International Forecaster Weekly

Meanwhile in the Eurozone

You have to be wearing shades to believe such hype. Specifically of the rose-colored variety. Sadly, all of these factoids and random bits of economic good news fall apart under the slightest scrutiny.

James Corbett | April 26, 2014

Don't worry, everyone, the Eurozone “recovery” is ticking along just fine!...according to the same ratings agencies that brought you such AAA certified debt instruments as “Collateralized Debt Obligations” a decade ago and nearly crashed the world economy.

            That's right, just yesterday the illustrious Standard & Poor confirmed France's AA long-term credit rating with a stable outlook, and Fitch upgraded its rating of Italian debt to BBB+.

Keep in mind that this is the same S&P that is still being investigated by the US Department of Justice for its alleged role in defrauding the public with deliberately inflated ratings on the subprime mortgage market last decade. But I'm sure they've learnt their lesson and moved on, so maybe we should trust them this time.

            After all, what's there not to like on the Eurozone economy front these days? Greece has turned the corner and just had their 2013 surplus of 1.5 billion Euros confirmed by the European Commission! Earlier this week, Spain sold 2.65 billion Euros of ten-year government bonds at a record low yield of 3.059%! Last year's Q4 GDP growth was 0.3%! In March, the European Commission's Economic Sentiment Indicator measuring business and consumer sentiment hit its highest level since 2011! We could continue along these lines, but do we really need to? Suffice it to say, the Eurozone's future is so bright it's gotta wear shades.

            Or you have to be wearing shades to believe such hype. Specifically of the rose-colored variety. Sadly, all of these factoids and random bits of economic good news fall apart under the slightest scrutiny.

            Greece did indeed post a 1.5 billion Euro surplus last year under its IMF-imposed austerity measures, but all that does is allow them to beg for another 6.3 billion Euros in bailouts from the Euro Working Group. Even the European Commission says that Greece's debt dynamics have worsened and the country still has to rely on the EU to stay solvent.

            Spanish debt falling to record low yields? Thank Japan. A Reuters report last January revealed how Prime Minister Shinzo Abe and the Japanese were buying Spanish (and Italian) debt at the highest rate in five years, a sudden spike in interest that just so happens to exactly coincide with the fall in Spanish (and Italian) bond yields. That and Draghi's guarantee that the ECB will do “whatever it takes” to protect the Euro (which investors know means the funny money good times are set to roll whenever the hammer does actually drop on the Euro) means that investors are actually treating Spanish and Italian bonds as a safe haven asset during the current Ukraine crisis. It's hard to decide whether that fact is mind boggling or horrifying.

            GDP actually increasing by 0.3% in Q3 2013? Not that that's anything to get excited about in the first place, but coming after nearly two straight years of declining GDP, all the positive number indicates is that the economy isn't shrinking anymore. And even then, most of that growth was shouldered by (you guessed it) France and Germany, as always, and was coupled with a drop in German consumer spending in the same period.

            And on and on. For every fragrant rose of economic happiness being touted by the Eurozone booster brigade, there are a dozen thorns that make for a very different picture. We haven't even mentioned the continuing record Eurozone unemployment, the record low credit creation, the record loan delinquencies or the fact that house prices are dropping like a stone in “safe haven” Italy and Spain.

            No, the “recovery” that is being trumpeted in the mainstream headlines is not really that dramatic, and certainly not on solid ground (a point that many of these mainstream stories raise as an afterthought “below the fold”). But the “recovery” narrative has been largely internalized by market players at this point, so the sentiment is there to keep the markets functioning for now. What could possibly come along to upset this applecart?

            Back on January 1, virtually no one would have said that Ukraine would go on to become a central focus of European markets (not to mention European politics) this year. But then again, few people on January 1, 1914 would have guessed that a political assassination in Sarajevo would go on to start the bloodiest conflict in world history to that point, so you never do know where the applecart-upsetting pebble is going to be found. But now that the Ukraine crisis has taken that central position, the markets are still trying to figure out how to price this wildcard on Europe's eastern flank.

            As we've discussed in these pages in recent months, Europe is set to be one of the big losers from any serious sanctions placed on Russia as the result of this crisis, just as Europe was hurt by its own sanctions against Iran a few years ago...or would have been if the US hadn't exempted 10 European nations from the Iranian sanctions regime. In this case, it's energy-dependent European countries who are looking to put the brake on the Russian sanctions bandwagon.

            But it's not just the gas and pipeline politics that we outlined last week at play here. Belgium's Bruegel think tank has estimated that European banks have $150 million of claims in Russia compared the $40 billion of American bank claims. Meanwhile, Europe's corporate giants, from BP to BASF to Eni, are all warning that the sanctions are likely to backfire on them and their deep ties to the Russian economy. BP, for example, owns 20% of Rosneft in association with the Russian government itself. As BP CEO Bob Dudley acknowledged earlier this month, “We have a unique position” in relation to Russia, and they will continue their business activities as usual “mindful that the mutual dependence between Russia as an energy supplier and Europe as an energy consumer has been an important source of security and engagement for both parties.” Translation: make whatever sanctions you're going to impose toothless, or else.

            Having said that, markets are reacting to each day's news and trying to predict where things are headed next. Sometimes the action is rearguard: when the news began blaring its headlines about Russian troops deployed to the Ukrainian border, a stock plunge wiped out $1 billion of Rosneft's $70 billion valuation overnight. Sometimes the action is preparatory: gold continues to maintain over $1300/oz. on the flight-to-safety trade that the conflict is generating. But for the time being there is a tense equilibrium in European markets as everyone waits for the other shoe to drop.

            Which brings us back to the ratings agencies. Amid increasingly tough talk from the G7 on tightening Russian sanctions (including German Chancellor Merkel's insinuation that Russia is prolonging the tensions in the conflict), S&P has just come out to downgrade Russian sovereign debt from BBB to BBB-, just one step up from junk bond status. Yes, this is the same S&P that just gave French government debt the AA seal of approval, and no, not much has changed since the bad old days of the subprime bubble when ratings were wantonly manipulated for the benefit of the agencies and their clients. The only difference is that this time the ratings are being used as a weapon in the game of economic cat-and-mouse between the old cold war rivals.

            The markets reacted quickly to the move. Moscow's stock index fell 1.5% and the ruble lost 0.6% against the dollar on word of the downgrade. Russia, for its part, was quick to respond, with the country's economic minister, Alexei Ulyukaev, dismissing the downgrade as political maneuver that won't affect Russian economic policy. However, as the threat of further sanctions continues to loom, word is now spreading that a top adviser to Putin has suggested a radical action plan for economic security if new sanctions are applied. This includes withdrawing Russian assets from NATO countries, reducing dollar holdings, increasing use of non-dollar, non-Euro currencies in bilateral relations, and selling Russia's own bond holdings in sanctions-supporting countries. Every countermeasure would be designed to further accelerate the process of economic decoupling with the West that we talked about here two weeks ago, and all of them would end up hurting Europe in the long run.

            For the moment, that's still just talk, but as the crisis continues to deepen, that talk seems more and more likely to materialize into something substantial by the minute. There are still several lines to be crossed before the two sides are in overt economic warfare or Russian debt is downgraded to junk bond status, but once we arrive there it's by no means certain that there's any way to bring down Russia without also bringing down Europe. And as bad as the economic outlook is for the Eurozone if the Ukraine crisis should heat up, the prospect of actual military warfare on Europe's doorstep is that much worse. If this turns into a shooting war with the world's largest nuclear superpower, the Eurozone economy is going to be the least of the Europeans' worries.

            ...Now what was that about a Eurozone “recovery”?



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