It’s a reasonable question and one which many were asking themselves on Friday in the wake of the disappointing US jobs data. There was also an expectation of some statement from EU and/or G7 leaders over the weekend to offer reassurance to markets. As it was, there was nothing of substance, with the result that Asian equities were down over 2% today, with the fall in Chinese stocks the biggest for two months. The latest PMI data for the services industry showed a further modest slowdown in China. So looking around the world economy, there are currently few signs of decent momentum, either in the emerging or developed world. Still, if the German newspaper Welt-am-Sonntag it to be believed, EU leaders are drawing up a crisis plan to be ready by the end of the month. This reportedly contains many of the measures (integrated budget policy, banking union, and political union) at which many member states, notably Germany, have balked at in the past. But the truth is that we are at the point where bold measures will have to be taken if the euro is to stand a chance of staying intact. Incremental, compromised and late initiatives have failed spectacularly.
The narrowing policy road post payrolls. Friday’s US labour market painted a fairly bleak picture, but also narrowed the divide that had emerged earlier in the year between the picture being told by the labour market and some other indicators on the US economy. The household survey showed the first increase in the unemployment rate for nearly a year (from 8.1% to 8.2%). Furthermore, data on average hourly earnings fell for the second consecutive month (to 1.7%, an 18 month low). Another point of concern is the further fall in hours worked, in other words those remaining in employment are working less, never a sign of underlying strength. In all the mire of the eurozone crisis, the performance of the US economy was meant to be one of the offsets for the global economy, helped by the extent of earlier stimulus measures and more recent measures to support growth. The question to be answered is whether these numbers are just a pull-back from recent (relative) labour market strength, or a sign that the economy cannot fight against the slowdown being seen not only in the eurozone, but also in many emerging nations. The indications suggest a bit of both, but more of the latter.
Europe’s choice is binary. Europe’s sovereign debt and banking crisis has now reached the point of no return. Recently, it has become abundantly clear that both Spain and Greece are now in a depression, which given their respective debt mountains renders servicing and repaying that debt impossible. The ECB is likely considering another helicopter drop of liquidity in the form of a further round of LTRO, but frankly all it does is buy a little time. Indeed, at this stage it is akin to giving a patient with two broken legs another shot of morphine; it dulls the pain for a few hours, but the excruciating pain of the busted limbs soon returns. More LTRO would make a very bad situation even worse, if that is possible. Europe’s banks, especially those in the south, are over-leveraged, and their governments have run out of buyers for their debt. And so it has come to this. Europe must decide, and the choice is binary. Either each goes their own largely separate ways, or they bite the bullet and have a central treasury, which has the ability to issue their own bonds and collect their own taxes from the whole of the eurozone. Southern Europe wants the latter, for very good reasons (they are basically insolvent/broke); France wants it as well, because their national balance sheet also looks dreadful. However, the north (and especially Germany) is resisting, fearing that financial decisions made out of Brussels will be much more accommodating/liberal than those made in disciplined Berlin. That said, the latter continue to weigh up the options. Now that a Greek departure from the euro is looking likely, it may be the case that relatively soon Greece will undertake to pay their debts off, but in (massively devalued) drachmas rather than euros. Under review by European creditors are the legal mechanisms whereby a country such as Greece could be made to pay in euros rather than drachmas. Under the Maastrict Treaty, how enforceable would contracts be in the event that Greece leaves the single currency? And if Greece takes this step (pay in drachmas), what is to prevent Spain (which is imploding in a fashion much like Greece) from taking the same decision, namely to pay their debts off in pesetas? Frankly, if Germany has held out until now, it is unlikely to relent any time soon, notwithstanding the financial hit it will take should southern Europe debase their debts by paying in local currencies. Right now, the best bet is on a messy divorce within Europe.
The MPC’s dilemma. Sterling has been on the defensive in recent trading sessions, not helped by month-end selling and Friday’s very poor manufacturing PMI. The latter fell to a 3 year low, with the details showing new orders falling at the fastest pace for over 3 years (March 2009). The other point to note is the fall in domestic orders outpacing that of export orders, so it can’t simply be blamed on events in the eurozone. Of course, the pound has managed to rise above events in the eurozone to a degree, as shown in the price action on EUR/GBP, which dipped below the 0.8000 level once again towards the end of May. But whilst the record lows on UK yields reflect the fact that it’s not the eurozone (10 year now yielding 1.5%), it’s also the case that it is very much intertwined with events across the channel, not only through the export channel (around half going to the eurozone), but also via the banking sector. Friday’s PMI data make more QE likely, but markets would be right to question the impact of this on both Gilt yields (which are heading lower anyway) and also the wider economy, with the lending numbers earlier in the week showing rising rates (e.g. mortgage rates at 1 year high) and falling credit as households pay down debt. That said, if the weakness seen in the manufacturing PMI is reflected in the services data and other readings through the month (the Bank places strong emphasis on survey data), the Bank will struggle to sit on the sidelines and do nothing.