Political/policy risks in the EZ are rising

Japanese Q2 GDP declines sharply to just +0.3% Q/Q or +1.4% Y/Y. The preliminary estimate is sharply down from the revised +5.5% annualised growth in Q1 and well below the +2.3% expected. The strong Yen, combined with slowing economies worldwide, are impacting exports to China and Europe, in particular. Private consumption in Q2 grew by just +0.1%, the lowest in 5 Q’s and as opposed to +1.2% in Q1. JPM report that employee earnings were down -0.5% in nominal terms, though flat in real terms, suggesting that consumption will continue to be weak. If it were not for public investment, which rose +1.7% Q/Q (though expected to decline in H2), the numbers would have been even worse, as net exports reduced GDP by -0.1% (Source FT). The extremely poor numbers will add to the pressure on the BoJ to enact further monetary stimulus measures. However, the Yen has not reacted to the numbers;

Continuing policy disagreements in China, between those who want to stimulate the economy, such as the outgoing Premier Wen and others (who will become the new Chinese leaders and who fear the consequential impact) is paralysing policy action. However, as the economy deteriorates further, I believe that the Chinese leadership will become increasingly concerned and, whatever the consequences (bad in the medium to longer term) the Chinese will ease monetary policy and, in addition, increase stimulus measures. The key will be unemployment, which apparently has not increased materially – if it does, the Chinese will act. Whatever, the days of the Yuan appreciating against the US$ are over, in particular due to the weaker Euro. Mainland Chinese markets were some -1.5% lower today. BoA cut its forecast for GDP growth to just +7.4% for this year, though JPM believe that the economy will pick up in the 2nd half;

Greece’s Q2 GDP declined by -6.2% annualised, better than both expectations of -7.0% and -6.5% in Q1. The numbers were not seasonally adjusted and in addition, I am extremely wary of Greek data, given their history. Recently, data has met the Troika’s targets (apparently?), but I continue to believe that Greece will exit the EZ, quite possibly this year. Recent comments by members of Mrs Merkel’s coalition partners are particularly negative. The EZ is to consider Greece in mid October and further aid ahead of that will be difficult. Greek politicians have (finally) realised that they have to deliver – there is no alternative. However, can they? and, is it too late? (see below);

German newspapers sets out 5 major problems for Mrs Merkel, now that she has returned from holiday. They include;

a) Increasing reluctance to provide further aid to Greece from members of the FDP (her coalition partner) and the CDU’s Bavarian sister party (the CSU). In addition, there is the matter of the decision by the German Constitutional Court as to whether the German President can sign off on the fiscal compact and the ESM – generally, the German press is raising the issue of conditionality;

b) Issues in respect of renewable energy, childcare and gay rights;

c) The weakening support for her coalition partner the FPD – now has just 4.0% of the vote in recent polls. You need at least 5.0% to gain any representation;

d) Mrs Merkel’s sister party the CSU is getting more populist, given impending State elections next year. They are opposed to a further Greek bail out;

e) Recently, Mrs Merkel had to rely on support from the opposition SPD and the Greens to get her EZ/Euro rescue efforts passed in Parliament, due to defections from her own coalition. However, Peer Steinbruck, a leading member of the SPD and former Finance Minister, states that Mrs Merkel cannot count on their continued support, without offering “concessions”;

More on this below;

Dutch retail sales decline materially. June retail sales rose by +1.0% Y/Y, as opposed to expectations of +2.5% and +1.6% in May. The markets have ignored Holland – dangerous. The Dutch are becoming more Euro sceptic, given their economic problems and general elections are due in mid September. They are also one of the remaining 4 countries in the EZ, which has a AAA rating, the others being Germany, Finland and Luxembourg. However, Moody’s have stated that Germany, Holland and Luxembourg risks losing their AAA status. The Dutch have been particularly hawkish on Greece;

French June current account deteriorated to -E4.9Bn M/M, worse than the -E4.1bn expected and the revised -E4.0bn in May. French economic problems continue and, based on its current policies, I see no respite. Indeed, I continue to believe that France is going to (increasingly) face serious economic problems, which will materially impact the EZ;

The selection of Paul Ryan as the VP candidate will focus attention on the budget. Democrats suggest that his previous comments on Medicare and on the elderly will lose Romney votes, whilst Republicans welcome the debate.


Further monetary easing, combined with fiscal stimulus in China is coming in my view, especially if unemployment rises, as I expect it will, unless these measures are enacted. Clearly bullish if enacted.

However, the real issue remains the EZ.

Over the weekend, I read numerous articles which (for, effectively, the first time) keep bringing up the subject of a referendum (in respect of the EZ/Euro) in Germany. Yes, the SPD has proposed a referendum and Schaeuble, a month or so ago, talked about it. However, the increase in calls for a referendum has surprised me. In addition, there is increased speculation (including on Bloomberg today) that whilst the the Constitutional Court will allow the German President to sign off on the fiscal compact/ESM, they may impose conditions which (severely?) impact the ability of Mrs Merkel/Germany to act. As you know, I believe that the Constitutional Court will allow the President to sign off on the fiscal compact/ESM, but remain concerned about (restrictive?) conditions. Any such conditionality will clearly be a major negative. In addition, the ECB have stated that they will only act if the relevant countries first seek support from the EFSF/ESM. Any material limitations which, for example, do not allow the ESM to be leveraged, due to conditions imposed by the Constitutional Court (it’s far too small at present), will be a major problem.

As you know, one of my biggest concern remains that Mrs Merkel has not sold the idea of the EZ/Euro to the German’s, preferring to do deals in dark, smoke filled rooms with the doors firmly bolted. I continue to believe that this is a very dangerous and high risk strategy. In addition, a number of German politicians report that Mrs Merkel says one thing in public, but does the opposite in private. That game has ended – the spotlight is on her and on her actions. There is no question that Mrs Merkel and most German politicians are keen to support the EZ/Euro. However, with increasing opposition from her own party and coalition partners and the SPD’s statement that they want (presumably political) “concessions” for on going support, (which Mrs Merkel will clearly need), the Risk/Reward situation is changing.

Recent polls suggest that the Germans understand that the costs to their economy will be far greater if the EZ/Euro breaks up, but it looks as if the support is slipping. Populist politicians are playing to the crowds, which will aggravate the situation.

The impending Dutch elections remains a serious threat and is being ignored – dangerous.

Today, the Greek data (I caution you, it’s Greek data and, in any event, non seasonally adjusted) and, in addition, a better Italian bill auction has lifted the peripheral EZ markets (Spain, Italy, Greece) and the Euro is up to US$1.2367 – cant see that holding. In addition, 10 year bund yields have risen a few (4 – 5) bps. However, German French and UK markets are flat to slightly lower.

I have been bullish to date (especially following Draghi’s ECB statement, week before last), though the surprising number of potentially negative (mainly political) reports I read over the weekend, with similar follow ups today, suggest that risks (as set out above) are rising. Hedge funds have closed their shorts in the main, though are not really long, according to data supplied by Bloomberg – not helpful. The markets have rallied materially, especially the higher beta stocks. The rally was based on policy/political action, rather than anything else. If that becomes a problem,……….There is going to be a policy vacuum until the German Constitutional Court decision is know – not positive. Draghi’s statement was helpful, but questions are being asked.

Time to get cautious and, I for one, will be taking some profits.

Kiron Sarkar

13th August 2012

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