Saved by the Pound
On paper, the UK’s fiscal position looks almost as shaky as many of its European peers.
Like most other developed nations, the country spent considerable public money during the 2007-09 recession in an effort to recapitalize the banking system and spur economic growth. The country’s budget deficit topped 11 percent in 2008 and 13 percent in 2009. The nation’s government debt-to-gross domestic product (GDP) ratio was just under 80 percent at the end of 2010, up from less than 45 percent at the end of 2007. Although the UK’s coalition government has enacted some of the most severe budget austerity in the nation’s post-war economic history, Britain’s debt-to-GDP ratio isn’t likely to decline meaningfully under 80 percent until after mid-decade.
Britain’s public-sector debt situation isn’t nearly as dire as that of Greece or Italy; the nation’s debt-to-GDP ratio is similar to that of France and a bit higher than Spain.
Moreover, UK households are deeply in debt–check out my graph below.
Source: International Monetary Fund
According to the International Monetary Fund, UK household debt-to-GDP ratio stands at more than 100 percent, compared to about 90 percent in the US, 50 percent in Italy, 60 percent in Germany and 54 percent in France. Only Ireland and Switzerland have higher household debt-to-GDP ratios than the UK.
The emerging markets–including China, India, Russia and Brazil–really stand out on this graph. With extremely low household debt and rising disposable incomes, these nations are all well-placed to benefit from sustainable growth in consumer credit. Heavily indebted consumers in countries such as the US and UK will remain focused on deleveraging and paying down debts, a headwind for the consumer.
The high household-debt burdens in the US, UK and Ireland are due in large part to the unprecedented housing boom and subsequent bust in all three nations over the past decade. At the end of 1999, the average home in Britain cost a little less than GBP83,000, rising to a high of GBP200,000 in 2007. Over the past three years, home prices have essentially flat lined at GBP163,000, down about 19 percent from their bubble-era highs. Finally, the hard-hit banking industry is central to the UK’s economy, hardly a favorable characteristic in today’s market environment.
Despite this litany of significant negatives, check out my graph below.
This graph illustrates the 10-year yields on government debt for a number of EU countries. There’s a major divergence evident in this graph, particularly over the past few months. Yields on debt issued by more fiscally troubled EU nations such as Italy and Spain have soared; earlier this week, the yield on Italian 10-year debt soared well over 7 percent, a level considered unsustainable.
But even as yields have soared for the PIIGS (Portugal, Italy, Ireland, Greece and Spain), concerns about weak economic growth and fiscal austerity have promoted traders to look for safe havens from risk. Germany, considered the most fiscally sound of the big eurozone nations, is one logical destination for safe-haven flows and the yields on German government debt have plummeted from highs of close to 3.5 percent earlier this year to recent lows under 2 percent.
France’s 10-year debt also acted as a safe haven for much of the past two years. But starting last summer, the nation’s borrowing costs began to spike rapidly as investors grew increasingly concerned about the nation’s fiscal position and the potential for a downgrade to France’s credit rating. Another major concern for France is the country’s banks have significant exposure to debt issued by troubled EU nations like Italy.
Despite the country’s economic headwinds, UK government bonds, known as gilts, have remained a safe-haven investment in Europe. The 10-year gilt currently yields less than 2.3 percent, more than 1 full percentage point (100 basis points) less than 10-year debt issued by the French government. This is a major reversal of fortune as, for most of the period covered on my chart, the UK’s borrowing costs were actually higher than those for France.
This remarkable divergence reflects several factors, including the British government’s credible set of austerity measures to bring down the country’s sovereign-debt burden. But the most important point to note is that the UK does not use the euro and its government debt is denominated in pounds sterling.
The long-standing structural weaknesses of the European single currency have been laid bare in recent years. In the long-term, it’s not sustainable for individual European nations to retain control over their national fiscal policies while allowing monetary policy for all euro nations to be controlled by the European Central Bank (ECB). Countries such as Greece, Spain and Italy enjoyed a major decline in borrowing costs as a result of their entry into the eurozone, and these artificially low rates undoubtedly helped fuel the sovereign-debt bubble. Consider that at the beginning of 2008, Italy’s 10-year bond yielded 4.46 percent, just 33 basis points more than German 10-year debt.
If Italy still used the lira, the value of that currency would have undoubtedly declined sharply against the euro and other global currencies. This would have effectively delivered a haircut, easing the nation’s credit burden. A weaker currency would also have boosted competitiveness by making Italian goods less expensive in foreign currency terms and making the nation a cheaper destination for tourism. Because investors would presumably demand higher interest rates to buy lira-denominated debt, the country may not have been able to run up such a massive debt burden.
