The improving 4Q growth outlook should be evident in solid results in the coming week's initial round of key data for November, with the sharp recent improvement in jobless claims, strong regional manufacturing surveys outside of New York, and industry and anecdotal reports pointing to good results from the employment, ISM and motor vehicle and chain store sales results in the coming week. And the recent improvement in the labor market outlook and the impact this has had on consumer income growth have boosted expectations that the +3% 2H10 GDP growth pace can be sustained into 2011, assuming the dysfunctional Congress passes an extension of the Bush tax cuts and avoids a massive fiscal tightening on January 1 when it returns from Thanksgiving break on Monday. A key point from the FOMC minutes, however, that investors have had some trouble accepting, is that even with the FOMC's higher 2011 GDP growth forecast of +3.3% and then an acceleration to +4% in 2012 and 2013, the Fed expects the unemployment rate to end next year near 9% and does not expect to achieve its dual mandate - defined as a 5-6% long-term unemployment rate forecast and 1.7-2.0% PCE inflation - for five to six years. Indeed, core PCE inflation slowed to a record low +0.9% in October, and we expect the unemployment rate to hold steady at 9.6% in November even with another decent payroll gain on top of last month's upside surprise. An extension of QE beyond June remains significantly more likely than an early curtailment, in our view, even if the recently improved tone to the economic data continues, and we expect that the ongoing ramping up of the Fed's buying of Treasuries will before too long move nominal 10-year yields back down towards 2.25% and the 10-year TIPS yield towards zero (see Strategy and Economics: QE2 Will Pull Yields Lower Again, Richard Berner and James Caron, November 24, 2010).
Investors were clearly unconvinced of this, however, as when focus briefly shifted to the domestic economy's improvement on Wednesday, the Treasury market got pounded. This was offset for the week, however, by rallies Monday, Tuesday and Friday in response to the deteriorating international backdrop, with both a continuation of the recent pressure on peripheral EMU government bond market as main worries shifted from Ireland to Portugal to late in the week Spain and the rising tensions in Korea that added to pressure on Asian markets from concerns about inflation and policy tightening in China. For the week, the spread of 10-year government bond yields over Germany rose by about 100bp to near 640bp for Ireland, 120bp to 425bp for Portugal, and 40bp to 243bp for Spain. Widening in these countries' sovereign CDS spreads for the week were similar - 100bp to 605bp for Ireland, 90bp to 510bp for Portugal and 70bp to 330bp for Spain, the latter two hitting a series of record highs through the week. Greek CDS didn't move much this week, since the market was already priced for the likelihood that Greece will default with its CDS spread at 955bp. With the Irish fiscal crisis really a banking sector insolvency crisis, market talk continues to mount that losses on bank debt may eventually be a part of the solution, with the Irish Times reporting Friday that the EU and IMF were moving towards including losses on senior bank debt as well as junior as part of the detailed bailout plan that is expected to be announced over the weekend. According to the article, "At present attention centres on two similar schemes. In the first, bank debt would be converted into equity shares. In the second, bond investors would be given the choice of injecting fresh capital into banks or face a cut in their investment." This news put additional pressure on senior Irish bank bonds and also had significant knock-on impacts on Spanish and Portuguese bank debt, which weighed broadly on European credit markets with smaller knock-on impacts on US credit markets and weakness in near-term eurodollar futures, as forward Libor/OIS spreads widened significantly on concerns about rising liquidity demands from European banks.
The net of the boost the Treasury market received from flight-to-safety from European and Korean problems and the weakness in response to the domestic economic news was a small decline in benchmark yields for the week of 1-5bp, with the long end outperforming. The old 2-year yield fell 1bp to 0.50%, 3-year 1bp to 0.77%, old 5-year 1bp to 1.50%, old 7-year 1bp to 2.19%, 10-year 1bp to 2.86% and 30-year 5bp to 4.20%. Even with the dollar index surging 2.4% as the euro plunged from an overnight high Monday in a brief initially positive reaction to the Irish bailout of $1.378 to $1.323 at week-end, commodity prices posted decent gains, which helped TIPS do a bit better than nominals. The 5-year TIPS yield fell 2bp to -0.20%, 10-year 3bp to 0.69% and 30-year 6bp to 1.62%. Lower-coupon mortgages had another rough week to extend a terrible performance this month, but they at least managed to stabilize in Friday's short trading session, with Fannie 4% issues rallying in line with Treasuries and outperforming a significant widening in swap spreads that was driven by the European-focused pressures on eurodollar futures. For the week, current coupon MBS yields rose about 5bp to near 3.8%, a high since June after about a 50bp rise since the FOMC meeting. Average 30-year mortgage rates hit a record low 4.17% a few weeks ago, but the major originators are now quoting rates in a 4.5-4.75% range.
