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27 October 2011

Global Strategy
Alternative view
www.sgresearch.com

Global Strategy Weekly


Bust, bust and bust
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

The increasingly frenzied attempts of eurozone governments to persuade financial markets that they can draw a line under this crisis will ultimately fail even if this weeks measures bring some short-term relief. I have minimal confidence that governments can turn this around within the confines of the eurozone project. You might be surprised though that I feel more bullish! Why? Both Dylan and I have come to the view that the ECB will be forced, by events, to monetise debt in the GIIPS and beyond. And if investors believe the governments in Spain and Italy are bust, then Germany, France, and not forgetting the UK and US, are far, far worse.
Q After almost 30 years analysing the macro situation, few things now surprise me. But one thing that really did surprise me in the euro crisis (so far) is that Italy got sucked into the maelstrom. Itms not often I am more bullish than the consensus, but in my original vision of an inevitable break-up of the eurozone, I went out of my way to exclude Italy from being drawn into the eye of the storm q see GSW, 12 Feb 2010.

Global asset allocation


% Equities Bonds Cash
Index Index neutral SG Weight

30-80 20-50 0-30

60 35 5

35 50 15

For unlike the other GIIPS (as we now call them), Italy never suffered from inappropriately low interest rates during the 2003-07 period. The lone size fits allm eurozone interest rates were clearly lwrongm for Greece, Ireland, Portugal and Spain (GIPS), and the resultant private sector credit/housing booms ended in a bust. The depressionary forces unleashed were the primary cause for the explosion of public sector deficits in the GIPS. In that sense their story is similar to the US and UK, with one key difference: the GIPSm fate was largely out of their own hands. By contrast, the US and UK monetary authorities were just totally incompetent.

Source: SG Cross Asset Research

Q Italy never lenjoyedm a boom to suffer any bust. And on many measures, including reputable attempts to take account of off-balance sheet liabilities, Italian public sector debt fares well on cross-country comparisons (see chart below). These off-balance-sheet liabilities will now increasingly become visible to all. Who then will be really bust?

If Italy is insolvent, what are France and Germany? And whos going to bail them out? (Total net government liabilities off and on balance sheet, both as % actual GDP)

500%

Total net govt liabilties


(includes off balance items) 418%

549%

Official govt net liabilties


442% 364% 434%

541%

Global Strategy Team


Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

250%

244%

0% Germany
Source: OECD, Gokhale (2009)

Spain
Rates

France

Italy
Equity

UK
Credit

EU

US
Derivatives

Macro

Commodities

Forex

Please see important disclaimer and disclosures at the end of the document
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Global Strategy Weekly

Wemll come back to Italy and the eurozone a bit later, but first we note that stronger than expected data out of the US and China has helped to perk up risk sentiment recently. The markets are being beguiled by the current data into concluding there will be no recessionary problem because of the recent run of stronger data. It reminds me of when I was the US economist at Kleinwort Benson in 1989 and we believed the economy was slipping into recession. But then in H1 1990 the data strengthened markedly and everyone relaxed q incorrectly as it turned out as the economy indeed slipped into recession in July 1990. Regular readers will know we like to use leading indicators. These have been weakening for some months in the US and elsewhere. We have not highlighted the Economic Cycle Research Institutems (ECRI) weekly leading indicator for some time, although it is as weak now as it was last year (see left hand chart below). But, unlike last year, this time around the ECRI have put out a rare recession call q link.
ECRI weekly and Conference Board monthly leading indicators The US unemployment rate has only been this high at the start of a recession in 1937
25.0 %

30 20 10

Conference Board (r/h scale)

8 6

20.0

4 2 0 0 -10 -2 -20 -30 -4


5.0 10.0 15.0

ECRI

-6
0.0 1919 1924 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Source: Datastream, SG Cross Asset Research, ECRI