The UK has been able to follow a far looser monetary policy than the ECB over the past few years–aggressively cutting rates and instituting several rounds of quantitative easing. The value of the pound has declined against the euro–at its highs in early 2007, the pound was worth about EUR1.53 compared to a low of about EUR1.025 in late 2008 and EUR1.17 today. If the UK had adopted the euro, you can bet that yields on gilts would be firmly in the market’s crosshairs today and the country would not enjoy some of the lowest borrowing rates in the developed world.
The Current Outlook
The past week has been light in terms of major economic data. The good news is that the scraps of data we have received continue to look solid for the US; fourth-quarter GDP growth looks likely to come in at 3 percent or more, it’s fastest pace since early 2010.
The Citigroup Economic Surprise Index–a measure of how incoming economic data compares to consensus forecasts–has been trending steadily higher since early June and recently reached its highest levels since April. The most important data point released this week was initial jobless claims–check out my graph below for a closer look.
This graph shows weekly data on initial claims, the number of people filing for first-time unemployment benefits. Because the raw weekly data can be volatile from week-to-week and is subject to significant revisions, most economists also watch the four-week moving average of claims. Because jobless claims are released weekly and offer a real-time look at the employment market, they’re considered one of the more important leading indicators of economic activity. That’s one reason that claims are a component of the Conference Board’s Index of Leading Economic Indicators (LEI).
The sharp rise in claims starting in March and April was among the first concrete signs of the economic soft patch. But since summer, the four-week moving average has been steadily declining and now sits at the lowest level since the first quarter of 2011, when the US was adding 200,000 or more private payrolls in some months. The raw data showed just 390,000 claims, around 10,000 fewer than the consensus expected and the lowest level since last spring.
The severe sell-off in global stock markets on Wednesday was due to the spike in Italian bond yields well over 7 percent, a level considered unsustainable in the long term. The market remains concerned over Rome’s delays in implementing a credible austerity plan to bring the budget back into balance and reduce the country’s sky-high public debt burden. Two additional factors exacerbated the selling: concerns about the credit default swaps (CDS) market and changes in margin requirements.
As to the first point, credit default swaps are a form of insurance on debt; if a country or corporation defaults, CDS make the investor in that debt whole. The problem is that in late October, EU leaders agreed to a plan in which banks are effectively writing off half the value of the Greek debt they hold. The EU held what amounts to a gun to the bankers’ heads, threatening a disorderly default and market chaos if they didn’t agree to the haircuts. This deal was technically “voluntary” because the banks agreed to the cuts. Because the deal was ostensibly voluntary, the reductions aren’t considered a default, even though the haircut is a default in every other sense of the term.
That means that CDS won’t protect investors. That cozy deal between the EU and banks calls into question the value of the CDS market. After all, if governments and banks can get together and reduce the value of bonds without technically defaulting, CDS don’t offer much insurance.
This makes Italian bonds less attractive for investors. Some investors have been willing to buy Italian debt because they thought they could hedge those bonds using CDS. That looks like a dubious assumption. That leaves only one way to pare exposure to Italian bonds: sell. This is a good example of how market manipulation can have significant undesirable and unintended consequences.
The second issue is collateral requirements on Italian debt. This means that firms using Italian debt as collateral to borrow money now need to post more collateral. This makes it more expensive to buy and sell Italian bonds, forcing some traders to partially liquidate their holdings.
The severity of Wednesday’s sell-off is a good indication of how sensitive markets remain to headlines out of Europe. But once again, Europe appears to be giving the markets what they want. In particular, Greece has sworn in Lucas Papademos as Prime Minister, replacing Socialist leader George Papandreou. An MIT graduate and former Vice President of the ECB, Mr. Papademos is one of the most respected economists in Europe and will head a coalition “unity” government tasked with implementing much-needed reforms. This is a huge market positive as it adds significant credibility to Greece’s austerity plans.
Italy appears headed for a similar outcome. On Friday, the Italian Senate passed a major austerity measure which is headed for the nation’s lower house on Saturday. As soon as the Italians pass the austerity measure, Prime Minister Silvio Berlusconi is due to resign. The most likely outcome is some form of technical government headed by Mario Monti, a respected economist and international advisor to Goldman Sachs. Like Papademos in Greece, Monti’s government would be tasked with implementing tough austerity measures ahead of a new election at some point in 2012. This is shoring up confidence that the Italians will muddle through with planned austerity–10-year Italian government bond yields have plummeted more than 100 basis points off their highs.
Across the pond, the US corporate bond markets have seen little negative impact from Europe’s troubles. In the first 11 days of November alone, US high-yield issuers have sold nearly $16.5 billion worth of bonds. To put that into perspective, high-yield issuers sold only $25.2 billion in debt in the entire third quarter. There is no global credit freeze resulting from Italy’s debt travails.
Bottom line: A US recession looks increasingly unlikely over the next two quarters and the EU continues to muddle through its current difficulties. I expect a continuation of the recent rally in the S&P 500 through year-end.