27 October 2011

Global Strategy
Alternative view
www.sgresearch.com

Global Strategy Weekly
Bust, bust and bust
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

The increasingly frenzied attempts of eurozone governments to persuade financial markets that they can draw a line under this crisis will ultimately fail – even if this week’s measures bring some short-term relief. I have minimal confidence that governments can turn this around within the confines of the eurozone project. You might be surprised though that I feel more bullish! Why? Both Dylan and I have come to the view that the ECB will be forced, by events, to monetise debt in the GIIPS and beyond. And if investors believe the governments in Spain and Italy are bust, then Germany, France, and not forgetting the UK and US, are far, far worse.
Q After almost 30 years analysing the macro situation, few things now surprise me. But one thing that really did surprise me in the euro crisis (so far) is that Italy got sucked into the maelstrom. Itms not often I am more bullish than the consensus, but in my original vision of an inevitable break-up of the eurozone, I went out of my way to exclude Italy from being drawn into the eye of the storm q see GSW, 12 Feb 2010.

Global asset allocation
% Equities Bonds Cash
Index Index neutral SG Weight

Q

30-80 20-50 0-30

60 35 5

35 50 15

For unlike the other GIIPS (as we now call them), Italy never suffered from inappropriately low interest rates during the 2003-07 period. The lone size fits allm eurozone interest rates were clearly lwrongm for Greece, Ireland, Portugal and Spain (GIPS), and the resultant private sector credit/housing booms ended in a bust. The depressionary forces unleashed were the primary cause for the explosion of public sector deficits in the GIPS. In that sense their story is similar to the US and UK, with one key difference: the GIPSm fate was largely out of their own hands. By contrast, the US and UK monetary authorities were just totally incompetent.

Source: SG Cross Asset Research

Q Italy never lenjoyedm a boom to suffer any bust. And on many measures, including reputable attempts to take account of off-balance sheet liabilities, Italian public sector debt fares well on cross-country comparisons (see chart below). These off-balance-sheet liabilities will now increasingly become visible to all. Who then will be really bust?

If Italy is insolvent, what are France and Germany? And who’s going to bail them out? (Total net government liabilities off and on balance sheet, both as % actual GDP)

500%

Total net govt liabilties
(includes off balance items) 418%

549%

Official govt net liabilties
442% 364% 434%

541%

Global Strategy Team
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

250%

244%

0% Germany
Source: OECD, Gokhale (2009)

Spain
Rates

France

Italy
Equity

UK
Credit

EU

US
Derivatives

Macro

Commodities

Forex

Please see important disclaimer and disclosures at the end of the document
F176487

But then in H1 1990 the data strengthened markedly and everyone relaxed q incorrectly as it turned out as the economy indeed slipped into recession in July 1990. ECRI Lakshman Achuthan. when some market bears interpreted the decline in one of the institute’s indexes as a signal that a recession was in the offing.0 4 2 0 0 -10 -2 -20 -30 -4 5. But. unlike last year. in the summer of 2010. US analyst optimism (% upgrades) and change in optimism (3m mav. SG Cross Asset Research. ECRI weekly and Conference Board monthly leading indicators The US unemployment rate has only been this high at the start of a recession in 1937 25. although it is as weak now as it was last year (see left hand chart below). “By contrast. These have been weakening for some months in the US and elsewhere.0 1919 1924 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 Source: Datastream. this time around the ECRI have put out a rare recession call q link.0 10. but only to weakness.0 % 30 20 10 Conference Board (r/h scale) 8 6 20.Global Strategy Weekly Wemll come back to Italy and the eurozone a bit later. the institute said the pattern pointed not to recession. It reminds me of when I was the US economist at Kleinwort Benson in 1989 and we believed the economy was slipping into recession.0 ECRI -6 0. pervasive and persistent” downturn consistent with a recession. This is indeed a crisis. Regular readers will know we like to use leading indicators. but first we note that stronger than expected data out of the US and China has helped to perk up risk sentiment recently.” (Does he mean me? Surely not!) The last time we entered a recession with unemployment this high was back in 1937 (see right-hand chart above). The markets are being beguiled by the current data into concluding there will be no recessionary problem because of the recent run of stronger data. the ECRIms COO notes that they made the recession call only after an array of economic indicators showed a “pronounced. We have not highlighted the Economic Cycle Research Institutems (ECRI) weekly leading indicator for some time.0 15. change on 6 mth seasonally adjusted) US change in analyst optimism (pp ch 6m) leads OECD lead indicator Source: Datastream 2 27 October 2011 F176487 .

