Fear Itself

The relative insouciance of non-Europe financial risk prices in the face of the Eurozone's grinding catastrophe may partly be owing to the time non-Eurozone financial institutions have had to tiptoe quietly away from direct involvement. But there's another reason too: all over the world, the anticipation of Europe's financial crisis finally getting completely out of hand is stopping businesses investing and hiring, and in turn that is stopping households spending. In short, everywhere in the world, private sector savings surpluses are on the rise once again.

And this is despite the fact that bond yields remain far below 'fair value' – a pricing which in the past has been effective in discouraging excessive saving, whilst encouraging corporate investment. Fear itself is financing the retreat in financial risk pricing.

This unanticipated new surge in private sector savings surpluses was noticeable first in the US, partly because the US reports its data early, but also because the rise defied other usually reliable cyclical indicators. When we search for the reasons behind the 'soft patch', this is what we discover: during 1Q12, the PSSS jumped to 7.5% of GDP, up from 4.5% in the same period last year. The change was just big enough to inflect the 12m curve upwards.

In the Eurozone, the story is less clear-cut (and less securely accounted for by official data). However, my best estimate is that during 1Q the Eurozone's PSSS climbed to 5% of GDP, up from 4.5% in 4Q11 and 4.8% in 1Q11. This is only a fractional rise, but it occurred during a time when the Eurozone's financial system was still feeling the short-term relieving effects of the ECB's Long-Term Refinancing Operation. Throughout the first quarter the fall in European CDS rates reflected the momentary retreat of the Eurozone crisis – they fell from a peak of around 632bps in early December 2011 to a low of around 365 in late March.

But of course, the crisis is back. Currently CDS rates are around 480bps, and every survey of European consumers, businesses or investors tells the same story of dramatically collapsed confidence. So we can assume the Eurozone private sector savings surplus is also surging. And whilst we cannot yet make the calculations (because we don't know the details of what's happening on the fiscal side), the result isn't in doubt. During March and April this year, the Eurozone's current account showed a Eu10.36bn surplus, compared with a deficit of Eu3.95bn in the same period last year.  

What about Asia? The quarterly charts tell us that during 1Q, surpluses in both China and Japan were in smooth retreat: China's 12m surplus fell to 3.5% from 3.9% in 4Q11, whilst Japan's fell to 5.2% from 5.9% in 4Q11. In both cases, this fall underpinned Asian domestic demand (consumption and investment spending) whilst moderating the (still positive) inflow of cash into Asian financial institutions.

But as with the Eurozone, it seems very likely that this is now reversing. We can see this in the trade data: China's trade surplus during 1Q was a very modest US$1.15bn, compared with a very modest deficit in US$706mn in the same period last year. However, during the next two months the surplus burgeoned to US$37.12bn, up 34% yoy, even as domestic demand indicators continued to soften. In Japan, the fall of the PSSS during the past 12 months has been more dramatic than in China, but as the next chart shows, that fall has already stopped on a 12m nominal basis. The chart runs to the end of April, but May's trade data suggests the stasis is continuing. So too do the downturns in Japan's domestic demand data (starting mid-May).

We can therefore observe that a non-cyclical upturn in private sector savings surpluses emerged in the US during 1Q, spread at first moderately and more recently fiercely to the Eurozone in 2Q, and is now arriving in both China and (to a lesser extent) Japan. Since this is happening against the background of extremely low global bond yields – yields far lower than 'fair value' and thus historically likely to discourage net savings – it's reasonable to assume this change in behaviour is a response to collapsed confidence.

This change in financial behaviour has markedly different financial and economic effects. For the financial system, the private sector's private sector savings surpluses represent accelerated net inflows of cash into the system. Because, by definition, the banks cannot recycle this into private sector credit, this cashflow must go to buy either government debt or foreign assets. Such forced buying of government debt can be expected to depress yields and consequently risk pricing.

But those private sector cashflows are only generated by deferring spending on consumption and investment. The non-cyclical savings behaviour in turn becomes precisely the motive factor stripping demand from the world economy and tipping it into a cyclical downturn.

Whilst Europe's national political leaders evidently consider 'protecting the Euro' a more important goal than securing national economic survival, there's no reason the rise in Europe's private savings surpluses

should abate. But if financial institutions and financial centres in the US and Asia have in fact spent the last couple of years quietly quarantining Eurozone financial institutions, the best hope of abating the rise in private sector savings surpluses is probably for Europe's crisis to come to its head sooner rather than later.  Since, outside the Eurozone, it's fear itself which is now doing the damage.

  

How Do the FT's Editors Sleep at Night?

I wonder if it's just an extreme case of softening up public opinion in advance of the inevitable catastrophe.  Over the years, the FT has gambled a stupid amount of its intellectual credibility on supporting the doomed Euro.  In that, I think it's fair to say that the cheerleader in chief has been Wolfgang Munchau.  But what's this? In today's paper, he sounds almost clear-eyed about how it's all turning out:

"The [European] Council's priority is to triangulate domestic political interests, while managing news headlines. They are getting good at this.  But they still have no crisis resolution strategy. This is why I am sceptical about the pledge that they will do 'whatever it takes' to save the euro. That may turn out to be the ultimate phantom giant."

I'm not a particularly nice or tolerant person, but I recognize that pouring scorn on commentators/institutions with whom I disagree isn't attractive.  But there are two serious questions here:

First, it's clear that Greece, Ireland (who's banks need a further Eu27.5b from the government, apparently, and who's central bank has banned asset sales because of impossible losses they'd generate), and now Portugal are insolvent.  The odds on them defaulting are shortening every day, even though the CDS markets still have European banks' rates at around 350, actually lower than in December, remarkably. One must assume that they've all managed to offload their Greek/Irish/Portuguese (and while you're about it, Spanish & Italian) over the last few months?

Of course they haven't. Which means when the defaults start hitting the banking system, we'll find the current CDS rates on European banks look cheap in retrospect.  The point is this: the second round of the financial crisis is shaping up to happen in Europe, soon. This year, and possibly this quarter. Are you protected? If you're an investor with a natural long bias, how can you be?

Second, almost every aspect of the Eurozone crisis was predictable, and indeed widely predicted (if you were living in Asia at the time, where every economist is Austrian).  The only bit that didn't go exactly to script is that when Ireland's banks went bust, the German banks were in no position to buy them, having already unexpectedly blown themselves up in the CDS market.

Needless to say, the FT either couldn't hear the arguments, or couldn't understand them. Providing such comprehensive editorial aircover for what may yet turn out to be one of the biggest financial and economic disaster of our age deserves some acknowledgement, some contrition and, indeed, some redemptive punishment.

Put it this way: I hope Wolfgang Munchau isn't the only fool at the FT to get paid in Euros.