What’s Broken in Europe? May 21, 2013

Last week (May 13 – 17), markets digested reports on gross domestic product (GDP) growth in the Eurozone during the first quarter of 2013 (please see “The Big Picture” for details about the Eurozone’s structure). Overall real GDP in the Eurozone contracted by 0.2% in the first quarter of 2013, following the 0.6% drop in the fourth quarter of 2012. The Eurozone’s economic contraction in the first quarter of 2013 was its sixth consecutive quarter of decline, dating back to the fourth quarter of 2011. Among the larger economies in Europe, only Germany (+0.1%) and Belgium (+0.1%) saw first quarter 2013 gains in their economies, while Austria’s GDP was unchanged between the fourth quarter of 2012 and the first quarter of 2013. France (-0.2%), Italy (-0.5%), Spain (-0.5%), and the Netherlands (-0.1%) all saw their economies contract in the first quarter of 2013.

Among the smaller economies on the Eurozone’s periphery, the news was just as bad, but the string of weak GDP readings extends back much further. Real GDP in Greece declined 0.6% in the first quarter of 2013, marking the 13th consecutive quarter of contraction. Greece’s economy has now contracted in 20 of the past 23 quarters since mid-2007. Over that time, the Greek economy has shrunk by 23%. Real GDP in Portugal contracted by 0.3% in the first quarter of 2013, marking the 10th consecutive quarterly decline. Ireland’s GDP fell just 0.1% in the first quarter of 2013, and it has managed just three quarters of growth since late 2010.

Looking ahead, financial markets seem to suggest that the double-dip recession in Europe — recession in 2008 and 2009, a modest, halting recovery in 2010 and early 2011, followed by another recession since mid-2011 — may be ending, and that the Eurozone economy may eke out small gains in the second half of 2013. The consensus of economists (as compiled by Bloomberg News) sees real GDP in the Eurozone contracting in both the second and third quarters of 2013, before a modest upswing begins in late 2013. Our view remains that the Eurozone is likely to be in a recession throughout 2013, despite the best efforts of the ECB and other policymakers.

The Fix? Some Keys to Help Strengthen Eurozone Economic Growth

As we have noted in prior publications, there are several keys to help strengthen economic growth in the Eurozone, including, but not limited to:

• ƒ Fixing Europe’s broken financial transmission mechanism;
• ƒ Broad-based labor market reforms;
• ƒ European-wide banking reform (including a pan-European deposit insurance scheme); and
• ƒ Financial sector reforms.

In our view, fixing Europe’s broken financial transmission mechanism should be at the top of European policymakers’ long list of “to dos.” The ECB, like almost every other major central bank around the globe, has lowered the rate at which banks can borrow from the ECB, expanded the ECB’s balance sheet to purchase securities in the open market (QE), and tried to encourage banks and other financial institutions to lend, and businesses and consumers in Europe to borrow. The results, however, have not (as yet) had the intended effect: to get badly needed credit (in the form of loans) into the European economy, and especially to the consumer and small businesses. In short, the mechanism that allows credit to flow from the ECB, to banks and financial institutions, and finally to businesses and consumers was badly damaged in the Great Recession and its aftermath.

Major European-based global corporations are benefitting from the ECB’s actions, and are taking advantage of low borrowing costs and relatively healthy — although not quite back to normal — European capital markets to issue debt and fund operations. While credit via traditional credit markets is flowing to large, global corporations in Europe, credit to SMEs, is severely restricted dampening economic activity.

How European Banks Can Help

As in the United States, most SMEs in Europe cannot borrow in the capital markets, so they rely on bank loans, and other types of bank-based funding for working capital and cash to expand existing business. This is especially true in countries at the periphery of Europe, like Greece, Portugal, Cyprus, and increasingly in core European nations like Spain and Italy. The problem is that the main conduits of the ECB’s low rates and QE policies are European banks, which:

• ƒ Are undercapitalized;
• ƒ Are reluctant to lend;
• ƒ Are losing deposits;
• ƒ Lack regulatory clarity; and
• ƒ Have impaired balance sheets.

Therefore, European banks are not lending, or more precisely, not lending enough.

Figure 1 shows the breakdown in the financial transmission mechanism in Europe. Money supply growth (a decent proxy for the ECB’s actions to pump liquidity into the system) is running at around 2 – 3% year over year. Not robust growth, but enough to foster some lending by financial institutions. The other line on Figure 1 shows that despite the 2 – 3% growth in money supply in Europe, loans by financial institutions in Europe to private sector borrowers (SMEs and consumers) have turned negative. Therefore, credit to two key components of the Eurozone economy is contracting. The gap between these two lines is a good proxy for the broken financial transmission mechanism in Europe.

A quick look at Figure 2, which shows similar U.S. metrics (M2: money supply and bank lending), reveals that the financial transmission mechanism — while not quite back to normal — is functioning a lot better than Europe’s. M2 growth is running at around 7% year over year, while bank lending to businesses is running close to 10% year over year.

How the ECB and Policymakers Can Help

What would help to repair Europe’s broken transmission mechanism, and in turn, help to boost economic growth in the Eurozone? One way would be if the ECB was willing to take some credit risk on their balance sheet, and take an approach similar to the Bank of England’s (BOE) “credit easing” program. The BOE announced in late 2011 and mid-2012 that it would provide cheap loans and loan guarantees to the banking system to encourage the banks to lend more. Or, the ECB could decide to make loans directly to SMEs, essentially bypassing the broken European financial mechanism. Such a move by the ECB, of course, remains difficult — although not impossible — to achieve, given the fractured state of banking regulation in Europe and reluctance by key constituencies within the Eurozone to expand the ECB’s mandate. The bottom line is that until the ECB (or other policymakers) can agree on a plan to get more credit to capital-starved SMEs and consumers in Europe, we don’t think a meaningful recovery in Europe’s economy is in the cards.

