Through its recently published World Economic Outlook (WEO) and statements by Christine Lagarde and other top officials, the IMF has taken the position that Europe is presently on a course that will lead to economic disaster. According to the IMF, unless Europe undertakes a drastic reversal of policy - from austerity to stimulus - a 1930s style economic depression will be the result.
The IMF View
The recent World Economic Outlook published by the IMF projects that, unless Europe radically reverses its current austerity policies and applies massive doses of monetary and fiscal stimulus, the eurozone will suffer an economic contraction of more than -4.0%, with even greater contractions in the PIIGS.
First, based on the admittedly optimistic assumption that appropriate policies will be enacted by EU nations, the IMF projects that across the board (including France and the U.K.), the rate of economic activity in the EU will be much lower than previously forecast and that fiscal targets will be violated by a wide margin. For example, the IMF estimates a GDP contraction of -1.7% for Spain and a fiscal deficit of -6.7%. My own best case forecast is for at least a -2.0% contraction and a fiscal deficit of -8.0%. Either way, what is clear is that even in a best case scenario, Spain's recently agreed to fiscal target of 4.7% of GDP will be violated by a wide margin.
Second, the IMF has clearly warned that austerity policies are not working and that a drastic change of policy will be required. The IMF has essentially endorsed the view that in order to avert collapse, Europe must do a complete about-face in terms of policy and embrace full-fledged fiscal and monetary stimulus on a massive scale.
How This Affects My Thesis
My main fundamental thesis regarding Europe consists of three parts.
The substance and timing of the IMF's WEO report has surprised me. It is far more realistic than I would have expected and far bolder in its policy recommendations. This could change the political dynamic going forward. I was expecting that confrontation over austerity policy would probably heat up in March as it became clear that the PIIGS would not be able to meet their fiscal targets. The IMF report has made this fact clear well in advance of that date and has made a rather bold bid to transform the terms of the upcoming debate.
Thus several things have changed. First, the debate/confrontation with Germany over austerity policy will begin sooner than expected. In fact, it has already begun and the first salvo has been fired by Italy and Spain. Second, the IMF will be joining the PIIGS and others in "ganging up" on Germany. As a result, Germany has become utterly isolated in its insistence on austerity. Third, putting the first two factors together, there is a fair amount of time between now and March (the deadline for fiscal union legislation) for the world to convince Germany and the ECB of a change of course.
Will Germany change course under pressure? That is not a simple question and it will be the topic of my next article.
Conclusion
I have been predicting for several months that under conditions of austerity, economic growth in the PIIGS would be considerably lower than forecast (in fact, I have been predicting a major contraction of GDP) and that this would cause the PIIGS to violate fiscal covenants by a very wide margin. I have also said that this situation would provoke a political clash pitting the PIIGS and other nations against Germany and her allies.
These two aspects of my prediction have played out flawlessly. At this point, there can be little doubt that I have been correct on this.
The only remaining question is what will be the German response to this challenge. The ball, as they say, is now in Germany's court.
It has been my view that the Germans would be resistant to change course and that this would provoke an economic and financial crisis. In my next article I will focus my analysis on what the German response is likely to be.
If you believe that the Germans will reverse course quickly and underwrite a massive and comprehensive bailout scheme as proposed by the PIIGS themselves and now seconded by the IMF, then you should go out and buy equities such as Apple (AAPL), Microsoft, Citigroup (C) and Chevron (CVX) as well as ETFs such as (SPY), (DIA) and (QQQ), hand over fist.
If you believe that the Germans and other EU members will recoil at the prospect of a drastic policy about-face, then the downward economic spiral in the PIIGS will continue, diplomatic acrimony will rise, the prospect of major defaults will become more imminent and global financial markets will get hammered. Under such circumstances investors should either be heavily in cash and bonds or outright short.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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