Guest post by Hubert Marleau, Chief Investment Officer, Palos Management Inc.
The Euro-crisis is shaking the confidence of households, businesses and investors. This is the main reason why North American stock prices are at least 20% lower than they should be. Currently, the S&P 500 index trades on a forward P/E multiple of less than 11.5 times. Assuming that the U.S. economy is poised to grow over the long term around 5% per year (2.0% for price inflation, 2.0% for productivity growth and 1.0% for increase in employment) the PEG ratio (the P/E divided by growth) is historically low at 2.3x. It is approximately 25% less than the long term historical average. It should be noted that the latter metric, while very reliable under normal circumstances, works for as long as corporate profit margins hold up and the pace of corporate profits closely matches that of GDP in nominal terms (NGDP). It usually does.
In the fullness of time and putting aside the insolvency issue, yields on ten-year government bonds more-or-less equate to 75% of NGDP growth, yields on triple-B corporate bond around 100% and yearly changes in stock prices near 125%. In this connection, one could conclude that government bonds are very expensive, corporate bonds are fairly priced, stocks are relatively cheap and gold is speculatively expensive.
Of course, there are good reasons for market participants to fret and act in a highly volatile manner. For many there is no sunlit future for the chronic condition of the Euro for it has only brought us miseries and frustrations. Yet, we are of the opinion that it can be resolved and that a solution is at hand to hold all or most of the monetary union together. Here is what we know:
Firstly, the bond market and the rating agencies are perhaps correct when they speculate that the core of the Euro-zone is not what it used to be. The sovereign debt crisis has taken down Greece, Portugal, Ireland and maybe Italy and Spain. Even France is in question! France has not had a budgetary surplus since the 1970’s. In order to restore French public debt to 60% of NGDP by 2030, a lot more fiscal work will be needed. The IMF has calculated that a fiscal tightening of 6.3% of GDP by 2020 is required. Moreover, the French banks are overly exposed to the debt of the Southern periphery.
In this connection, the pool of safety for market investors is rapidly shrinking. In 2007, seven of the Euro-zone’s major bond issuers were triple-A credits accounting for 75% of the Euro-currency bloc GDP. Today the bond market believes that unless something big comes up, only Germany, Finland and the Netherlands are safe havens accounting for only 35% of Euro bloc GDP.
The situation is creating and posing a serious threat to the Franco-German alliance that has been at the heart of the European project. The latter is making Germany the lead director putting Angela Merkel in the driver’s seat and German technocrats as the architect of the eventual fiscal concord under their terms and conditions.
Secondly, Germany will never leave the Euro-zone because when it’s all said and done the Euro subsidizes German exports, gives German producers huge comparative advantages, institutionalises efficiencies, eases transfer of wealth, avoids protectionism and eliminates would-be competitors. Let’s look at the facts. The Germans are going to give away what is below just because they remember the hyperinflation of the Weimar Republic of 100 years ago? NO WAY.
It’s a human condition to think short term.
- Germany accounts for about 1% of the world’s population and nearly 10% of its total exports;
- Germany exports almost 50% of its GDP to the rest of the world of which a big chunk goes to Euro-zone members;
- Germany has a current account surplus of about $200 billion or 5% of its NGDP. Coincidentally, the PIIGS have a current account deficit of $200 billion;
- Germany has a federal budget deficit for 2011 that is set to be under $34.5 billion or 1% of NGDP;
- Germany benefits indirectly from the official buying of peripheral bonds for private sellers are redeploying their receipts into Bunds.
Thirdly, it is very troubling that economic activity is deteriorating quickly and if internal devaluation is permitted, the economy could end up in a free-fall adding to the current political and social chaos.
On December 3rd, the EU will meet again and this time, if rumors are correct, the policymakers are going to be a lot more in tune with what must be done to stop the contagion. History shows that in times of turmoil someone usually steps up to the plate. Surely, the Germans find financial incoherence, economic decline and social chaos unacceptable. Given that Angela Merkel has been able to consistently convince the German parliament to vote overwhelmingly in her favour on all European financial, monetary and economic matters, she could surprise the world and come up with the alternative vision that would create shared objectives and energize common action and communicate the value of the Euro project.
If the Germans can get a binding commitment from all members of the Eurozone that they are all good and ready to do what is necessary to reduce deficit spending and public debt, they may allow the European Central Bank to become a lender of last resort. Yes, this would lead to the monetizing of debt but it may not be inflationary for growth for the whole of 2012 is forecast at about 0.5% with a very slow return in 2013.
Deflationary fiscal policies arising from austerity measures combined with expansionary monetary policies should neutralize each other, at least in theory. Moreover, the ECB could provide liquidity at a penalty rate or refuse to buy if the countries in question do not abide by the new rules. The ECB could declare an interest rate cap for countries that are on their way to financial sanity. As Michael Lewis said in his new book “Boomerang” the Germans are clean on the outside but dirty on the inside.