Austerity’s Bite

“Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth.”

-Marcus Aurelius

 

Austerity is the new buzz word in Europe; from newly elected UK Prime Minister David Cameron in the north to Italian PM Silvio Berlusconi in the south, the issuance of austerity measures from European governments to combat bloated fiscal imbalances seems like a near daily occurrence.

 

The word austerity comes from the Latin austerus meaning “dry, harsh, sour, tart” and was originally used to describe fruit and wine, however in economics refers to a government’s reduction in spending and/or increases in taxes to reduce a budget deficit.  Over the last weeks, European austerity packages have included such provisions as civil servant wage freezes, extensions on the age of retirement, and levies on alcohol and tobacco to an additional tax on the price of an airplane ticket. In short, governments are trimming obvious “fat” and creating revenue streams to rein in over-extended budgets.

 

Here’s a quick recap of budget deficits (as a percentage of GDP) and the notable austerity packages issued in Europe over the last months:

 

Greece – (13.6%); plans to cut €30 Billion in spending over the next three years

UK – (11.5%); £6.2 Billion (or €7 Billion) in spending cuts this year

Spain – (11.2%); €15 Billion in spending cuts and 5% reduction in public worker wage this year

Portugal – (9.4%); plans to issue measures to save €2 billion this year

Italy – (5.3%); €25 Billion in cuts over two years (*strike planned for June 25th)

Germany – (3.3%); €11.2 Billion in spending cuts for next year, or ~€85 Billion by 2014.

 

The most obvious question to ask is will these measures be enough to reduce deficits and return “health” to Europe?

 

In both the immediate and longer term the answer to this question appears to be No and a qualified No. In the near term, Europeans are taking to the streets, with strikes over austerity measures already held in Greece and Spain. While the estimated 2.5MM strikers in Spain appeared mostly harmless (a colleague likened the visual displays on TV to a pre-game World Cup party), strikes in Greece had a very ugly undertone with the death of 3 protestors.  As Keith has noted recently, austerity will equate to civil unrest:  the confluence of a government’s need to tax its people versus the public’s cry that they aren’t responsible for the government’s fiscal mismanagement, and therefore refusal to bear the brunt of the measures. We believe that deficit reduction alone won’t solve Europe’s fiscal problems.

 

In the longer term there are numerous structural and fundamental concerns related to the Eurozone. We’ve pointed out in our quarterly theme work that the investment risk related to sovereign debt default or restructuring is not limited to Greece, but will spread to Spain, France, and Italy, much larger economies than Greece with debt exposure to European banks far greater than Greece’s obligations by a factor of 4-5 times. The outcome could cause further (and greater) downward pressure on markets. 

 

Importantly, it’s worth noting that the European and IMF-led €750 trillion “loan” facility to buy up toxic debt from European countries “in need” (and return investor confidence) has failed to buoy European markets largely because ECB President Jean-Claude Trichet has not outlined just how the facility works! As a result, we’ve tracked increases in government bond yields, sovereign CDS, and equity underperformance, along with the Euro-USD that broke through our immediate term support line of $1.20-1.21 earlier this week to a low of $1.1876 on 6/7 and is down 15% YTD.

 

Further, what we have seen since the facility was announced on May 10th is strong headline risk (think comments from a Hungarian official last week of a Greece-like debt crisis in his country that sent markets plunging) and continued day-to-day volatility. Also, the separate European/IMF funded €110 Billion aid package to Greece hasn’t made a dent in performance or sentiment: the Athex is down 33% YTD and the worst performing major index in the world.

 

Could it be that the experiment of uniting disparate economies is a losing effort?

 

As we see it, there are two main threads of questions that still need to be worked through to determine the path of the Eurozone:

  1. Should European officials revise the standards of the Stability and Growth Pact, which limits members to a budget deficit no greater than 3% of the country’s GDP?  Could more malleable standards be devised (alongside an oversight body) to limit fiscal imbalances across countries, to benefit both the individual country and the Union as a whole? Conversely, is there any merit in imposing harsh budget reduction mandates (that governments may likely fail to meet) at the expense of growth?
  2. Can the Eurozone, a union of 16 disparate countries that share the Euro as a common currency and are tied to the European Central Bank for monetary policy, exist at all, if countries cannot manipulate (devalue) their currency to inflate their way out of debt or independently adjust interest rates to spur or quell growth? 

