Are the Eurozone's problems over?
So the problems are over and Europe is on the road to recovery. Right? Well, maybe not. European sovereign debt is so large that they have to grow to keep their debt stable or impose even harsher austerity measures
Things looked bad. Yields of Spanish and Italian bonds were soaring. They were at levels that were over time unsustainable. Greece, Portugal and Ireland had all received bailouts. It looked like the Eurozone itself was close to extinction. Then in stepped Mario Draghi, the president of the European Central Bank (ECB). In July of 2012 he told the media “the ECB is ready to do whatever it takes to preserve the euro”. Then he added, “believe me, it will be enough.” Things began to look up.
After a few negative quarters, by the middle of 2013 the Eurozone economy began to grow slowly. As mild growth kicked in, the cost of borrowing, especially for the hard hit peripheral economies, began to drop rapidly. Both Ireland and Portugal have exited their European Union (EU)/ International Monetary Fund (IMF) bailout packages. Greece insists that its economy is strong enough to make a third bailout unnecessary.
Ireland’s recovery is rather amazing. In 2011, it was forced to pay as much as 11 percentage points more than the UK to borrow money. Now its borrowing costs have fallen below the UK for the first time in six years.
As interest rates fell, rating agencies took notice. Spain’s credit rating was raised from BBB to BBB+. The outlook for seven of the Eurozone countries including Portugal, Ireland, Germany and Italy moved from negative to stable. Even Cyprus has recovered sufficiently to have its outlook raised to positive.
Manufacturing Purchasing Managers Index (PMI) is an economic indicator of the economic health of the manufacturing sector. PMI of more than 50 represents expansion of the manufacturing sector. The PMIs for the Eurozone countries have been rising steadily through April. The composite Eurozone Manufacturing PMI hit 53.4 in April but backed off to 52.5 in May.
So the problems are over and Europe is on the road to recovery. Right? Well, maybe not. There are some major problems that have not been solved. The largest is France. France is stagnating. Finland, Netherlands, Italy and Portugal’s GDPs have all turned negative. Inflation barely registers.
Normally a slight contraction in GDP would not be a problem. But in Europe it is a big one. The problem is that European sovereign debt is so large that they have to grow to keep their debt stable or impose even harsher austerity measures. Italian debt grew from 127% of GDP in 2012 to 132% in 2013, despite the fact that their deficit was only 3% and their primary fiscal surplus before interest was 4.7%.  The same problem exists for the other peripheral countries. Ireland’s sovereign debt is 124% of GDP: Portugal at 129%, Spain’s is 94% and Greece at 175%.
In light of the slow or no growth and the rising debt levels, their bonds look decidedly frothy. Portuguese bonds carry a junk rating. Still their 10 year bonds offer a yield less than triple A rated Australian bonds. Greece owes huge amounts to the EU and the IMF, but can borrow for five years at 4.95%. Ireland’s 10 years notes demand only 2.89%, only 36 basis points higher than US Treasuries. Meanwhile triple A rated New Zealand has to pay 4.2%. Valuations of equities are also bubbly. They reached an all time high just last week.
The US hasn’t helped. Despite almost unanimous predictions, US interest rates fell this year. This has weakened the dollar and strengthened the Euro. European countries, especially Germany, are far more dependent on exports than the US. A strong Euro eating into their competitiveness definitely doesn’t help.
The banks are also having problems. Impaired loans rose 8.1 % to over €1 trillion since last year. Like most banks they were under recognizing bad loans. Fortunately their loan reserves have been rising, but this has put a further crimp in lending. Without new lending it is difficult to gain any growth or put a dent into unemployment rates, which are still above 20% in both Spain and Greece.
Part of the froth in the equity and bond markets is again the result of statements by ECB president Draghi. He has told the markets there will be some sort of simulative action taken at the next meeting of the ECB. But what? The hope of a European Quantitative easing (QE) is off the table, because buying more Greek bonds does not sit well with the Germans. There is some speculation about negative interest rates, but there is also a question as to whether these would even work.
While it is possible that the recent pull back in European growth is temporary, the bar for sustainable growth is quite high. Like most countries in the present market, there is remarkable faith in the monetary management of central bankers. So much so that Europe still has not made the crucial structural reforms necessary to fix its multiple problems. With equities and bonds at extreme heights, some sort of correction appears to be inevitable.  
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
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