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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

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INDEX DESCRIPTIONS
Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is
not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Predicted Policy Positives Priced In, Producing Potential for Precarious Pitfalls – Weekly Market Commentary by Garrett & Robinson September 13, 2012

There are many highly anticipated economic policy events this week, primarily in Europe. The markets will debate whether these will finally be enough or if more are required. It is likely there will be more to come. However, the series of policy actions in the United States, China, and Europe have already had a powerful positive impact in the markets:

• Federal Reserve (Fed) Chairman Ben Bernanke’s speech on August 31, 2012, from Jackson Hole, Wyo., reaffirmed the market’s expectation for another major policy initiative from the Fed to be unveiled this week. The anticipation of further economic stimulus has helped to lift the U.S. stock market, measured by the S&P 500, back to four-year highs.
• Last week, China announced that it approved a large number of infrastructure projects estimated to total nearly a quarter of all the stimulus China put to work during the global Great Recession of 2008-09. On the news, the Shanghai Composite, which had been sliding to near four-year lows, surged nearly 4%.
• Even without the European Central Bank (ECB) making a single purchase of the bond-buying program announced last week, it is already working and adding to the backdrop of other potent policy measures. European bank stocks have surged, and 2-year Spanish bond yields have plunged from 6.5% less than two months ago to less than 3% last week.

This week is set up to deliver another week of policy announcements that may drive the markets. The most significant begin on Wednesday and include: Germany’s constitutional court ruling and possible aid for Spain, the Fed’s likely announcement of yet another stimulus plan, and inspectors reviewing if Greece’s progress on reforms merits any more aid.

Figure 1: Key Policy Events This Week

Sunday:           International Monetary Fund (IMF) inspectors begin meetings with Greek leaders to review progress.

Wednesday:    The German constitutional court will present its ruling on the European Stability Mechanism (ESM).

The European Commission will present a plan for a banking union.

The Netherlands will hold parliamentary elections.

Thursday:        Federal Open Market Committee (FOMC) meeting.

Friday:             Eurozone finance ministers will meet in Cyprus.

• Greece’s Inspection. The troika, made up of members of the European Commission, International Monetary Fund (IMF), and the ECB, are in Greece reviewing progress on a number of delayed reforms and spending cuts. The final report is set for October 8; however, much of the deliberations are transparent. Greece is hoping to convince the inspectors of the commitment to its plans, but a number of provisions run counter to what some of the new government coalition members promised voters just three months ago. If the inspectors sign off on the latest cuts and are convinced of Greece’s reform drive, Greece will get 31.5 billion euros next month, without which Greece would likely default and send markets lower.

• German Constitutional Court Ruling. On Wednesday, the German Constitutional Court is due to rule on the legality of the Eurozone’s permanent rescue fund, the European Stability Mechanism (ESM). The ESM is intended to replace the nearly exhausted temporary European Financial Stability Facility (EFSF). The market has priced in the most likely outcome that the judges will let the ESM move forward. However, if the court were to rule the ESM violates the German constitution, it could have a very negative effect on the markets by casting doubt on the rescue of troubled southern European countries.  But, even if the court gives its ok, it may complicate rescue efforts by setting limitations or veto powers that may undermine confidence and spook the markets.

• Spain’s Memorandum of Understanding. Following a favorable decision by the German Constitutional Court, Spain may request European assistance in the form of a broader bailout than the banking sector aid received earlier this year. The terms of this bailout, spelled out in a memorandum of understanding, are already being negotiated with Spain attempting to moderate politically unpopular conditions such as cutting public pensions. The markets are sensitive to how long it takes to cut a deal after the German court rules—the sooner the better.

• Netherlands Election. The coalition government that may form could have a high proportion of representation from the parties that are skeptical of further Eurozone integration.  This could raise another hurdle to rescue efforts.

• European Banking Union. A proposal for a single banking supervisor based at the ECB—rather than leaving all banks regulated at the national level and risking capital runs from banks in one country to banks in another—will be presented to the European Parliament this week. Most favor broad regulation since problems have spread from smaller institutions to larger ones. However, Germany wants the ECB to supervise only the top-25 systemic cross-border banks and leave the rest to national regulators. This week is set up for a showdown over the future of banking in Europe after European bank stocks have rallied sharply in recent months.

• The Fed’s Quantitative Easing. The Fed is widely expected to announce open-ended quantitative easing at the conclusion of its two-day policy meeting on Thursday.  Indications from recent speeches, papers, and economic data failing to meet the Fed’s stated objectives, all point to action.  But if the Fed believes it has the time to wait for more data given the recent significant improvement in European markets mitigating a key risk, and providing more time for the extended Operation Twist program to work prior to its end in December, it may put off its decision until after the election. If so, the markets would likely react negatively.

This week ends with European finance ministers meeting in Cyprus to argue over the banking supervision proposal and the terms of aid for Spain and Greece.

The market is anticipating generally good news from each of these events, so volatility may return if they are mixed.

While all of the policy events last week and this week hold significance for the markets, over the next few months, the policy initiatives in China may be the most important. A bigger economic downturn for China would have broad global implications that would be hard for European or U.S. policymakers to offset. 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990 with a base value of 100. Index trade volume on Q is scaled down by a factor of 1000.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. “Operation Twist” describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

LPL Financial, Member FINRA/SIPC