Those who expected the European crisis to be over by now (probably nobody outside of the European political elite) are in for a rude awakening. Not only does the Greek government press ahead with highly destructive austerity policies – together with the Spanish and Portuguese governments – but there is also growing discomfort among financial investors with Europe’s long-term direction. A new report from Fitch Ratings (no-cost subscription required) sends a chill down your spine:
55% of investors say fundamental credit conditions for sovereigns will deteriorate [in Europe], more than double the vote in the last survey (24%), reversing the more optimistic trend since Q212. The more circumspect sentiment was evident across all sectors, notably also banks.
This is bad news for the European Central Bank which has tried to prop up European treasury bonds with an endless commitment to buy them back from whoever wants to sell them, whenever and at whatever amount. Investors simply do not believe that the ECB can or will print that amount of money.
That is understandable. Theoretically, we are talking about 400 billion euros just to honor every Spanish treasury bond.
Then Fitch reports something rather interesting:
Recession Fears Spread Gloom: An all-time-high of 86% of respondents rate prolonged recession as a high risk to the European credit markets, up from 69% last quarter. Eurozone sovereign debt problems are ranked as the second-highest risk. … Only 9% of survey participants expect inflation to be a problem in the next 12 months. Deflation is seen as more likely, based on the 29% who voted this as high risk.
A continued recession combined with deflation is about the worst that Europe could face right now. Deflation is a highway to business depression, primarily so for the so called Keynes effect:
- A business owner borrows $48,000 today and expects to pay the bank $1,000 per month for the next four years;
- At a constant sales volume he earns $8,000 per month, pays $6,000 for his production costs and $1,000 to the bank, leaving $1,000 in profits;
- He expects prices to rise with inflation, or two percent per year, which with reference to the bank loan will reduce its cost by a small annual margin.
With a two-percent inflation rate his sales revenue – at constant volume – will rise to $8,160 per month in the second year. Given that his production costs go up by the same percentage he is left with a profit margin of $1,040, a four-percent uptick in one year.
Assume instead a two-percent deflation rate per year. With the same numbers and production-volume assumption his sales revenue decline to $7,840 in the second year. If his production costs fall accordingly he is left with $960 in profits.
In the first case inflation eases the cost of the bank loan; in the second case deflation makes it more costly. If this was a small business with no profit margins – the situation for a large number of small businesses in recession-ravaged Europe – the obvious decision would be not to invest in any expansion of production at all. But even larger businesses suffer from deflation and will be less inclined to expand during a period of price declines.
Before we return to Fitch, I also want to point out that the deflation fears come amid the large money-printing endeavor in the history of the European Central Bank. This is therefore yet more evidence that the transmission mechanisms that build a bridge from the monetary sector into the real sector are pretty much dormant at this point. There is in other words very little demand for liquidity because there is far too little activity in the real sector of the economy.
Back to Fitch and the backlash from the Cyprus Bank Heist:
A strong majority of 80% interpret the Cyprus bank resolution as a precedent which removes implicit sovereign support from bank senior debt.
How do the European political leaders expect their banks to attract savings in the future, when people know that the government can flip their savings into bank assets at the slightest glimpse of a new recession?
Overall there are signs that Europe’s investors have become more short-sighted in their strategic planning, which is an endemic feature of deep, long recessions. Fitch makes this point, though more techically:
Insatiable High-Yield Hunger: 27% voted high yield (HY) their most favoured investment choice, down from 29% last quarter, but still clearly ahead of runners-up emerging-market (EM) corporates (16%) and banks (15%). … In Fitch‟s view, there is a stark dichotomy between the continuing recession with rising unemployment across Europe and the rally in financial markets. If the latter is not validated by economic stabilisation and progress towards banking union, the danger is that market volatility will return with a vengeance over the summer, as it did in 2012 and 2011.
The combination of high-yield hunger and a financial rally in the midst of a deep recession is reminiscent of historic episodes of financial instability. The notion seems to be to make as much money in as little time as possible because the future is so dim that no one can even see it. But this combination also reinforces an important impression from the Fitch survey, namely that investor confidence in Europe’s economic future is getting weaker, not stronger.
In all likelihood, they are all well aware of the most recent macroeconomic data. We will therefore review those numbers here in a day or two. In other words, stay tuned for more bad news on Europe…