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Global Outlook – “Whatever it Takes”

By Martin Fowler
Posted: 4th October 2012 09:29
In late July, the European Central Bank (ECB) president, Mario Draghi, said that the ECB would do “whatever it takes to preserve the Euro (zone)”.  These comments were widely unexpected and were intended to allay fears of a possible breakup of the Euro Zone (EZ).  Despite the lack of detail, rhetoric won the day and markets rallied on the expectation that a more comprehensive solution to the EZ woes might be found.  At the highly anticipated ECB meeting on September 6, further measures were announced, the most important being a new bond buying program named “Outright Monetary Transactions” (OMT), which replaces the Security Markets Program (SMP).  While bond buying programs are nothing new, the key difference was that purchases were this time potentially unlimited (unlike the SMP which was limited and finite in nature, the European Financial Stabilisation Mechanism (EFSM) which is capped at  €60 billion, and the  European Financial Stability Facility (EFSF), capped at €780 billion.), although subject to strict conditionality to prevent abuse (As an example, in 2011 the ECB bought Italian bonds to drive down bond yields only for the then Prime Minister, Berlusconi to drop reform promises days later).  Tellingly, the German Central Bank, the Bundesbank, was the only ECB member to vote against the proposal.
What does all this really mean?  By way of background, countries sell bonds to investors to help finance budget deficits.  In exchange, investors receive a certain rate of interest in return.  If a country’s finances deteriorate, the price of the bonds issued will usually fall in value as investors concerns about the issuers ability to meet its obligations are reflected in increased selling on the secondary market.  As the price falls the yield or interest return required by new investors to hold the same bond rises.  It is at this point where new bonds issued or rolled over must be offered at similar yields to those trading on the secondary market, otherwise they won’t attract any buyers.  Higher yields mean higher interest repayments, putting more stress on the sovereign borrower. 
Any action to reduce sovereign bond yields of course is a positive development as it reduces the risk of a country defaulting on its debt repayment obligations.  However, it is also true that the OMT initiative is not a “game changer”.  The OMT addresses only a symptom of the underlying problem (higher bond yields) rather than the root cause of too much debt and little or no growth.  Further, it adds risky assets (poor quality sovereign bonds) to the ECB’s balance sheet.  This is not to say that the OMT is a waste of time and money but it is definitely no “magic bullet” either.  What the OMT has done is buy policymakers more time but the gravity of the underlying problem remains as daunting as ever. 
It is impossible for the PIIGs to meaningfully reduce sovereign debt without restoring growth.  With growth forecast to contract by over 7% this year, Greece remains locked in a severe depression.  The potent combination of too much debt, high unemployment and austerity measures remains unsustainable and will make it incredibly difficult for Greece to meet the conditions required by the Troika for further funding.  A default and /or severe social unrest leading to an eventual exit from the EU remains the most likely option.   
Meanwhile conditions in Spain remain only marginally better.  While Spain has to date only requested assistance for its banks, the Government itself is likely to request a bailout in the next 12 months as the effects of the severe recession only add to its deficit and debt woes.  Italy may be faring a little better but the likelihood of its Government requesting a bailout in the next few years is also rising.
In summary, the risk of another sovereign default has not eased.  Although the ECB has made a bold claim that it is prepared to do “whatever it takes” to save the EZ, what Europe really needs is a clear and credible long term plan to restore market confidence.  The path to not only formulating such a plan but actually gaining agreement remains as difficult as ever.  The German central bank’s opposition to the OMT is proof enough of that.  Without German support, a more integrated fiscal, monetary and political union appears remote. 
Across the Atlantic, the resilience of the US economy has showed signs of renewed weakness.  This is perhaps not surprising given the slowdown in demand from its key trading partners, Europe and China.  Moreover, domestic demand is unlikely to take up the slack as consumers deal with falling real wages, high household debts continue to limit credit growth, and government spending faces cuts to reduce the spiraling public debt.  Nevertheless, the business sector remains in good shape and unemployment, while still relatively high, has been slowly trending in the right direction. 
As a result, we were mildly surprised that the Federal Reserve chose to embark on another round of Quantitative Easing (QE) in September.  (As a reminder, QE is when the central bank effectively prints money to buy assets, usually bonds or mortgage securities, off banks.  Technically, it does not add to a government’s net debt position as the additional debt created by printing money is offset by the asset purchases).  The reason we were surprised is that the main aim of QE is to 1) provide the banking system with more money to lend, and 2) lower interest rates to encourage business and consumers to borrow more. 
Yet the reality is that consumers are still recovering from high household debt levels and much lower asset values (house prices) that have both deterred and limited their ability to borrow.  Further, businesses, while in much better shape, will only borrow more if they are confident about their future prospects.  Given the elevated global uncertainty, credit growth is likely to remain below trend.  In other words, we do not believe QE3 will prove successful.
Despite stimulus measures enacted in the EZ and the US in September, we believe the outlook for global growth remains particularly challenging.  The EZ faces the prospect of a protracted recession, China continues to slow and growth in the US is likely to be tepid at best. 
Martin Fowler is a director of Moore Stephens Sydney Wealth Management where he provides financial advice to high net wealth individuals and conducts research into the social impact of economic policy. He is also a director of Whitefield Limited, an investment company listed on the Australian Stock Exchange.
Martin can be contacted via email at 
Mjfowler@Moorestephens.Com.Au or alternatively by phoning +61 2 8236 7700.

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