Europe's Debt Mess and China Slowdown

Posted: Jul 22, 2011 12:01 AM
European Debt Crisis. European equities and the euro did a full reversal today, rising out of negative territory as details emerged on preparations for today’s European summit.  We note several positives:
1) Germany continues to make very clear comments about its focus on the euro.  We think a breakdown of the euro system – any country converting euros to local currency – is the only big risk to the global financial system.  The other issues are important in dividing up the losses on the bad debt and stopping economic contagion to Italy and Spain, but won’t have much impact on the global outlook.  

2) The ECB will make its own determination of default, undercutting the pro-cyclicity problem caused by the non-transparent CDS market and bond ratings.  It allows the ECB to continue providing funding mechanisms, while ruling out a tax on banks. 

3) The maturity of EU loans may be extended to 15 years from 7.5 years.  The interest rate on EU loans (and IMF loans, we think) may be lowered to 3.5% from roughly 5% forGreece, with positive implications for Portugal and especially Ireland.  

4) Some private sector creditors may extend their Greece maturities to 15 years. 

5) The European Financial Stabilization Facility may be given the latitude to lend to countries which are not under an IMF program, breaking the decades-long link between public money and the often anti-growth IMF austerity programs.  The EFSF may also be allowed to buy sovereign bonds in the secondary market, therefore allowing the EU’s very low borrowing cost to arbitrage the high yields the CDS market has been assigning to the debtor countries.  Our view: Europe has many techniques to continue buying time as its leaders pour new public money into the debt crisis and many banks add capital through earnings.  We’re pleased with the Merkel/Sarkozy bedrock support for the euro itself.  
The U.S. debt limit still looks headed for a last-minute mini-deal with a smaller increase in the debt limit in return for scaled-down spending cuts (see our July 11 piece on the mini-deal.)  We don’t see much future for the Gang of Six or the CCB (Cut, Cap and Balance) legislation.  The President doesn’t have anything on the table.  The stakes are high, not so much because of the possibility of a ratings downgrade (expensive, but not very harmful) but because a progressive shutdown of payments starting August 2 would be more traumatic than supporters recognize.  This trauma points to a scaled down deal in which the debt limit is increased by $800 billion or so in order to get to December with equivalent spending cuts attached and presumably a tacit agreement to find more spending cuts.  The President has said he doesn’t want this, but if the House passes a mini-deal, the Senate and President will have little choice but to agree.
U.S. jobless claims rose to 418,000 last week from an upwardly revised 408,000 the previous week.  This reflects continuing weakness in the U.S. labor market.  We’ll be watching data on small-business job growth from ADP and the household survey and also auto sales for July.  If growth is improving, there should be a further decline in the four-week moving average in jobless claims (421,000 today) – though we don’t expect a big decline in claims since job turnover has been low and needs to pick up some.  The impact of the Minnesota government shutdown ended, contributing only 1,750 claims last week.    
Regarding China’s slowdown, HSBC’s PMI manufacturing index fell to 48.9 in July from 50.1 in June.  This index is only five months old, starting in March at 52.5 and falling gradually since then.  China’s GDP was reported at 9.5% year-over-year in the second quarter, slightly below the 9.7% in Q1.  China’s new quarter-over-quarter data showed second quarter growth faster than first quarter growth.  China’s retail sales have been strengthening, with June 17.7% above June 2010.  Industrial production is following the same strengthening pattern and is up 15.1% yoy in June.