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Silvia Quandt & Cie. AG, Merchant & Investment Banking: In-between the lines – Bernhard Eschweiler
Silvia Quandt & Cie. AG, Merchant & Investment Banking / Schlagwort(e): Sonstiges – Greece becomes sideshow as confidence in Euro recovers . – . and economic news improve – Target2 balances reflect ECB’s interbank policy and not transfer payments – Deleveraging, however, means the party will not last forever The equity rally has taken a breather for the last few days, partly triggered by worries over tensions in the Middle East, but a lasting change in direction seems unlikely. Market optimism reflects signs that global economic activity is reaccelerating and rising confidence that the Euro debt crisis will not spiral out of control. From Germany, the key news this week was the better-than-expected February IFO survey, which provides further evidence that the economy is recovering from the soft patch at the end of last year. Of course, trouble spots such as Greece remain. The second Greek bailout package is highly conditional and could fall apart in a few weeks if Greece fails to implement the promised reforms. But the risk of a Greek default is troubling markets less. Especially the ECB liquidity injections, which are spreading from the banking sector into sovereign bonds, have been instrumental in turning confidence. All the good news, however, should not disguise the fact that we are in the middle of a deleveraging period. That means economic and market cycles are shorter. The party is not yet over but may not last as long as in the good old days. Target2 balances and ECB liquidity measures The return of confidence is visible across financial markets. Equity markets have taken the lead followed by sovereign and bank credits. The 10-year PIIGS spread over Bunds, for example, dropped 150bps since the start of the year. Liquidity measures have also improved. The 3-month OIS-Euribor spread fell from 101bps to 67bps. To be sure, the interbank market is still impaired, but a meltdown has been averted by ECB liquidity injections. Encouragingly, after hitting record highs in January, bank deposits at the ECB have dropped visibly in the last weekly report (from EUR508 billion to EUR454 billion). Further success in stabilizing the Euro debt crisis should also result in a gradual decline of the Target2 balances, which some commentators view as hidden fiscal transfer from Germany and a few other core countries to the periphery. The surge in Target2 balances (positive and negative) is a reflection of the ECB’s policy response to the collapse of the interbank market and not a design flaw that makes a few surplus countries pay for the debts of the deficit countries. If the latter was true, not the Germans but the citizens of Luxembourg would be the biggest losers (per capita Target2 claims in Luxembourg are about a quarter million Euros versus just about EUR6000 in Germany). According to the latest Target2 figures, the imbalance between surplus countries and deficit countries exceeds EUR800 billion, an increase of more than EUR400 billion from a year earlier. The rise is much larger than what could be explained by current account imbalances. In fact, Austria and Belgium had current account surpluses yet their Target2 balances slipped further into the red. Instead, the main source of current imbalances within the Euro area is capital flows. Those capital flow imbalances, however, equate only into similar Target2 imbalances if the ECB accommodates banks’ liquidity needs. By granting the banks unlimited liquidity at low rates and relaxing collateral criteria the ECB prevented a financial crisis that would have been much worse than the Lehman crisis. Interestingly, ECB claims versus the banking system increased by about the same amount as the increase of Target2 imbalances over the last year. If the ECB would conduct its liquidity operations directly with the banks and not through the NCBs no smart German professor would have spotted it. Reducing the Target2 balances, which means healing the Euro-area interbank market, will take a long time, but there are some positive signs. Ireland reduced its negative balance by EUR29 billion in 2011. Portugal’s banks needed no additional liquidity support last year and the same has been true for Italian banks since the start of the year. Deleveraging changes cyclical patterns Better economic news, more stability in the Euro area and improved market sentiment cannot change the fact that the major industrialized economies, especially the US and much of Europe, are in a deleveraging period. That has far reaching economic and financial implications. For the real economy, deleveraging causes lower trend growth as well as higher output volatility. In particular, upswings are not amplified and extended by the creation of credit. As a result, the impact of short-term factors such as inventory swings, tech cycles and shocks like the Japanese earth quake or the Thai floods becomes more pronounced. Indeed, most major economies have already undergone two up-and-down swings since the financial crisis and are currently entering the third upswing. The positive momentum in leading indicators will probably last into the second quarter, but the probability that this will be followed by another downswing increases toward the middle of the year. The German economy is not plagued by excess leverage. In fact, the earlier restructuring means that its growth potential has probably increased. However, that does not insulate Germany from the short-term swings in global activity. Deleveraging has a similar impact on financial markets as on economic activity. This is most visible in equity markets. Equity markets trace the movements in economic activity closely. Thus, more economic volatility means also more market volatility. This is further compounded by the structural withdrawal of long-term investors, such as insurance companies, from risky assets such as equity. Deleveraging leads also to lower equity valuations. The DAX PE ratio, for example, is currently a third lower than its pre-crisis cyclical average. Companies use less credit to raise shareholder value, while the demand for stocks is restrained by the lack of leverage. Higher cyclical volatility and lower valuations means that equity markets will behave more like trading markets. For the DAX, the trading range is probably between 5,000 and 7,500. Disclaimer This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 24 February 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt. 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