There Are Also Reindeer

"Fantastic grow the evening gowns;
Agents of the Fisc pursue
Absconding tax-defaulters through
The sewers of provincial towns."

Raise a cheer for St Louis Fed President James Bullard who sat down with Reuters earlier this week and told them: 'I'm one that thinks that Greece could exit, and it could be handled in an appropriate way without causing too much damage, either in Europe or in the US.'

I've previously tracked how foreign banks in New York and London, including European banks, have restructured their offshore balance sheets to an extremely conservative stance. To those outside the Eurozone's political cluster it seems obvious that recovery from Southern Europe's Depression won't begin before they are set free from the hobbles of a wrongly-pegged faux gold standard. It also seems certain that the 'bad equilibria' between public and private sectors of the economy in Southern Europe are intensifying dramatically right now (see this story, for example), and that if post-Euro these countries get a chance to migrate to a 'good equilibrium' then their recoveries could be surprisingly dramatic.

Mostly, Bullard's comments remind us this is no longer just a financial or economic crisis (though it is that, right enough), but fundamentally a crisis of European politicians' unwillingness to confront  their own failure. Instead, like damned souls, they shuffle endlessly into windowless rooms (18 times in the last two years) in the hope, presumably, that the world will be different in the morning.

But perhaps we need not join them. As the Euro's denoument draws nearer, a curious thing is happening: CDS markets are beginning very gently to consider whether Bullard might be right. The correlations between movements in CDS rates in Europe and elsewhere cannot but be high, but the 30-day correlations have peaked for both Asia and Europe, and are now falling. For the US, in particular, the correlation is now below the average since August 2011 (which I measure as the start of the true end-game for the Euro).

For the crisis of the Eurozone is not the only thing happening in the world. Or, as Auden ended the poem:

“Altogether elsewhere, vast
Herds of reindeer move across
Miles and miles of golden moss,
Silently and very fast."

Eurozone Recession Spreads to the Core of the Core

Yesterday's collection of Eurozone PMIs were truly dreadful. The real shocker was the reading of 47.4 from the Composite PMI, which was below 1SD from consensus, and was the result of  manufacturing PMI collapsing to a 34 month low, and services to worst for five months.  It suggests Eurozone’s recession is intensifying during 2Q12.  GDP fell annualized 1.3% in 4Q11, and central forecast for the Eurozone’s 1Q12 based on the Composite PMI  (which does a better job than either the manufacturing or services PMI) is a contraction of 0.9% annualized (with a 1SD range of minus 2.4% to +0.6%). And unless April’s trend reverses dramatically, 2Q12 looks like contracting 2.6% (range, minus 4.1% to minus 1.1%).  The consensus can live with annualized  1QGDP falling 0.9%, but the 2Q forecast is three times worse than consensus.

The Composite PMI isn’t unerringly accurate as a GDP forecaster: it has signalled quarterly contractions three times in the last couple of years, twice wrongly. In 3Q09 PMI signalled contraction of 0.9%, but GDP grew 1.9%; 3Q11 PMI signalled a contraction of 0.4%, vs an outcome of +0.5%; and in 4Q11 it signalled a contraction of 2.1%, considerably worse than the 1.3% contraction recorded.

Recession in the Eurozone periphery is no surprise. The worst of today’s news came from the core of the core. Germany’s manufacturing PMI slumped to 46.3 – its worst reading for 33 months. New export orders were particularly badly hit, as orders from S Europe dried.   France’s services PMI also collapsed to 46.4, its worst reading since October 2011 and only the second monthly contraction since then.  If German manufacturing and French services can’t grow, the Eurozone won’t grow.

Continued and intensifying recession makes every detail of the Eurozone’s fiscal pact more tenuous economically, politically and financially. 25 EU members agreed to cut fiscal deficits to 4.6% of GDP this year and 3% next year: bond markets and currency markets will find those targets much harder to believe today than yesterday.  

Spain Still Has a Fighting Chance

In January this year I was invited to a CapitalWeek conference in Beijing to talk on the likely trajectory of Europe's financial crisis. Recall, if you can, those carefree days of January when Portugal could get 10yr money for sub-7%, Ireland for 8% and change, and even Greece's bonds sometimes dipped below 11%. Well, Europe was a bit off my geographic focus, but it seemed important, so I hashed out a simple methodology, under which I calculated a hurdle rate for nominal GDP growth, which, if a country hit it, it could stabilize its sovereign debt, but beneath which, the already-heavy debt burdens could only grow. That hurdle rate was essentially debt/GDP multiplied by market rates for 10yr sovereign debt.

Working out the likely trajectory then became a matter of judging whether it was plausible that a country could hit its nominal GDP hurdle rate any time in the foreseeable future.  Here's how it looked (then) for Portugal:

Back in January, you had to believe that Portugal could sustain nominal GDP growth of 6.2% to work down its sovereign debt burden.  Since the introduction of the Euro, Portugal has only very rarely managed that hurdle rate of nominal GDP growth, and it was inconceivable to me that it was going to do so any time soon. So the conclusion was obvious - sooner or later, the sovereign debt burden would break Portugal.  As it subsequently has. And as this reality sank in, so bond yields rose and pushed up the hurdle rate - at today's yields, it stands at 8.5%. Anyone think Portugal's going to grow at 8.5% nominal?

On this methodology, there were other victims: Greece (obviously),  Ireland (less obviously), and . . . Italy (I'm afraid).

But Spain - the current focus of market attention -  was a close call. It had a hurdle rate of only 3.7% - well within its recent historic experience, and, with a 20%+ unemployment ratio, damned easy if you closed the gap with potential output. And the curious thing is,  even though Spain is under the market cosh, the hurdle rate has risen only to 3.9%, whilst its 1Q GDP rose by a nominal 2.6%. More, since its capital stock is contracting by around 2.8% a year, Spain's ROA must be climbing structurally - which suggests short/medium term cyclical support. Here's how it looks now:

My conclusion is this: even if/when the People's Party is going to spend the next weeks finding stacks of IOU's down the back of the municipal sofa, Spain's sovereign debt has still got a fighting chance.