The economic calendar is busy in the week ahead with the key round of early data for November - ISM and motor vehicle sales Wednesday, chain store sales covering the initial surge in Black Friday weekend buying on Thursday, and employment Friday - that should show positive results. This could again provide some offset to the flight-to-safety flows from international turmoil. Other data releases due out include consumer confidence Tuesday, revised productivity and construction spending Wednesday, and factory orders Friday:
* We look for the Conference Board's consumer confidence index to rise 5 points to 55.0. The University of Michigan sentiment survey posted a good rise in November, with the report noting a significant rise in the number of respondents saying they had heard positive news about the job market. And the Conference Board gauge places greater emphasis on labor market conditions, which finally appear to be showing some improvement. So, we look for a decent gain in the Conference Board measure relative to the 50.2 reading seen in October.
* We expect 3Q productivity growth to be revised up to +2.6% and unit labor costs down to -0.2%. The measure of output relevant for this report was revised up a bit more than the half-point upward adjustment to GDP growth, pointing to a significant upward revision to the originally reported 1.9% rise in productivity. An upward revision to compensation growth in 3Q should mostly offset the impact of stronger productivity on unit labor costs, however, leading only to a small downward revision to the initially reported 0.1% dip. There was also a sizeable upward revision to wage and salary income growth in 2Q in the GDP report that should substantially boost ULC relative to the currently reported +1.3%.
* We look for the manufacturing ISM to hold at 56.9 in November. Strong results from the Philly, Richmond and Kansas City Fed manufacturing surveys (with the Empire State an outlier) and the Morgan Stanley Business Conditions Index point to another robust ISM result. We are anticipating modest corrections in orders and production after big gains last month but offsetting increases in employment and inventories, which we expect to leave the overall composite index unchanged.
* We forecast a slight 0.2% decline in October construction spending, with a further decline in the private sector being partially offset by another jump in the public category.
* Preliminary indications are that November motor vehicle sales held near the 12.2 million unit pace recorded in October. Of course, this represented the best result since the cash-for-clunkers spike seen last summer and suggests that the underlying pace of activity is still on the upswing.
* We forecast a 140,000 gain in November non-farm payrolls and a steady 9.6% unemployment rate. The pullback in jobless claims has become increasingly evident in recent weeks, pointing to some underlying improvement in labor demand. Meanwhile, federal government tax withholding data continue to show signs of employment gains. In November, we expect to see another sharp jump in temp help jobs, along with a solid rise in the retail trade category, reflecting company reports of a stepped-up pace of hiring for the holiday season relative to recent years. Also, weather conditions were generally favorable during early November according to official government data, and this may provide some support for the construction sector. Meanwhile, census workers are no longer a significant factor, but we expect to see some renewed job cuts at the state and local government level. From a broader perspective, the recent pick-up in labor demand reflects a transition from a productivity-led recovery to one that is sustained by job creation and associated income growth. Such a hand-off is fairly typical at this stage of the economic recovery, although the degree of improvement in job growth certainly remains subpar in comparison with past recoveries.
* We forecast a 1.2% decline in October factory orders. The 3.3% plunge in durable goods orders that was driven by a 4.5% decline in core capital goods bookings should be partially offset by a good gain in non-durable goods with support from higher commodity prices.
Bottom line: The headline size of the programme, at €85 billion, is as expected, but the €17.5 billion contribution from the Irish National Pension Fund Reserve and the government's own cash resources are a surprise and reduce the amount of external support. The split between providing funding for the government and recapitalising the banking system is also close to earlier press reports, with a split of €35 billion for stabilizing the banks and €50 billion for funding the Republic of Ireland. At around 5.8% based on today's market conditions, the interest rate on the EFSF portion is within the 5-6.25% range we had estimated (see Life on the Edge of the EFSF, November 8, 2010), but considerably lower for the IMF/EFSM loans, where we would expect an interest rate of around 3.5%. The maturity of the loans granted to Ireland, however, is likely to be much longer than initially expected. Similar to Reuters/Bloomberg reports that the Greek loans are to be extended to ten years or more, the Irish package can be rolled for up to 10 years.
