Steen Jakobsen's Articles
06 June 2011
Steen Jakobsen, Chief Economist
"To me, consensus seems to be the process of abandoning all beliefs, principles, values and policies. So it is something in which no one believes and to which no one objects." Margaret Thatcher.
There are three major themes this morning: the election in Portugal, Greece bail-out, Part II, and confirmation of slowing US growth.
On the surface, the Portuguese election looks like a victory for change as the Social Democrats (PSD) secured 30 per cent of the vote and appear to have a solid majority of 126 seats in the 230-seat Parliament with the support of the Conservative Popular Party. The new prime minister, Passos Coelh, has promised austerity beyond the needed cuts of 3.5 per cent of GDP per annum layed out in the IMF plan.
But real change - what change? A good friend of mine, Paulo Pinto of DIF Brokers in Lisbon, said to me this morning: 'This reminds me of when the French moved to the right and Sarkozy won the elections. Everybody thought it was a historical change. This is not about left or right, this is about those being in debt and the few who are not. The parties that signed the agreement with the Troika (ECB, EU and IMF) had 90 per cent of the votes even before the election so there will be illusion but not growth for the next two years and people will be disappointed soon'.
This goes to Jakobsen's law of politics: It's not what the policy makers say which is important, but that they do. Clearly, as a long-term visitor and friend of Portugal, I want the best for Portugal. But Portugal has become the poster child of an Entitlement Society – the public sector has extended everywhere and private capital has been crowded out by the need to keep the public sector employment in place. The only solution to Portugal's catch-22 is to create real private sector growth and to cut the public sector down in size. Portugal has one of the lowest GDP growth rates in Europe with a four-year average of -0.7%, and an outlook for -2.1% in 2011 and -1.5% for 2012, according to the ever too optimistic OECD. Even more importantly than GDP growth rates, unemployment will rise to 11.7% and then 12.7% over the next two years from present 10.8%! That's a recipe for a social upheaval.
This is the huge national dilemma – Portugal has gone beyond the point of no return – the problems facing the country are not merely those of "challenges", but massive, structural intractable problems. Even if Portugal did the "right thing" – curtailed the public sector, refinanced the banks, and created a pro-business, pro-growth agenda, it would take years, not months before Portugal again starts moving forward. My issue, as always, is not with the people or the individuals of Portugal, but with the system. The Portuguese entitlement society began collapsing years ago, and the only reason the situation has been allowed to limp along until this year was due to the artificially low rates generated by the ability to ride German credit rating for years.
It is time for Portugal to move forward – I hope the new prime minister is not merely a man of words but also of action. Portugal has always played a unique role in history and could do so again for better or worse.
The Greek drama continues – basically no one has a clue how to solve the issue of giving Greece more money when the funding runs out next spring. The "re-profiling" of debt (extending duration and the like through a "soft restructuring"), the Vienna solution and the new path of creating ratings default but not a CDS default event are all too complicated for me. My mentor always told me: if it takes more than one minute to understand your arguments, you have no arguments. Clearly, using Greece as the benchmark for how the EU will face down the sovereign debt issue, the EU institution is critically challenged, and Greece is even more so.
For starters, we have to shake our heads at the fact that, the EUR 327 billion in outstanding Greek debt, more than 90 per cent is under Greek law (source: Citigroup), whereby Greek bonds have no collective action clause (CAC). This would mean that a voluntary debnt restructuring requires 100 per cent of investors to accept the terms to avoid triggering a default. As bad as that sounds, I'm not naïve enough to believe that this is major issue for the EU, which has proven that they will do everything within their power to find an extend and pretend "solution" for the problem by addressing a solvency issue with more liquidity.
Here's another critical issue: Standard & Poor's explained their methodology for determining a default this past Friday: Issuers rated Single-B, like Greece, would be in default if: creditors receive securities with terms less favorable than are available in the secondary market. This is a rather high watermark, since 2- and 10-year Greek debt trades at 22.1% and 15.7% respectively right now. Furthermore, the ECB continues to object to any sort of debt restructuring as it would blow a hole in their own portfolio and create a moral hazard. Good luck to EU trying to resolve this before the June 23-24 summit.
How low can we go on US growth? The status quo is maintained and extended in the USA – as the fortunes for Main Street and Wall Street continue to head in opposite directions. The Bernanke cocktail of lower rates for longer has only made Wall Street richer and Main Street poorer. There are two well known and oft used rules of thumbs in US economics: Consumer spending is roughly 70 per cent of US GDP and labor has received two thirds of the overall national income. However, this is no longer the case: Labor's portion of income has now dropped to 57.5% (source: David Rosenberg) – the lowest level in sixty years! This means that Main Street is as poor as ever before. The Financial Times published a piece this weekend under the headline: China Investors: Beware of inequality. The article points out that over the last 30 years, the top 1 per cent of the US population's share of total income rose from 8 per cent to 16 per cent. During the same period, US median incomes have barely grown in real terms. Again confirmation that the social tension, or the inability to create inclusiveness could become the topic not only in the US election but also across Europe as protests grow in size in Greece and we continue to see youth unemployment of over 40 per cent in Spain.
Where from here? We have our most likely scenario as one called 'QE to Infinity' but it may need to be changed to QE and Operation Twist to Infinity. Operation Twist is the new buzzword in political and central bank circles as Bernanke mentioned it in his "famous" deflation speech from 2002: "Deflation: Making sure 'It' does not happen here" - the very same speech which was academic reasoning for QE and QE2.
Mind you, this time the Operation Twist is merely a footnote – specifically footnote 11: "An episode apparently less favorable to the view that the Fed can manipulate Treasury Yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling short end and buying in the long-end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates was not to close to zero" .
The bold text is my work – as it clearly indicates Bernanke thinks it's only a matter of size and objective to do what could not be achieved in the 1960s. As it happens, Operation Twist not only failed but became the Great Inflation of 1965-81. Fed rates were 3.0% (wow! What a coincidence!), and were supposed to go back to 2.5% but ended at 6.0% before the Fed of the 1960s gave up.
The purpose was explicitly to flatten the yield curve – helping the housing market while supporting the US Dollar. Clearly, now you only need to replace a falling US Dollar with commodities and it is all nice and dandy for Chairman Bernanke and his effort to find 'justified' new instruments in the keeping rates lower for longer. We believe 2.0% is likely in 10- year rates merely on the talk of Operation Twist. All research shows, unfortunately, that all benefits gained from QE and Operation Twist come from the anticipation rather than the implementation.
We remain bearish the market as per my earlier note: "No more Silver Bullets" and I have increased the Crisis 2.0 odds from less than 10% to 25% as the amount of troublesome issues continue to rise day-by-day.
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