but also suffering from a very high government debt/GDP ratio. Yet her recession predictor using financial conditions suggests the probability of recession within the next 12 months to be just below 70% (see American Themes.Global Strategy Weekly Analyst optimism on profits has also slipped sharply recently (see left-hand chart above.00 100 100 80 7. Our US economist. Reuters reported on 8 July that nSpeculation is growing that Italy's Economy Minister Giulio Tremonti – credited with shielding the country from the eurozone debt crisis – will soon be forced out of government. 27 October 2011 3 F176487 . It could/should have escaped this debacle. "He thinks he's a genius and everyone else is stupid. they are definitely still in the eye of the storm. that drove bond yields to new lows (see right-hand chart below). optimism defined as EPS upgrades as % of all estimate changes). without a government to speak of (an advantage?)."He is the only minister who is not a team player. Now they trade at a clear 50bp premium. has by contrast managed to keep below the marketms crisis radar. It is especially shocking that in this cyclical recovery.00 5. when Italian Prime Minster Berlusconi turned on his well-regarded Economy Minister. 21 Oct 2011).00 6. We find the change in optimism (dotted lines in both charts above) is a good leading indicator for the official leading indicators (see right-hand chart above).50 100 present situation 160 160 140 140 9. One thing she noted was that her predictor using real economy variables was showing a minimal 10% probability of recession ahead.50 private sector de-leveraging 50 1989 1990 1991 1992 1993 1994 0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 0 5. wrote an interesting report looking at her own leading indicators of recession. The trigger for this was back in early July. which would further raise the heat on Italian bonds… Tremonti overcame cabinet resistance to push through a tough austerity programme last week. but now looks increasingly isolated and appears to no longer have the full support of Prime Minister Silvio Berlusconi.50 80 80 2 70 60 expectations 60 10y yield (rhscale) 7. Italian bonds yields had consistently traded below Spanish yields by about 75bp (see chart below). This signals continued weakness ahead. With Italian 10 year bond yields once again pressing towards 6% in recent weeks.00 8. This is the same q just much worse. US consumer confidence: heading back to rock bottom 200 200 Consumer expectations slumped three times in the early 1990s 110 consumer confidence 10. Yikes! Meanwhile the Conference Board measure of consumer confidence is slumping anew (see lefthand chart below). with yields once again pushing up close to 6%. the Present Situation subcomponent never even rose near to the nadir of the previous recession! The slump in expectations is exactly like the early 1990s. Aneta Markowska.00 180 180 9.50 90 120 120 8. a previous period of de-leveraging. Italy has been ill-served by its politicians for dragging the country to its knees unnecessarily.00 Source: Datastream Let us return to the eurozone. Belgium." Berlusconi said in an interview with Repubblica daily on Friday." Until this untimely outburst.50 40 40 60 20 20 1 3 6.