The European Commission endorsed the four-year plan presented by the Irish government last week and will allow the government an extra year to bring the budget deficit back below 3% of GDP. Contrary to market concerns about senior debt holders in Irish banks facing a haircut, triggered by a report in the Irish Times on Friday, the package announced this evening foresees no such debt restructuring. Senior bank debt is being left untouched, at least for now. However, a separate announcement on the future Crisis Resolution Mechanism (CRM) by European governments and the recently enacted German Bank Restructuring Act point to potential risks for private sector investors in future bailout operations.
Bailout package agreed between the ‘troika' and the Taisoeach. Funding for the €85 billion bailout programme will come from the EFSM, the EFSF (a total €40 billion), the IMF (€22.5 billion) and bilateral loans from the UK, Sweden and Denmark (totaling €5 billion). An additional €17.5 billion will be provided by the Irish National Pension Fund Reserve and the government's cash buffer. The EFSF loans have a maturity of up to nine years and carry an average interest rate of around 5.8%, according to the Irish government. A final decision on the interest charged will be made early next week. The EFSM likely will provide a larger-than-usual chunk of the funding because it is backed by the whole European Union and because it is carrying a lower interest rate than the EFSF loans and possibly even lower than the IMF loans as well. This compares to a current market rate of nearly 9% for 10-year Irish government debt. The bilateral loans could vary in terms of the interest rate and the maturity. Hence, in addition to the decision-making process at the European level (where the disbursement of the loan is now only a government decision and except for Finland does not need a parliamentary vote), we probably need to keep an eye on how the UK contribution - the largest of the bilateral loans by far - comes along.
As usual, there is strict conditionality attached to the financial bailout package. The full details of these conditions and the timeline for their implementation will likely become available over the next few weeks, when the loan agreement will be published. The Eurogroup will decide on the adoption of the conditions attached to the loans at its next meeting on December 6, and the Ecofin Council will debate it the day after. For now, we need to work with the key points detailed in the statements published by the Irish government, the European Commission and the IMF (see Appendix in the full report for details).
In the case of Ireland, the conditions focus on three main elements: bank restructuring, fiscal austerity and some structural reforms (notably in the labour market). While the fiscal austerity programme seems to be the more prominent in the public debate at the moment, we deem the bank restructuring to be the more relevant element. This is because the banking system is at the heart of the Irish sovereign debt crisis. The fiscal position is a consequence, not the root cause, of the crisis.
The four-year austerity plan, presented by the Irish government last week and endorsed today by the European Commission, foresees €15 billion of budget cuts by 2014, €6 billion (equivalent to about 4% of GDP) of which will be implemented as early as next year. The four-year plan brings the total budget cuts in Ireland to €30 billion since the beginning of the crisis. Two-thirds of the budget cuts will be spending cuts, notably in the area of welfare spending and capital expenditure. In addition, a number of tax hikes will be phased in over the next four years, including a VAT increase, the introduction of a property tax and water charges, a hike in carbon taxes, and higher income taxes and lower tax credits. The corporate tax rate of 12.5%, which has long been a cornerstone of Ireland's industrial policy, remains unchanged, despite widespread criticism from other European countries.
The full details will only become known when the 2011 budget is presented in the Dail on December 7. We believe that the widespread concerns over the negative impact of the fiscal austerity package on the economy are overdone. First, we would stress that it is not the size of the budget cuts that affect GDP growth but the change in these budget cuts. Given that Ireland has already put through more than €4 billion of budget cuts in 2010, the impact on 2011 GDP growth should be relatively muted. On the back of the additional cuts, we lowered our real GDP forecast from 1.7% to around 1.0% for 2011. Hence, we do not expect the Irish economy to double-dip. Second, for such a small, open economy as Ireland, where exports of goods and services account for 93% of GDP, it matters much more how the global economy is doing and how the exchange rate is evolving. Incoming data suggest that global manufacturing is reaccelerating into year-end, and it seems less and less likely that the euro will strengthen further in the light of the recent escalation in the euro area sovereign debt crisis.
