There is a sense of déjà-vu about the uneasy start to Q2 for risky assets. It happened in 2010 and 2011. Having enjoyed robust gains in Q1, equity markets are taking a more sober approach about the economic outlook. Buoyancy in equity markets during Q1 was underpinned by perceptions that US labour demand had finally showed meaningful and self-feeding signs of improvement, and that funding stresses within the eurozone banking system had been significantly lowered by the European Central Bank’s aggressive use of Long-Term Refinancing Operations (LTRO’s). Such optimism now appears to be on shakier foundations.
Weaker-than-expected US labour demand in March, coupled with signs of rising hawkishness by the Fed, have punctured the complacency in equity markets. These “reality checks” were quickly followed by an apparent lack of credibility embedded in Spain’s latest round of austerity measures. The concerns of Spain’s foreign creditors have not been eased, given the front-end loaded nature of fiscal tightening.
The Fed Raises the Hurdle for Quantitative Easing
The US economy finished 2011 and started 2012 with respectable momentum. The key issue for financial markets was whether the Fed truly believed the economic data: seasonal adjustment factors on many US economic indicators have been distorted by the collapse of Lehman Brothers. Seasonally adjusted data for Q4 and Q1 are subject to upward distortions, while Q2 and Q3 data will be subject to downward bias.
How will the Fed interpret Q4 and Q1 data? The disappointing growth of non-payrolls in March (+120K) may have spooked some investors into believing that US labour demand is faltering. I suspect that some of the impressive gains in January and February payrolls were a reflection of warm weather. The underlying gains in payrolls were probably more around +170K per month for the first two months vis-à-vis the headline +258K monthly average. On this basis, the outcome for March payrolls is less-disappointing. The Fed will not be swayed by one data point.
The recent release of the minutes to the 13 March Federal Open Market Committee meeting showed that Fed staff raised their forecasts for both real GDP growth and inflation. This was a somewhat surprising development. Fed Chairman Bernanke has consistently advocated a dovish stance to policy conduct, particularly given his recent comments about the continued soft state of the US labour market. Higher inflation and growth forecasts make justifying further quantitative easing difficult, despite persistently high levels of unemployment.
The implications for US monetary policy are interesting if the Fed is accepting the view that structural unemployment has risen. The policy stance of the Fed will have zero impact on the level of structural unemployment in the economy. Under this paradigm, keeping near-zero interest rates until late-2014 could become increasingly difficult to justify.
Spain’s Austerity Measures Fail to Inspire
The ability of Spain to implement fiscal austerity without damaging economic growth prospects was always going to be the toughest policy challenge in the eurozone in 2012. Despite the announcement of huge fiscal tightening in 2012 by the newly-elected government in the region of 3.5% of GDP, the confidence of foreign creditors has yet to recover. Yields on Spanish sovereign bonds have been rising since the beginning of March.
Even allowing for the massive magnitude of fiscal tightening planned for 2012, Spain will struggle to meet these targets. The aim is to reduce the general budget deficit from -8.5% of GDP in 2011 to -5.3% in 2012. The problem in deficit reduction is not with central government in Madrid, but with the 17 autonomous regions of the country that have not been engaging in fiscal discipline. Central government is threatening to wrest budgetary control from these autonomous regions as early as May.
The credibility of fiscal austerity and consolidation is partly determined by the prospects of economic growth. If austerity measures crimp growth too much, then the prospects of targets being achieved are undermined via a reduction in the tax base and higher transfer payments. Official government forecasts show that real GDP will contract -1.7% in 2012. This is the problem facing Spain: it is caught in a growth trap, driven by the need to engage in austerity.
Banking Problems in Spain
If the problems attached to excessive sovereign debt and a dearth of economic growth were not large enough for Spain, then persistent solvency concerns about the banking system could become very well-founded if economic activity were to further flounder. Degrading asset quality could force a potential new round of capital raising, although the Bank of Spain is trying to assure markets that the nation’s largest banks are in good shape. Credit default swap spreads for Spanish banks have, however, taken a different view and have risen sharply since mid-March.
Spain Will Determine Future Stress in the Eurozone
At the end of March, European Union finance ministers announced the inception of a 500bn euro “firewall” under the auspices of the EFSF/ESM. This figure was at the low end of market expectations. A combination of sovereign and banking woes in Spain could easily absorb the majority of the firewall’s resources. This scenario would leave inadequate lending capacity to members of the euro zone.
The importance of the outcome to Spain’s current battle to achieve both austerity and economic growth should not be underestimated. The aggressive use of LTRO’s by the ECB will be rendered ineffective if Spain cannot achieve austerity and growth. Markets would quickly ask the same questions of other periphery countries in the eurozone, making the outlook for the entire region exceptionally bleak.
Fiscal Adjustment in Spain Appears Flawed
The bulk of the fiscal adjustment process in Spain is front-end loaded in an apparent attempt to placate financial markets. This strategy is fundamentally flawed, since the private sector does not, at present, have the wherewithal to fill the void left by the public sector.
A credible commitment to budget cuts over a longer time frame would seem a more sensible approach, coupled with appropriate tax incentives to encourage growth. Labour markets will, however, need to undergo major reform. Finally, some government support for funding banks should not be ruled out.
The ECB can assist Spain via bond purchases or direct capital injections in banks through the ESM. There is little doubt, though, that the flawed structure of Spain’s austerity programme has put the country in a position where other members of the euro zone need to offer a helping hand. Perhaps it will require another full-blown euro crisis to usher in such offers of help?