Lakshman Achuthan, the ECRIms COO notes that they made the recession call only after an array of economic indicators showed a pronounced, pervasive and persistent downturn consistent with a recession. By contrast, in the summer of 2010, when some market bears interpreted the decline in one of the institutes indexes as a signal that a recession was in the offing, the institute said the pattern pointed not to recession, but only to weakness. (Does he mean me? Surely not!) The last time we entered a recession with unemployment this high was back in 1937 (see right-hand chart above). This is indeed a crisis.
US analyst optimism (% upgrades) and change in optimism (3m mav, change on 6 mth seasonally adjusted) US change in analyst optimism (pp ch 6m) leads OECD lead indicator

Source: Datastream

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Analyst optimism on profits has also slipped sharply recently (see left-hand chart above, optimism defined as EPS upgrades as % of all estimate changes). We find the change in optimism (dotted lines in both charts above) is a good leading indicator for the official leading indicators (see right-hand chart above). This signals continued weakness ahead. Our US economist, Aneta Markowska, wrote an interesting report looking at her own leading indicators of recession. One thing she noted was that her predictor using real economy variables was showing a minimal 10% probability of recession ahead. Yet her recession predictor using financial conditions suggests the probability of recession within the next 12 months to be just below 70% (see American Themes, 21 Oct 2011). Yikes! Meanwhile the Conference Board measure of consumer confidence is slumping anew (see lefthand chart below). It is especially shocking that in this cyclical recovery, the Present Situation subcomponent never even rose near to the nadir of the previous recession! The slump in expectations is exactly like the early 1990s, a previous period of de-leveraging, that drove bond yields to new lows (see right-hand chart below). This is the same q just much worse.
US consumer confidence: heading back to rock bottom
200 200

Consumer expectations slumped three times in the early 1990s


110

consumer confidence

10.00

180

180

9.50 100

present situation
160 160 140 140

9.00

8.50 90

120

120

8.00

100

100

80

7.50

80

80

2
70

60

expectations

60

10y yield (rhscale)

7.00

6.50

40

40

60
20 20

3
6.00 5.50

private sector de-leveraging


50 1989 1990 1991 1992 1993 1994

0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

5.00

Source: Datastream

Let us return to the eurozone. With Italian 10 year bond yields once again pressing towards 6% in recent weeks, they are definitely still in the eye of the storm. The trigger for this was back in early July, when Italian Prime Minster Berlusconi turned on his well-regarded Economy Minister. Reuters reported on 8 July that nSpeculation is growing that Italy's Economy Minister Giulio Tremonti credited with shielding the country from the eurozone debt crisis will soon be forced out of government, which would further raise the heat on Italian bonds Tremonti overcame cabinet resistance to push through a tough austerity programme last week, but now looks increasingly isolated and appears to no longer have the full support of Prime Minister Silvio Berlusconi. "He thinks he's a genius and everyone else is stupid," Berlusconi said in an interview with Repubblica daily on Friday."He is the only minister who is not a team player," Until this untimely outburst, Italian bonds yields had consistently traded below Spanish yields by about 75bp (see chart below). Now they trade at a clear 50bp premium, with yields once again pushing up close to 6%. Belgium, without a government to speak of (an advantage?), but also suffering from a very high government debt/GDP ratio, has by contrast managed to keep below the marketms crisis radar. Italy has been ill-served by its politicians for dragging the country to its knees unnecessarily. It could/should have escaped this debacle.

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Bond yields: Why was Italy sucked into the crisis? It could have avoided the markets attention
4.50

Berlusconi opens his mouth and puts his foot in it

4.50

4.00

Italy

4.00

3.50

3.50

3.00

3.00

2.50

Spain

2.50

2.00

2.00

1.50

Belgium France

1.50

1.00

1.00

0.50

UK
MAY JUN JUL AUG SEP OCT

0.50

Source: Datastream

Italyms debt problems are well known, but they have been well known for years.
Italian households are not highly leveraged...
100 90 80 70 60 50 40 30 20 10 2003 2010