In our view, the growth assumption in the government's four-year plan of an average 2.75% a year between now and 2014 is somewhat optimistic, though not wildly so. After 2011, when the additional austerity measures are tailing off noticeably, GDP growth could rebound robustly. Hence, we would expect that it will either take a little bit longer or further budget cuts to achieve the goal of the Irish stability programme. To be clear, we would not be overly worried by any small budget slippage in Ireland. This is because, in contrast to Greece, the fiscal situation is not the root cause of the problem. It is only a consequence. In terms of the total debt dynamics (including the debt incurred via the promissory notes for one of the banks), we estimate debt to GDP to peak out at around 125% of GDP, assuming a further €20 billion of capital injections into the banking sector are made. In this context, we would also stress that the EFSF loans do not add to the debt burden in Ireland, only the additional bank recapitalisations that might have become necessary to add to the debt load. The EFSF loans replace expensive market funding with cheaper intergovernmental loans and therefore help to contain the increase.
The vote on the 2011 budget and the four-year plan could prove extremely close. Now that the government coalition has lost the by-election in Donegal South-West to Sinn Fein - an indication of a protest vote by the local electorate in what used to be Fianna Fael stronghold - it is ever more reliant on the support of independent TDs, notably Michael Lowry and Jackie Healy-Rae. Currently, the Dail has 162 members, and the government has 82 votes if both independent TDs also support the motion. The main opposition party, Fine Gael, will outline its own budget strategy next week. In our view, the EU-IMF ‘troika' will likely accept future changes to the details of the austerity package as long as any future Irish government firmly commits to the overall budget goals. Note that officials from the European Commission have been in talks with the opposition for some time to ensure a minimum degree of bi-partisan support.
In addition to the budget cuts, the government aims to cut the minimum wage by €1 (or 12%) to €7.65 per hour. Lowering one of the highest minimum wages in the EU will be another important step to regain competitiveness within the euro area and strengthen incentives for companies to employ workers - notably young labour market entrants and workers with a low level of skills. While the lower minimum wage might only affect new hires - employer associations indicated that they might not cut wages for existing staff - we are already observing an impressive improvement in competiveness in Ireland.
Real depreciation of about 8% against the rest of the euro area measured by relative core inflation clearly sets Ireland apart from other peripheral countries. If one country is well equipped to adapt within the euro area, it is Ireland. This is because of its flexibility to adjust due to a greater degree of liberalisation and deregulation (see Ireland: Mastering the Challenges Ahead, September 13, 2010).
Anecdotal evidence of withdrawal of bank deposits from the Irish banking system and official ECB data on deposit dynamics and the use of the refi facilities suggest that funding stress has increased recently. In our view, a stronger capitalisation of the banks would help to stem these concerns about bank funding. The bailout programme has set aside €10 billion for an immediate recapitalisation of the Irish banks and another €25 billion for a contingency fund. The aim is to bring the core Tier 1 capital ratio up to at least 12%. To assess the capital needs, the authorities will conduct another stress test in Ireland as soon as possible.
Contrary to a recent Irish press report, senior debt holders in Irish banks will not face haircuts or maturity extensions, according to Commissioner Rehn. Ultimately, the concerns about the potential contagion that could have been caused in the wider European banking system and about the ramifications of not honoring the guarantee given to senior debtors by the Irish government seem to have prevailed. While this decision is good news from a systemic point of view, the debate about senior debt could resurface when the banking bill needs to be pushed through the Dail.
In our view, the banking bill will be debated as actively as the four-year budget plan and the vote on the bill could be as close as that for the fiscal austerity package. Even beyond the parliamentary passage of the banking bill, which, according to unconfirmed reports in the Irish Independent, could be scheduled as soon as late January, the debate on senior debt might be reopened after the general election in early 2011. This is because several opposition politicians have demanded that senior debtors participate in the bailout. According to a poll this weekend, conducted by the Irish Independent, 57% of the public would be in favour of a restructuring of the bank debt. In our view, the restructuring of senior debt in the Irish banking system could well flare up again as a concern for financial markets. But, on balance, we believe that at this stage senior debtors will not have to contribute to the bailout package. The same is not true for equity owners and subordinate debt holders, however. As we have argued on several occasions, the key feature of the bailout mechanism is the provision of bank capital via the EFSF (see The Lure of Liquidity, June 17, 2010). In our view, capital injections into the banking system in Ireland and elsewhere are essential to restore calm to the financial markets in Ireland and the wider euro area. Note though that these capital injections are a necessary but not a sufficient condition to reassure markets.
