Italy’s Crisis is Also a Global One
TCW Asset Management
By Komal S. Sri-Kumar
November 9, 2011
I have stressed repeatedly that the single most important risk indicator to watch in Europe – and, by extension, for the global economy – is Italy’s ten-year bond yield. Italy’s €1.9 trillion in total public debt makes the country too big to save. After rising to over 6% in recent weeks and stubbornly staying above that critical level, the yield surged by over one-half percentage point today to more than 7.25%. Just as important, the ten-year German bund, the region’s “safe haven,” fell in yield to 1.72%, pushing the Italy – Germany yield spread to a record high 5.50 percentage points. Clearly, the market is suggesting that Italy is not too far behind Greece in either being forced to restructure its debt, or default on its obligations. Reinforcing the seriousness of the situation, Spain’s ten-year bond yield shot up to 5.8%, also approaching the 6% danger level. Most worrisome of all, the France-Germany spread rose to a record 1.5 percentage points, making France a very weak AAA. The risk of a downgrade by one or more rating agencies has risen significantly.
Heightened Risk of a U.S. Double-Dip Preliminary official estimates indicate that U.S. real GDP rose by 2.5% in the third quarter, posting faster growth than in the earlier quarters. It is too soon to say, however, that the U.S. economy has dodged the double-dip bullet. My concern from over a year ago about a second recession has been built on several potential risk factors:
1. Surge in U.S. Treasury yields following an inability of the Obama administration to show a clear exit strategy from high annual fiscal deficits. While deficits remain at high levels, Treasurys have actually fallen in yield as the U.S. fiscal profligacy is seen as heightening global risk even more than U.S. risk. Even before the S&P downgrade of Treasurys in August, I switched my anticipation to lower yields due the greater importance of the United States as a safe haven.
2. Flight from the dollar due to concerns over an unending series of Quantitative Easing by the Federal Reserve. Here, even though Chairman Bernanke keeps open the possibility of a QE3 if the economy needs it, market concerns have resulted in the dollar remaining weak rather than a full-scale capital flight. Europe’s debt problems meant that there is no “safe” capital market large enough to accommodate a massive flight from the U.S. dollar.
3. Persistent weakness in consumer spending as U.S. households are discouraged by the continuation of high unemployment rate. With household expenditures accounting for around 70% of GDP, it would be difficult to contemplate sustainable economic growth without the consumers participating. Acceleration in GDP growth to 2.5% in the third quarter resulted from increased consumer spending on durables, as well as a surge in business investment. Figures for September suggest, however, that nominal disposable personal income declined by 0.1% even though nominal personal consumption expenditures rose by 0.6%. The divergence suggests that the consumer spending growth is unsustainable.
4. The European debt crisis becomes widespread as the regional leaders – Germany and France – are unable to build a firewall around Greece. It has become persistently, and increasingly, clear since the Greece “bailout” of May 2010 that the European leaders lack the ability to end the crisis promptly. With the Eurozone’s GDP roughly comparable to that of the United States, European problems would have an inescapable impact on U.S. and global developments. This appears to be the clearest risk factor for the U.S. and global economies over the next year.
Even though U.S. real GDP rose by an estimated 2.5% in the quarter just ended, it is important to note that only in this quarter did the level of U.S. real GDP return to its pre- December 2007 (i.e. pre-recession) level. In other words, if economic recovery is defined as a return to growth, the U.S. recovery has just begun! And as noted above, with so many risk factors affecting the future path of the U.S. economy, slow economic growth involving anemic job creation heightens the risk of falling back into recession. We just do not know which risk factor will eventually prove to be the determinant one.
The ongoing debt crisis may provide the answer. The European Union is likely to show near-zero growth in the final quarter of 2011 and go into recession in the first half of 2011. New austerity measures announced yesterday by France’s Finance Minister, François Fillon, will probably push the economy deeper into recession even though it may not succeed in saving France’s treasured AAA rating. Even the new European Central Bank President, Mario Draghi, uttered the “R” word last week in forecasting a “mild recession.” Finally, the European recession may be the straw that broke the camel’s back. With a significant portion of S&P 500 corporate earnings coming from trans-Atlantic developments, Europe’s problems may ultimately turn out to be the factor that moves the U.S. economy from lackluster growth to an actual decline in the level of GDP.
(c) TCW Asset Management
