Greece Still Unresolved but Contained; Eurozone Economy Stagnating

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As another week draws to a close with the bailout of Greece still unresolved, financial markets, while still volatile, appear to be taking a more positive view of the eventual outcome and its implications. The European governments have obtained the commitments they have been seeking from the Greeks, yet some are seeking further safeguards that the commitments will be met. Experience has shown that “implementation risk” is significant in the case of Greece, particularly in view of the elections in April. The time line for reaching an orderly rescheduling is getting short. Monday’s meeting of the Eurogroup may be able to clear a bailout agreement, but there will still be further actions necessary for Greece to take before the funds are released.

The European Central Bank (ECB) is aiding Greece with a swap of outstanding bonds it is holding, for new Greek bonds, at no loss to the ECB. It is also expected to continue its efforts to shore up the European banking system and credit markets with another very sizable (perhaps 1-trillion-euro) extension of 3-year credits to banks at the end of this month.

The more positive market sentiment was illustrated earlier this week by the way the market shrugged off a round of downgrades by Moody’s of European sovereigns, and announcements of reviews by the ratings agency of European and global banks. Moody’s actions were long overdue, already priced into the markets, and in the case of banks probably were more needed several months ago than at present.

At Cumberland, we pay particular attention to developments in sovereign borrowing rates and interest-rate spreads. Readers can view credit spreads around the world on our website. The general improvement since late November is apparent.

This week has witnessed several successful Eurozone sovereign bond auctions. France raised 8.46 billion euros with no problem. Spain raised 4 billion euros, experiencing a sharp fall in its borrowing costs. A bond maturing January 2015 had a yield of 2.97%, some 200 basis points lower than the 4.9% yield of a similar Spanish bond sold last August. Markets may be coming to the view that Greece is indeed a special case and its financial problems are of a dimension that the other European countries can and will effectively address and contain.

There is no other country like Greece in the Eurozone. Portugal does have a difficult debt financing situation and may need some official financial help. But Portugal fortunately is not in the same league as Greece.

The Greek tragedy is a real tragedy for the people of Greece. Greece’s economy declined 16%, as measured by real GDP, between the fourth quarter of 2008 and the fourth quarter of 2011. Domestic demand is estimated to have dropped 20%. The austerity measures, that the Eurogroup has demanded from Greece, will make emergence from this severe recession a distant prospect. Increasing tax revenues in such a situation would be a daunting challenge for any government. In Greece there is the special hurdle of a widespread tradition of not paying taxes. This is only one of the governance problems plaguing the country. Another striking example is the fact that Greece has a rank of 80 in Transparency International’s measure of domestic public-sector corruption. Greece ranks worse than countries like China, Cuba, and Georgia. In comparison, Portugal has a rank of 32 and Spain of 31.

The latest economic and survey data confirm that the Eurozone economy contracted in the fourth quarter, with Netherlands, Italy, and Portugal (along with Greece) already in recession, that is, with two or more consecutive quarters of declining real GDP growth. The French economy, on the other hand, surprised observers with a positive advance, although that may be reversed in the current quarter. While Germany’s economy also eased in the final quarter of last year, there were signs during November and December and continuing in January that it is once again advancing. Italy, on the other hand, continues to slump. Thus, while Germany’s prospects are improving, the rest of the Eurozone economies are either depressed or at best (e.g., in France) stagnant.

This divergence in the paths of the various Eurozone economies presents a difficult challenge to the ECB. Policies appropriate for the German economy are likely to be inappropriate for those economies in recession, and vice versa.

Thus far in 2012, the Eurozone equity markets have reflected both the general improvement in market sentiment toward the Zone and the divergent economic prospects. Using the MSCI equity market indexes for comparison, the Eurozone markets as a whole have advanced 11.46% year-to-date, compared with 8.59% for the US market. Germany has been a market leader, with an advance of 17.40%. That is considerably higher than France’s 10.61 %, Italy’s 9.44% and Netherlands’ 7.02% advances and in marked contrast to Portugal’s 1.41% and Spain’s 2.55% increases. Cumberland Advisors’ International and Global Multi-Asset Class ETF portfolios remain underweight with respect to the Eurozone, with positions limited to the “core” economies of Germany, France, and the Netherlands.

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About Bill Witherell