An important factor in the market reaction to today's announcement will be the actions and communications from the ECB. The continued insistence by several ECB Council members until recently that the exit from the bank's unconventional measures needs to proceed in 1Q11 has likely contributed to market concerns about bank funding. Against the backdrop of recent market turbulence, we believe it is unlikely that the ECB will announce further steps towards the exit at the upcoming ECB Council meeting on December 2. Instead, we expect the Council at the very minimum to leave the existing full allotment, fixed-rate tenders in place in early 2011. As in May, the ECB might, however, decide to launch fresh measures to support bank funding. It could, for instance, bring back some of the longer-dated LTROs, it could reopen the Covered Purchasing Programme or step up or widen the Securities Market Programme. All of these are possible steps that the Council could consider before contemplating all-out QE via unsterilised asset purchases. And all these measures would lend support to euro area financial stability. But, ultimately, none would provide any additional capital to the banking system. Here the ECB faces a dilemma. Its unlimited liquidity provision might have contributed to relatively slow progress on the recapitalisation front, as governments appeared to believe that it was back to business as usual in the banking system.
What hurdles still lie ahead for the Irish bailout package? We don't foresee any major setbacks to approving the Irish bailout on the donor side, but financial markets might be unsettled in the run-up to some of these risk events. Note that the EFSF activation and approval of the loan agreement is an executive decision of the euro area governments (with the exception of Finland, where a parliamentary vote is still required). In addition, we would watch the approval process in the UK, Sweden and Denmark closely.
We expect the debate about bailouts and possible private sector involvement to continue. In Germany, Chancellor Merkel's junior coalition partner, the Free Democrats, who have already been highly critical of the Greek bailout package, are gearing up to demand that private investors contribute to any future bailouts. This is in line with proposals for the next crisis resolution mechanism (see The Next Crisis Resolution Mechanism, November 3, 2010) and also what is stipulated in the German banking restructuring law passed on Friday by the upper house of parliament, the Bundesrat (see http://dip.bundestag.de/btd/17/034/1703407.pdf for details). The Free Democrats are also adamant, at the moment, that they will not support an extension or an increase of the EFSF.
In addition, a group of political activists in Germany are gearing up again to file another plea for an emergency injunction with the German Constitutional Court to prevent any funds being disbursed. As highlighted before, we expect the Court to reject the emergency injunction very quickly. But the Court might still decide to hear one or more of the cases that have been filed against the Greek bailout and the EFSF in due course.
What Are the Implications for Portugal?
On balance, we see a risk that access to funding might dry up to such an extent that Portugal too might not be able to avoid going to the EFSF eventually - if markets continue to behave in ‘systemic mode' and associate Portugal's current difficulties with, say, those of Ireland or Greece. What's more, while there are no immediate funding pressures and the most meaningful funding-related outflows of next year are only in the spring, the Lusitanian economy will have to make non-negligible redemption and coupon payments in January, February and March too.
The main risk is the psychology of contagion. With considerable reliance on foreign bond investors, next year's funding might turn out to be quite difficult, especially in the light of the above-mentioned funding-related outflows in 1Q. In particular, with three-quarters of the debt held by non-residents, a ‘buyer's strike' looks a more concrete possibility in Portugal and Ireland than, say, Spain or any other large EMU country. In a sense, the major risk is the psychology of contagion, i.e., that investors keep testing the next weak link once a more distressed country is removed from the market through some kind of bailout.
Naturally, while there is an element of ‘self-fulfilling prophecy' in these market dynamics, this is not to say that Portugal's economic problems don't matter. Rather, the Lusitanian economy has some deep-rooted structural deficiencies, as weak productivity has precipitated Portugal into slow growth and poor competitiveness. In other words, the Portuguese fiscal imbalances are the result of these structural deficiencies, rather than an inherent lack of fiscal discipline and problems with the tax-collection system, as in Greece before its efforts to comply with the demands of the belt-tightening programme as part of the financial support package granted back in May. Nor can the deterioration of Portugal's public finances be compared with Spain's boom-bust economic developments or Ireland's high private sector leverage and oversized banking system.