but it had been in excess of 100% for many years and was. the public sector deficits in all the GIPS rocketed above 10% of GDP q just as they did in the US and UK. SG Cross Asset Research Sources: ECB. Reflecting this.50 UK MAY JUN JUL AUG SEP OCT 0.5% in 2007 and a primary surplus of 3½% (deficit excluding interest payments). Scanning the OECD databank.0 Labour productivity: Output per hour worked Household debt as % of GDP Belgium France Austria Greece Finland Ireland Spain Italy NL 0 Euro area Portugal Q4 2001 Q2 2002 Q4 2002 Q2 2003 Q4 2003 Q2 2004 Q4 2004 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Q4 2008 Q2 2009 Q4 2009 Q2 2010 Sources: ECB. Italian households are not highly leveraged. suffered from inappropriately low interest rates that resulted in a private sector credit boom and bust.0 3. Eurostat. Portugal and Spain) who had.50 1.50 2.00 Italy 4.00 0.50 Berlusconi opens his mouth and puts his foot in it 4.Global Strategy Weekly Bond yields: Why was Italy sucked into the crisis? It could have avoided the market’s attention 4. Italyms budget deficit was notably under control. the economic situation that Italy found itself in after the bubble burst was very different to that of the GIPS (Greece.00 2.. Italyms general government debt may have been notably large (in excess of 100% of GDP).00 3. Italyms cyclically adjusted general government deficit hence rose only 0.00 1.00 3. until very recently. By contrast Italyms public sector deficit rose more moderately because there was no busting domestic credit bubble to fight.00 2.50 Spain 2. the GIPS were running gargantuan 10% current account deficits (as a % of GDP). household sector debt in Italy was low both before and after the crisis (see top left-hand chart above).50 4. 100 90 80 70 60 50 40 30 20 10 2003 2010 Labour productivity barely growing at 1%yoy after a long slump 5.0 -3. By contrast. with a public sector deficit going into the crisis of only 1. not dissimilar to Belgium.0 -5.. Because of the nature of the GIPS private sector credit bubbles. but they have been well known for years. SG Cross Asset Research As mentioned previously. when the music stopped in 2008.50 0 0 Source: Datastream Italyms debt problems are well known.50 3. Eurostat. domestic demand growth in most of the GIPS was running around 5% yoy versus only 1½% in Italy. It is clear that in the run-up to 2008 crisis.0 1.4% in 4 27 October 2011 F176487 Q4 2010 . to a greater or lesser extent and through no fault of their own.5% between 2007 and 2009 against 6. whereas Italy was running a moderate external deficit of 2% of GDP. letms be boring and talk some numbers.50 3.00 1.50 Belgium France 1. Ireland. Italy was a very different animal to the GIPS.0 -1.

having been in excess of 2% yoy in the late 1990s. But we would agree with the well known eurozone commentator. In trying to keep its monetary virginity intact.5 2. The real issue is Italyms incredibly low productivity growth (see top right-hand chart above). Indeed its actions will mirror those of Rudolf Von Havenstein. Italyms trend GDP growth rate is now barely positive on Vladimirms estimates (see left-hand chart below) and investment in people is poor (see right-hand chart below). SG Cross Asset Research But as we showed on the front cover chart. The current eurozone talks will not solve this crisis and it will get worse q much worse. all governments are effectively bust. Notwithstanding some legal issues to get around and Germany being outvoted. It happens when the markets decides it is time to happen. who wrote “Everyone needs the ECB to step up to the plate. letms not kid ourselves. the bank threatens to destroy the eurozone.6%! Where does this leave us? I had a very long chat with our Italian economist.2% in Ireland. Paul de Grauwe of the Leuven University. Indeed letms make the comparison even more stark q Italyms cyclically adjusted deficit rose 0. Reinhart and Rogoff in their book This Time is Different: A Panoramic View of Eight Centuries of Financial Crises q (link) show that there is no magic public sector debt threshold that determines when a crisis hits. The question for me is not if the ECB will print.5 1. SG Cross Asset Research Sources: OECD. Francems rose 2. As populations age and unfunded liabilities increasingly appear on the balance sheet. The near-zero trend rate of growth means that Italy simply cannot grow its way out of its debt and will remain highly vulnerable to market shocks. but rather will Germany leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery? 27 October 2011 5 F176487 .0 1.0%.0 2.Global Strategy Weekly Greece.link.link. we think the impending threat of a euro break-up will force the ECB to begin printing money. very reluctantly joining in the global QE party. Italy’s potential growth rate is very low 4. 5.0 0. Letms be clear q neither Dylan nor I view ECB monetisation as a lsolutionm.6%. Vladimirms latest thoughts are contained in a recent Focus on Italy document .5% in Spain. and the Netherlands deficit rose 4. Hence. But Dylan and I feel more optimistic about the medium term. 8.0 Potential growth rate 1999-08 (average) 2012 forecast Italy’s low tertiary educational achievement stands out 50 45 40 35 30 25 20 15 10 5 0 Sources: OECD. president of the Reichsbank in the early 1920s.0 3.2% in Portugal and 9.5 0. Vladimir Pillonca.5 3.o The ECB will have to choose between its two most cherished ideals: the euro or its hard money principles. He says one single variable encapsulates the depth of Italyms economic problems: GDP per capita is lower today than it was a decade ago – none of the worst performances among advanced economies” in the IMF’s words. The ECB has no excuse not to act. He kept printing because he was scared of the mass unemployment that would ensue if he stopped .5% while even Germanyms rose 1.

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