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‘Worse before Better' Scenario Holds for 2013-14

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Tuesday, 03 Jul 2012 04:04 PM Current | Bio | Archive

It is certainly not encouraging to see the JPMorgan Global Manufacturing PMI, which is a composite index produced by JPMorgan and Markit in association with ISM (Institute for Supply Management) and IFPSM (International Federation of Purchasing and Supply Management) falling to a three-year low of 48.9 in June (a reading below the 50.0 mark means contraction.

Somewhat better and certainly not in contraction mode is the “final” Markit U.S. Manufacturing Purchasing Managers’ Index (PMI), which showed expanding business conditions (though the weakest in 18 months), coming in at 52.5, down from 54.0 in May.

It’s a fact the U.S. continues to see a better manufacturing-sector performance than almost all other economies around the world, thanks mainly to resilient demand from the U.S. domestic market. Nevertheless, with manufacturers hiring at the slowest rate since late 2010, I wouldn’t be surprised to see another disappointing nonfarm payrolls number on Friday, which could push June’s unemployment rate up from 8.2% in May. Further signs of weakness will be closely watched as that could prompt some kind of QEIII from the Fed later this summer, but we aren’t there yet, that’s for sure.

In the meantime, Japan, South Korea and Taiwan all fell back into contraction, while rates of decline are gathering pace in China and Brazil.

The eurozone remained the main source of global manufacturing weakness. The eurozone saw its production contracting by around 1%, which is the fastest rate in almost three years and is expected to accelerate further, while worrisome declines are recorded in Germany as well as France, but also in Italy, Spain and Greece. Long-term investors should take notice that companies in the eurozone are clearly preparing for worse to come and are cutting back on staff numbers as well as stock of raw materials at the fastest rates in two-and-a-half years. No, that doesn’t bode well for the eurozone and beyond.

All that said, job creation held up, so far at least, better in the U.S., with payroll numbers continuing to increase, albeit the least marked in three months. Job losses increased further in the eurozone, China, the U.K., Russia, Brazil and South Africa. The eurozone recorded its highest unemployment rate —11.1% — since the creation of the euro. The European Union (EU) as a whole saw its unemployment rate increase to 10.3%. The European Union youth unemployment came in at 22.7%, with Spain and Greece both at 52.1%, Portugal at 36.4%, Italy at 36.2%, Ireland at 28.5%, France at 22.7%, the U.K. at 21.7% and Germany at 7.9%. With good reason, talking publicly about “a lost generation in the making” in Europe is no more taboo.

The main question remains if the U.S. will be able to remain “more or less” immune to the eurozone contagion process that is still well alive notwithstanding the delusional burst of investors’ after last Friday EU summit that ended once again with no real broad-range and long-term solutions whatsoever and that only confirmed continuous disrespect for existing EU rules.

By the way, after Cyprus last week became the fifth eurozone member state to ask to be bailed out, it now becomes clearer by the day that Slovenia will be the next eurozone “small” economy that will have to ask for an EU bailout, which would be focused, of course, on its banking sector. You can bet that Slovenia won’t be the last one asking for a bailout.

Investors should certainly take notice that the Ernst & Young Eurozone Financial Services Forecast (EEFS) released on Monday (July 2) drew attention to the delayed impact of the current eurozone turmoil on financial services and the role they will play in the economy during 2013, when nonperforming loans will hit harder than many are expecting. The EEFS predicts that the eurozone’s banks will shrink their balance sheets by 1.6 trillion euros (about US$2 trillion) in 2012 as a result of disposals of noncore assets and a contraction in lending activity, which represents an even sharper shrinking of eurozone banks’ balance sheets than during the 2008-09 financial crisis. It is also expected while lending in Germany will grow slowly, reduced or restricted lending across other eurozone economies means that one should not expect corporate-sector loans for the region to bounce back until 2015.

All that said, I don’t think it is an overstatement to say that there is a really serious risk that the eurozone is going down a well-trodden but treacherous path that has been at the source of financial instability everywhere and certainly far beyond the eurozone itself. The eurozone is far from “monolithic” in its real undertakings, as it has 17 “sovereignties,” of which only four have more or less a similar order of magnitude in economic size and systemic financial risk. Besides, the eurozone has to live with a non-federal, weak capital in Brussels that is led by a bureaucracy that lacks any form of sound democratic legitimacy.

By way of comparison it shouldn’t be overlooked that all major successful monetary unions have always been run by a single center of power rather than “face-offs” among comparably sized and systemic economies. In modern times we have never seen any functional and successful monetary union with multiple competing centers of sovereignty. Yet, even dominant federal governments have often had difficulties imposing regional fiscal controls, as subfederal units commonly externalize and socialize local deficits across the federation.

Take, for example, Spain, which today is on the forefront of the eurozone member states in serious trouble. In practice, the country is a “loose fiscal federation” in which the central government in Madrid has not been able to contain patronage and financing at the level of autonomous regions and their local piggy banks, which are the “Cajas” as they call them in Spain. Even the “Federal Republic of Germany” itself has been unable to control the “munificence” of the Länder or Bundesländer (the 16 federal “state” subdivisions), which use of their own piggy banks (their “Landesbanken”) to fund pet projects or favored firms.

No, the eurozone and the European Union bureaucracy have not been able to fully enforce the rules of fiscal and financial probity down to the national or regional levels of their member states. Whether they will ever ever be able to accomplish their enforcement objectives remains the open question nobody can seriously answer today. As long as there is no clarity on the final outcome of that crucial subject, long-term investors shouldn’t take it into account. At least, that’s my opinion.

As a long-term investor I would still prefer to remain cautious. “Short-covering rallies” can take place in the markets, but my view hasn’t changed. I still expect a far “worse before better” scenario in 2013-14. Of course I could be wrong…

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2012-04-03
Tuesday, 03 Jul 2012 04:04 PM
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