Clearly these are big questions, all of which we don’t have the answer for.  What we can count on is the continued lack of political solidarity from European leaders to proactively address the region’s ails, which is risk we’re focused on managing around. Statements yesterday from EU President Herman Van Rompuy are case in point: “And if the plan [€750 Billion loan facility] were to prove insufficient, my answer is simple: in this case, we’ll do more.” This is not leadership! 

 

If austerity is the first start to something better, we caution that weaker growth prospects are ahead for much of Europe. In the longer term, it just may be that despite the Eurozone’s intention for the whole to be stronger than the individual parts, disparate parts may remain just that, or conversely, and to quote a line from William Butler Yeats’ poem “The Second Coming”: Things fall apart; the center cannot hold.

 

We’re currently short France in our virtual portfolio via the etf EWQ and have been short Spain (EWP) this year as a way to play the weakness we see in Europe.

 

Matthew Hedrick
Analyst

 

Austerity’s Bite - EL CDS


Cartoon of the Day: Acrophobia

"Most people who are making a ton of money right now are focused on growth companies seeing accelerations," Hedgeye CEO Keith McCullough wrote in today's Early Look. "That’s what happens in Quad 1."

read more

People's Bank of China Spins China’s Bad-Loan Data

PBoC Deputy Governor Yi says China's non-performing loan problem has “pretty much stabilized." "Yi is spinning. China’s bad-debt problem remains serious," write Benn Steil and Emma Smith, Council on Foreign Relations.

read more

UnderArmour: 'I Am Much More Bearish Than I Was 3 Hours Ago'

“The consumer has a short memory.” Yes, Plank actually said this," writes Hedgeye Retail analyst Brian McGough. "Last time I heard such arrogance was Ron Johnson."

read more

Buffalo Wild Wings: Complacency & Lack of Leadership (by Howard Penney)

"Buffalo Wild Wings has been plagued by complacency and a continued lack of adequate leadership," writes Hedgeye Restaurants analyst Howard Penney.

read more

Todd Jordan on Las Vegas Sands Earnings

"The quarter actually beat lowered expectations. Overall, the mass segment performed well although base mass lagging is a concern," writes Hedgeye Gaming, Lodging & Leisure analyst Todd Jordan on Las Vegas Sands.

read more

An Update on Defense Spending by Lt. Gen Emo Gardner

"Congress' FY17 omnibus appropriation will fully fund the Pentagon's original budget request plus $15B of its $30B supplemental request," writes Hedgeye Potomac Defense Policy analyst Lt. Gen Emerson "Emo" Gardner USMC Ret.

read more

Got Process? Zero Hedge Sells Fear, Not Truth

Fear sells. Always has. Look no further than Zero Hedge.

read more

REPLAY: Review of $EXAS Earnings Call (A Hedgeye Best Idea Long)

Our Healthcare Team made a monster call to be long EXAS - hear their updated thoughts.

read more

Capital Brief: 5 Things to Watch Right Now In Washington

Here's a quick look at some key issues investors should keep an eye on from Hedgeye's JT Taylor and our team of Washington Policy analysts in D.C.

read more

Premium insight

[UNLOCKED] Today's Daily Trading Ranges

“If I could only have one thing of the many things we have it would be my daily ranges." Hedgeye CEO Keith McCullough said recently.

read more

We'll Say It Again: Leave Your Politics Out of Your Portfolio

If your politics dictates your portfolio positioning, the Democrats and #NeverTrump crowd out there have had a hell of a week.

read more

Cartoon of the Day: 'Biggest Tax Cut Ever'

President Donald Trump's economic team unveiled what he called last week, "the biggest tax cut we’ve ever had.” Before you get too excited about that hang on a sec. "Trump Tax Reform ain’t gettin’ done anytime soon," Hedgeye CEO Keith McCullough wrote in today's Early Look.

read more