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Nominal GDP: Europe
Focusing on Europe, Cyprus comes out on top in terms of nominal 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 very long).

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-toGDP ratio worse than it already is. Harsh austerity is the medicine that kills the patient.

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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 Japan feels 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.

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Governments' Share of GDP
Which government is best at 'milking' its taxpayers? The French! 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 as positive example.

Government know one thing best, and that is to spend all available money (and then some). Not surprisingly, the French government is leading the charts, followed by Greece. Switzerland again stands out by far.

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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

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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 bailouts). In Spain, however, little attempts are seen at cutting spending, a clear mismatch to the decline in revenues.

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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 highlyindebted countries, it does not impose fiscal discipline as few countries have to pay the 'true' cost of their debt.

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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.

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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 are crowding 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).

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House Prices, Unit Labor Costs
Housing markets are booming in Scandinavia, while Spain looks 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 trade partners, 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).

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Retail Sales, Industrial Production
While retail sales are stagnating in Germany, they are 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.

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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 nonperforming loans and increased capital requirements will make banks reduce their lending, choking small and medium-sized companies.

This is reflected in declining loans by financial institutions in the PIIGS (with the exception of Italy - for now).

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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 small and 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.

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