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Don’t Get Distracted by 'Relief Rallies'

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Tuesday, 22 May 2012 02:01 PM Current | Bio | Archive

The recent G-8 summit spotlighted the disagreement between Germany (under Mrs. Merkel) and France (under newly elected Mr. Hollande) on how best to extricate the eurozone from its sovereign debt crisis.

Going forward, potential discord over the merits of also focusing on growth and not just spending cuts is likely to further add to the already significant uncertainty surrounding how effective and forceful the policy response from the eurozone will be to tackle contagion risks that once again threaten to spiral out of control. If such a contagion should happen, it would weaken further the euro, at least in the short term.

U.S. bank Wells Fargo said in a note that if the new round of Greek parliamentary elections fail on June 17 to bring a government that will keep the country's commitments to the EU/IMF program, Greece will soon run out of cash, exit the EMU, and default on its debt.

If that scenario materializes, the euro/dollar cross rate will drop to 1.10, and high beta currencies will depreciate by 5% to 10%, the bank added. EUR/USD is currently trading around 1.28.

The U.S. position on the EU crisis didn’t change over the weekend: Europe has the means to rectify its own problems and should employ them as soon as possible, for its own good, and for the good of the global economy.

Investors should take notice we continue to see U.S. Treasurys to be the strongest net bought across all fixed income markets globally.

The Chicago Fed National Activity Index, which is a monthly index designed to better gauge overall U.S. economic activity and inflationary pressure, showed U.S. economic activity increased in April and that growth in national economic activity was near its historical trend.

Total industrial production increased 1.1 percent in April after declining 0.6 percent in March, and manufacturing production increased 0.6 percent in April after decreasing 0.5 percent in the previous month. Employment-related indicators remained neutral and were down from +0.14 in March.

Interestingly, the report also notes that the still subdued rates of growth point to subdued rates of inflation.

The Organization for Economic Co-operation and Development (OECD) released its first of its twice-yearly economic outlook 2012. The OECD warns for a vicious circle in the eurozone, “involving high and rising sovereign indebtedness, weak banking systems, excessive fiscal consolidation and lower growth.”

Under condition the EU crisis doesn’t escalate, the OECD expects the eurozone to contract by 0.1 percent (real) in 2012 and grow 0.9 in 2013. It also expects the U.S. to grow (real) by 2.4 percent in 2012 and 2.6 percent in 2013. It also sees different dynamics developing in labor markets in the U.S., where unemployment is slowly decreasing (8.1 in 2012 and 7.6 in 2013) and in the euro area (10.8 in 2012 and 11.1 in 2013) where instead it keeps rising.

The OECD expects growth should continue to strengthen in the U.S. in particular (also in Japan) as confidence is picking up in both businesses and households. Financial markets are firming and household deleveraging is well under way which should allow saving rates to “ease.”

More generally, growth seems to be increasingly driven by private-sector demand rather than by policy. It sees fiscal consolidation is dragging growth, but only at a moderate pace. However, the risk of excessive fiscal tightening in 2013 remains to be addressed, failing which, growth would be severely affected.

Looking forward, long-term fiscal sustainability remains to be achieved, and a credible fiscal plan is needed to ensure it. Given the still weak recovery and sluggish job creation, monetary policy should remain accommodative, but conditional upon activity developments.

The OECD urges U.S. politicians to agree a solution to the “fiscal cliff” at the start of 2013, which risks “excessive fiscal tightening” unless Congress could agree measures to slow automatic large tax increases and spending cuts while seeking slower deficit reduction.

The OECD also urges the U.S. to formulate a credible medium-term plan for the public finances, which it said “remains to be achieved.”

Interestingly is also the fact the OECD now is in favor of EU jointly guaranteed bonds to underpin banks chime and hereby joins the new French finance minister, Pierre Moscovici, and other EU officials including José Manuel Barroso, president of the European Commission, and Mario Monti, Italian prime minister.

The question is if Germany will give in on its austerity claims when German deputy finance minister Steffen Kampeter said after his meeting with Wolfgang Schäuble: “We have always made it clear that as long as fiscal policy in Europe is not integrated, we flatly reject common financing via eurozone bonds. Eurozone bonds at the present time would provide the wrong signal of low interest rates, and remove the pressure for European economies to adjust. I think it is the wrong time for such a remedy, with the wrong consequences.”

In contrast, IMF Chief Christine Lagarde speaking in London, said; “"More needs to be done, particularly by way of “fiscal liability sharing” and we are looking for ways to do that. More needs to be in relation to supporting growth, particularly by way of structural reforms.”

The divergence of opinions could become a red-hot topic in the near future and maybe at the EU supper summit of EU leaders that takes place  in Brussels.

By the way, I wouldn’t expect too much of that summit. We all know that so-called EU growth measures are in the works whereby we can expect a boosting the paid-in capital of the European Investment Bank (EIB) and plans for what they call “project bonds” underwritten by the EU budget to finance infrastructure that might help a little but will by far fall a long way short of turning the eurozone economy around, so unless we get something more, on either the growth or the building defenses fronts, there’s scope for investor disappointment…

Unfortunately, there is undeniable evidence that continues growing of the EU’s impotence in the face of interminable crisis has brought its primary cause home to an ever wider audience: structure.

The region’s economic tragedy is a ready reckoner for the limited resemblance that the euro-area bears with an Optimum Currency Area; and whilst the latter is by no means an indispensable condition for successful monetary union, its absence, at the very least, demands appropriate fiscal transfers by way of mitigation, as we see it but in different forms, in the U.S., or UK for example.

Hence, while sovereigns retain control of their finances, then the eurozone will suffer from a kind of fallacy of composition: namely, a collective political will to effect change without the requisite support from individual states and, in my opinion at least, such a situation cannot keep the euro-area on the straight and narrow path in any downturn.

I think, for the moment least, the best hedge against the EU troubles is not being invested in the EU at all. Of course, the eurozone will, on day, become a very attractive “buy,” but we aren’t there yet.

For the time being my preference remains the U.S. and its “single currency,” the U.S. dollar, until the EU uncertainties go away for good.

As a long term investor I wouldn’t get distracted by “relief rallies.”

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2012-01-22
Tuesday, 22 May 2012 02:01 PM
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