Europe: What a Recovery Will Look Like
Higher costs of capital and the unwinding of excessive leverage burden recovery prospects as Europe emerges from recession. In Standard & Poor's view, the path to recovery will be long and narrow. Consumer demand is likely to be weak in indebted countries such as Spain, the U.K., and Ireland, while the sharp deterioration in public-sector finances across the region looks set to constrain any growth from that quarter. However, the overarching factor weighing on recovery is limited financing. A Solid Upswing, but Not for AllThe latest worldwide economic data generally confirm that activity started to pick up during the summer months and that a fairly solid upswing is currently under way in a number of key economies, notably Germany and France. The Purchasing Managers Indices (PMIs) for October show a well-synchronized lift, with all regions now having crossed the 50 line that indicates a return to positive growth. Meanwhile, initial Eurostat estimates for the third quarter of 2009 show that the recovery within the EU remains uneven, with highly indebted countries remaining mired in recession between July and September. Spain's GDP, for example, slipped 0.3% (after falling 1.1% in the second quarter). In the U.K., GDP fell 0.4% (5.2% year on year), marking the sixth consecutive quarter of contraction. So far, the U.K. economy has fallen 5.9% from its peak reached in the first quarter of 2008. This is far worse than the peak-to-trough decline from 1990 to 1991, and in line with that between mid-1979 and early 1981. In Germany, Europe's largest economy, on the other hand, GDP rose 0.7% in the third quarter, up from 0.4% in the second quarter. The French economy expanded 0.3% in the third quarter, while that of Italy rose 0.6%. Overall GDP in the euro zone rose 0.4% from the second quarter, when it fell 0.2%. Year on year, euro zone GDP was still down 4.1%, however, a reminder of the severity of the recession. Competition for Funding Is Bound to GrowAt the end of October, the European Commission published its latest economic forecasts for EU member states. In this report, the Commission begs the question: What sort of new equilibrium can be expected for EU economies in the coming two years? While acknowledging that with so many uncertainties still prevailing it's still too early to draw a definitive picture, the Commission points to several key forces likely to define the contours of that new equilibrium. In summarizing some of the Commission's main findings below, we will also add our own perspectives. First, the Commission notes that it's reasonable to expect a higher cost of capital following the financial crisis, mainly due to higher risk premia than in the pre-crisis period. What's more, says the Commission, investors are now aware of the consequences of mispricing risks. Higher financing costs are going to have important implications with respect to the sustainability of public debt in the future. In a period of low or negative economic growth, when interest rates exceed nominal growth, interest payments tend to result in a rising debt-to-GDP ratio, making public debt look less sustainable. Between 1997 and 2007, the gap between interest rates and nominal growth turned sharply negative for countries such as Greece, Spain, Ireland, and Portugal. In the case of Germany, France, and Belgium, the gap was positive, but diminishing between 2004 and 2007. In the years to come, higher interest rates combined with slower economic growth are going to make public debt sustainability harder to maintain, regardless of the actions taken by the fiscal authorities in terms of reducing their public deficits. While this is an important consideration affecting future economic prospects, we would also draw attention to another dimension affecting the financing of the current recovery. We will call this the consequences of regulatory uncertainties. Since the beginning of 2008, money supply growth has been steadily decelerating in the euro zone and in the U.K. The major counterparts of money supply—credit to households and to nonfinancial corporations—follow a similar trend, loans to companies declining in September 2009 compared with a year earlier. Meanwhile, the only money supply component showing constant growth over this period is what's called "credit to the general government," which rose 13.6% year on year in September. Such credit covers the purchase of sovereign bonds by financial institutions. Bonds are still a modest fraction of banks' and insurance companies' total assets; 4.3% in the euro zone and 4.4% in the U.K., compared with 12.5% in the U.S. But with financial institutions subscribing to more than 55% of all new sovereign issuance so far this year, we believe that proportion is likely to grow substantially. Bond purchases have been supporting the international bond markets by keeping spreads low and allowing large companies to secure some financing through this channel instead of through the banks. During the first nine months of this year, European nonfinancial companies issued €504.4 billion of new bonds, up 55% from the whole of 2008 according to Dealogic (DL.L), a data provider. In the current financial environment, financial institutions are incentivized to restructure their balance sheets by buying a much larger proportion of sovereign bonds. This provides major help to governments as they finance their growing debt, while (so far) allowing large companies to secure reasonably cheap financing. But such action leaves aside a significant part of the economy, namely small and midsize companies and households. Hence the question: Who is going to underwrite economic growth in the coming years? Financing requirements from sovereign entities are bound to rise, while credit demand from households and smaller companies should pick up as the recovery gathers pace. There is no simple answer to this conundrum. What is clear to us is that the limited financing available for the overall economy will likely weigh on the strength of the recovery. Debt, EverywhereA second dimension put forward by the Commission in its forecasts relates to deleveraging. "The current crisis has exposed sizable vulnerabilities within the EU economy, notably the excessive financial leverage of households, firms, and governments," it says. "The ensuing deleveraging process is likely to take some time and constrain the response of each sector to the recovery." The path to recovery is going to be very narrow, in our opinion. On the one hand, the reduction in private sector debt, slowly under way since early 2008, still has a long way to go, particularly in those highly leveraged countries such as Spain, the U.K., and Ireland. This leads us to anticipate weak prospects for consumer demand. On the other hand, the sharp deterioration in public debt ratios will in our view constrain the public sector's contribution to future growth. Unemployment and the Drift In Unit Labor CostsCompared with the Commission's latest economic forecasts, our own forecasts for October 2009 and 2010 appear broadly in line. But one striking observation is that labor market trends have been more resilient in 2009 than we anticipated. In other words, unemployment rates have not surged as much, or as early, as we originally forecast. The only exception is Spain, where the jobless rate averaged 17.9% in the third quarter. Several factors could explain the lagged effects of the recession on unemployment. One is the legendary inflexibility of European labor markets. The recession in Europe was more severe than in the U.S., yet U.S. unemployment rose to 13.3 million in September 2009, from 6.1 million in January 2008—a 118% increase. Unemployment in the euro zone, meanwhile, rose to 15.3 million from 11.4 million (a 34% rise) and in the EU-25 to 21.2 million from 15.4 million (a 37% increase). In the U.K., where labor markets are considered more flexible than in Continental Europe, the corresponding rise was 54%. A second possible explanation for the lower-than-anticipated unemployment count is that in several European countries, local authorities introduced measures to encourage part-time work; this is the case in Germany, for instance. But the slower rise in unemployment has another important implication: It means that European companies have been hit by a major income shock not having been able to fully reflect the decline in sales on their cost structure. Unit labor costs—which take into consideration employment levels, wage levels, and productivity—rose by 4.6% year on year in the second quarter in the euro zone, 5.8% in the U.K., and by a staggering 8.3% in Germany. In the U.S., they dropped 1.2% over the same period. Central Banks Maintain a Watchful EyeThe drift in labor costs is likely to moderate as activity (and productivity) picks up. But it will come under close scrutiny by the central banks, especially the European Central Bank (ECB). The ECB's last interest rate hike, in July 2008, coincided with key wage negotiations in Germany. In our opinion, once more evidence gathers pointing to a return of growth in the single currency zone's largest economy, the ECB may want to signal its ongoing concern that cost inflation should be kept at bay and start raising interest rates again. We believe that this is likely to occur sometime in the second quarter of next year. Rising short-term rates will automatically increase servicing of the short-term component of public debt. They will also send a signal to bond markets that the times of ultra-low interest rates are over.