Treasury Today Country Profiles in association with Citi

An Atlantic fault line? The US fiscal cliff and euro crisis explored

This week’s Global Research Macro Mid Year Report from Bank of America Merrill Lynch (BAML) outlined the challenges the global economy faces for the second half of the year, particularly in the US and Europe. A panel of the bank’s analysts discussed the findings in their London financial centre.

Ethan Harris, the bank’s chief North America economist explained that the US is currently experiencing slow growth of around 2% to 2.5%. This is not a great position to be in with the current euro issue. Europe is a serious problem for the global economy due to linkage and its effects on confidence.

Before even considering the impact of the euro crisis, the US has its own economic problems to deal with, in the form of the ‘fiscal cliff’. This is a near perfect storm of factors where, on one hand, tax cuts from the previous presidential administration, extended unemployment benefits and a payroll tax holiday will expire. But, at the same time, the Spending Control Act comes in to play with federal budget cuts. The fiscal cliff is running at around 4.5% of US GDP. Harris suggested that, while the US is not going over the fiscal cliff, it will have a negative impact on the economy in the second half of 2012 – and this is even before the Europe effect is taken into consideration.

Richard Thomas, credit research analyst at BAML, pointed out that in the long-term, the US has the best fundamentals to deal with a reduction in government spending when compared with other regions. The US dollar is a currency safe haven, something that has been seen in the equities and fixed income markets – take, for example, the rush to invest in the greenback after Standard & Poor’s downgraded the US’ credit rating last August – while the price of credit is comparatively low. The US is also investing in its large natural resources, such as oil and gas, which is giving a boost to the economy. Compare this to Europe, particularly the Eurozone, where the crisis is a crisis of capital, there is stagnation and low growth.

Across the pond

Looking at Europe, discussion moved to speculate what form a ‘Lehman-style event’ could take. Harris suggested that Greece leaving the euro would not be as bad as that, but that in the worst-case scenario a Spanish exit could prove to be. While the crisis keeps intensifying, the policy makers seem to be one step behind the whole way, he argued. When policy becomes completely impotent, a Lehman-style event could occur. In such an event, there is nowhere to hide, as all asset classes will be in trouble. Again, this was not a forecast of what will happen, but rather a worst-case scenario of what might.

In this environment, how do you stabilise the European banking market? While the European Central Bank has done a great job as a lender of last resort, it is now at the absolute limits of what it can achieve. The point was made that the vulnerability in Spain was not largely related to the events in Greece, and that instead it was a problem existing within its second tier banks. This is something that is less likely to be seen in second tier banks in other countries, as it was the real estate boom in Spain that particularly hurt these financial institutions. You couldn’t say the same thing about Italy, for example.

The current base case scenario that the BAML experts outlined is that Greece will remain within the Eurozone and that Spain will stabilise. While there will be an election in Greece this Sunday – 17th June – it was noted that all of the major political parties in Greece are in favour of staying within the European currency. The Greek establishment is largely in favour of the euro project, and the Eurozone members are currently of the same opinion.

When asked what the next potential trigger would be that would make policy makers get involved in the euro crisis, Gary Baker, head of European equities strategy at BAML, outlined that the bond market is where the pressure is. Baker highlighted the reaction to the recent Spanish bailout from the Eurozone as an example of this. The next six months is crucial for the Spanish banking sector, and the reaction to the bailout has been muted to say the least. It was noted that the way you actually do a policy is as important as the policy itself. A lack of decisiveness can mean that the decision that needs to be taken gets bigger. The bond markets themselves seem to have learned that to get proposals from the policy makers, they need to apply constant pressure.

In amongst the doom and gloom for Europe, there were a few positives to take away. While Italy does need more support, there is no sense that there is a hole in the economy that needs filling. There is a capital flow from Italian banks to the rest of the world, but critically there is not a trend for this happening from domestic accounts. Raffaella Tenconi, EEMEA economist with the bank, commented that while Italy does not have a credibility problem at the moment, some support could aid areas such as cost of capital for the corporate sector.

So where does all this leave corporates? Thomas noted that many companies are refinancing in equal or better terms that last year, while most European banks currently have fairly static balance sheets, and are renewing business rather than adding new business. On the other side of the same coin, Baker pointed out that while banks may have started to slightly relax their borrowing criteria, they are not seeing a huge amount of take up from corporates who are wary of extending their lending. Corporates are instead focusing on developing their own cash buffers. It is unlikely that this situation will become unblocked until there are greater policy shifts.

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