Labour productivity barely growing at 1%yoy after a long slump


5.0 3.0 1.0 -1.0 -3.0 -5.0 Labour productivity: Output per hour worked

Household debt as % of GDP

Belgium

France

Austria

Greece

Finland

Ireland

Spain

Italy

NL

Euro area

Portugal

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Q4 2008

Q2 2009

Q4 2009

Q2 2010

Sources: ECB, Eurostat, SG Cross Asset Research

Sources: ECB, Eurostat, SG Cross Asset Research

As mentioned previously, the economic situation that Italy found itself in after the bubble burst was very different to that of the GIPS (Greece, Ireland, Portugal and Spain) who had, to a greater or lesser extent and through no fault of their own, suffered from inappropriately low interest rates that resulted in a private sector credit boom and bust. By contrast, household sector debt in Italy was low both before and after the crisis (see top left-hand chart above). Scanning the OECD databank, letms be boring and talk some numbers. It is clear that in the run-up to 2008 crisis, domestic demand growth in most of the GIPS was running around 5% yoy versus only 1% in Italy. Reflecting this, the GIPS were running gargantuan 10% current account deficits (as a % of GDP), whereas Italy was running a moderate external deficit of 2% of GDP. Italy was a very different animal to the GIPS. Italyms general government debt may have been notably large (in excess of 100% of GDP), but it had been in excess of 100% for many years and was, until very recently, not dissimilar to Belgium. Italyms budget deficit was notably under control, with a public sector deficit going into the crisis of only 1.5% in 2007 and a primary surplus of 3% (deficit excluding interest payments). Because of the nature of the GIPS private sector credit bubbles, when the music stopped in 2008, the public sector deficits in all the GIPS rocketed above 10% of GDP q just as they did in the US and UK. By contrast Italyms public sector deficit rose more moderately because there was no busting domestic credit bubble to fight. Italyms cyclically adjusted general government deficit hence rose only 0.5% between 2007 and 2009 against 6.4% in

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Q4 2010

Global Strategy Weekly

Greece, 8.2% in Ireland, 5.2% in Portugal and 9.5% in Spain. Indeed letms make the comparison even more stark q Italyms cyclically adjusted deficit rose 0.5% while even Germanyms rose 1.0%, Francems rose 2.6%, and the Netherlands deficit rose 4.6%! Where does this leave us? I had a very long chat with our Italian economist, Vladimir Pillonca. He says one single variable encapsulates the depth of Italyms economic problems: GDP per capita is lower today than it was a decade ago none of the worst performances among advanced economies in the IMFs words. The real issue is Italyms incredibly low productivity growth (see top right-hand chart above). Hence, having been in excess of 2% yoy in the late 1990s, Italyms trend GDP growth rate is now barely positive on Vladimirms estimates (see left-hand chart below) and investment in people is poor (see right-hand chart below). The near-zero trend rate of growth means that Italy simply cannot grow its way out of its debt and will remain highly vulnerable to market shocks. Vladimirms latest thoughts are contained in a recent Focus on Italy document - link.
Italys potential growth rate is very low
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Potential growth rate 1999-08 (average) 2012 forecast

Italys low tertiary educational achievement stands out


50 45 40 35 30 25 20 15 10 5 0

Sources: OECD, SG Cross Asset Research

Sources: OECD, SG Cross Asset Research

But as we showed on the front cover chart, letms not kid ourselves. As populations age and unfunded liabilities increasingly appear on the balance sheet, all governments are effectively bust. Reinhart and Rogoff in their book This Time is Different: A Panoramic View of Eight Centuries of Financial Crises q (link) show that there is no magic public sector debt threshold that determines when a crisis hits. It happens when the markets decides it is time to happen. But Dylan and I feel more optimistic about the medium term. The current eurozone talks will not solve this crisis and it will get worse q much worse. But we would agree with the well known eurozone commentator, Paul de Grauwe of the Leuven University, who wrote Everyone needs the ECB to step up to the plate. The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the eurozone.o The ECB will have to choose between its two most cherished ideals: the euro or its hard money principles. Notwithstanding some legal issues to get around and Germany being outvoted, we think the impending threat of a euro break-up will force the ECB to begin printing money, very reluctantly joining in the global QE party. Letms be clear q neither Dylan nor I view ECB monetisation as a lsolutionm. Indeed its actions will mirror those of Rudolf Von Havenstein, president of the Reichsbank in the early 1920s. He kept printing because he was scared of the mass unemployment that would ensue if he stopped - link. The question for me is not if the ECB will print, but rather will Germany leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?

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