The upshot is that the rebalancing in Portugal has an inherently structural nature and is unlikely to correct very easily or quickly. For example, the current account deficit is still in double-digit territory, and, along with the accumulation of external debt, this is a cause for concern.
Why Is Portugal's Current Account Deficit Not Shrinking?
In our view, the rebalancing is not happening - at least not to a great extent - because Portugal did not experience a credit-fuelled housing boom-turned-bust, as in Ireland or Spain. The various structural problems, ranging from low productivity and weak growth prospects to poor competitiveness, can only be addressed over several years.
The various measures put in place to address these deficiencies (e.g., bringing R&D spending into line with the European average, raising the overall education attainments of the population, liberalising product markets, etc.), while appreciable, will only bring tangible results over a longer timeframe.
Yet some form of credit-fuelled overconsumption seems to have taken place in Portugal too. This is not to say that consumer spending has been particularly strong over the past decade or so. Rather, it is an observation that household consumption in Portugal expanded as rapidly as the euro area average, despite much weaker per capita income growth. In other words, before the economic fallout of the financial crisis, the Lusitanian economy exhibited excessively strong consumer spending relative to its fundamentals.
Of course, if the economy double-dips - as we expect - there might well be some rebalancing next year. The government forecasts a fractional expansion of 0.2% in 2011. We are more bearish and expect a double-dip of 1.3%.
The only source of growth will be exports, in our view, which are performing better than expected. Indeed, there are some encouraging signs on this front. While starting from a fairly low base, dispatches to Germany - especially of components and parts - are growing very rapidly and faster than the pace of expansion of German exports overall.
More broadly, the Portuguese export share of the Spanish market (by far Portugal's largest trading partner, accounting for about one-quarter of total exports) has not decreased so far, despite the weakness of the Spanish economy. And for some time now, the data have shown a decreasing share of low-tech exports and an increasing share of medium to high-tech exports, and more recently a technology balance finally in positive territory. The goal is to raise the export share of GDP to 40% from 32% over a decade.
Latest Fiscal Policy Developments
In Portugal, the minority government has now approved the 2011 budget. The tough fiscal package amounts to savings of about 3% of GDP, with approximately two-thirds of the total in spending cuts.
The goal is to bring the budget deficit down from an expected 7.3% of GDP this year to 4.6% in 2011. These targets seem broadly achievable, but only if all the measures are implemented swiftly and fully. The main risks relate to execution, especially as we expect GDP growth to re-enter negative territory next year.
So, for Portugal - where the problems stem from a low productivity and poor competitiveness trap - tapping the EFSF by itself would not be enough. In our view, the key is the government's ability to implement, over time, sufficient growth and productivity-enhancing structural reforms.
While social cohesion is quite tight in Portugal, and the number of workdays lost due to strikes compares favourably with other EMU countries - including some at the core of the euro area - investors will scrutinise any fiscal slippage, political tensions and social frictions (such as strikes and other forms of protest) to a great degree, in our view.
The Risks Ahead
As we have highlighted over the past several weeks, the risks for many money managers involved in the small peripheral countries are rather asymmetric, in our view. This factor is perhaps as important as the economic fundamentals in explaining recent market developments. Essentially, Portugal and Ireland offer little diversification benefits in portfolios, against asymmetric risks and considerable uncertainty. Larger peripherals - such as Spain - benefit from their relatively greater size and a wider domestic investor base.
While this does not make the larger peripherals immune to contagion, it might help to make them more resilient - up to a point. We suspect that many downside risks have to materialise before investors no longer feel inclined to own, say, Spain in one proportion or another in their portfolios. One cannot rule out this possibility, altogether, however.
Yet, should such a scenario eventually materialise, the tracking error relative to the benchmark in portfolios might well be substantial relative to simply underweighting - perhaps even to a great extent. While this is certainly not enough to keep investors engaged, it might make market dynamics less adverse for larger peripherals than for smaller ones.
How about Spain?
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