What’s Ahead for the Eurozone?

Investors are growing increasingly concerned as each successive proposal in Europe has fallen flat. While the deals have bought time, they have failed to make substantive improvements. Ominously, each failed attempt engenders ever more skepticism that Europe has the political will and economic savvy to fix the problem. This has left clear-eyed investors with one burning question: What is a real end game to all this posturing?

At this point, it looks like European leaders, led by Merkel and Sarkozy, will gravitate towards one of the following three remedies, or perhaps a combination of all three:

• European leaders will approve a massive new financial package (on top of all the previously created facilities) to cover the debt and deficit financing needs of the PIIGS.
• More moves will be made to enact greater fiscal and political integration within the European Union. These changes will allow the more solvent countries (read: Germany) to exert great fiscal control of the prodigal countries.
• The European Central Bank (ECB) will follow the lead of the Federal Reserve and come to the rescue as a lender of last resort, effectively guaranteeing the debt of the troubled nations or creating credit lines in their behalf.

But each of these “solutions” has major roadblocks, and we don’t see any meaningful changes until Germany and France have devised, launched, and ultimately lamented more doomed half measures. This process may well stretch into 2012-3.

A new financial bailout would likely require funds in the order of 1 trillion euros, a quantity of cash we believe is much higher than could be drawn from some mixture of the IMF’s 290 billion euro forward commitment capacity, the E.U.’s 250 billion euro Financial Stability Facility (EFSF), and various other smaller sources. We don’t know where that cash could come from. Although the extension of German political control may be enticing to the German ruling class, it will be significantly less popular among the rank and file, especially if it involves the commitment of more bailout funds to profligate neighbors. In addition, the legally complex and time-consuming measure of greater integration would likely take many months, if not years, and would probably face staunch opposition from key countries, such as the U.K. and Ireland. The third option, which would turn the ECB into a lender of last resort, runs afoul of E.U. treaties and would likely be politically untenable in Germany.

Our bottom line: We see an unavoidable resolution likely coming about via a voluntary default on sovereign debt by overly indebted counties and their possible exit from the Eurozone. Those countries that remain will likely have much better finances and will likely be more closely aligned with German economic policies. This could result in a more stable and powerful economic bloc of  fiscally responsible central and northern European countries, most notably Germany, that would share monetary and fiscal ties. Lastly, in order for any restructuring to have long term viability, we must see significant structural changes in France, which up until now has somehow avoided the budgetary limelight (see article in this newsletter by Andrew Schiff).  

Contrary to what many analysts project, we see the further deterioration of the European experiment as likely a positive development for the Euro in the medium- to long-term. Germany’s determination to avoid devaluing its currency as a means of escaping its current predicament stands in sharp contrast to the behavior of the United States and other OECD nations. Furthermore, removing the fiscally reckless countries like the so-called Club Med from the Eurozone may help move the Euro higher, as the economic appeal of the new group may better draw assets into the region and investors develop greater confidence in its budgetary position.

While many non Eurozone countries, most notably the United States, are struggling in the wake of the financial crisis, Eurozone members face the unique dilemma of being unable to reduce their debt load through currency devaluation. Greece, Spain, and Italy struggled with debt even before the crisis, and are now doubly wounded by the high yields they have been forced to offer. In the not-so-distant past, Americans might have smugly wondered why countries with such obvious debt issues would so blatantly refuse to swallow the bitter pill of fiscal reform. But the last few months of ineffectual Supercommittees and political paralysis in Washington have shown unmistakably that politicians on this side of the Atlantic are no more capable of putting their country on sound budgetary footing than their Old World peers.

However, we take pains to note that the European crisis is essentially a political struggle rather than an intractable financial quagmire. Sooner or later the continental powers will get on the same page and fashion a solution that will provide clarity and a legitimate path forward. Unfortunately no such solutions are currently even imagined here in the United States.     

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The Corporate Cash Myth
By: Neeraj Chaudhary, Investment Consultant

A central theme that has absolutely permeated the coverage of the Great Recession is that over the past few years US corporations have cautiously hoarded cash and have stubbornly refused to invest in corporate expansion. Some have described this as a nearly irrational timidity on the part of the private sector and has for many justified the currently robust intervention from the public sector in the form of deficit spending, fiscal stimulus and monetary accommodation. The saying goes that if companies won’t spend, government must pick up the slack to restart the economy. The story has been repeated so frequently and so often, that its veracity is rarely questioned.

The idea of “do nothing” corporations shirking responsibility fits neatly with the rhetoric coming out of the “Occupy Wall Street” movement which condemns the wealthy for doing little to help the economy. As proof of the story, many have pointed out that corporations have amassed a war chest on the order of $2 trillion. It is argued that millions of American jobs could be created if this money were to be put to work expanding corporate operations.

Unfortunately, facts have a pesky habit of mucking up an otherwise well tailored story. While it’s true that US corporations have a record amount of cash on their books, as is widely reported, they are also carrying a record amount of debt, which is hardly reported at all. The chart above tells the story succinctly. Since 2005, U.S. corporations have added a half a trillion dollars of cash to their balance sheets. While that sounds like a lot, they have simultaneously added more than three times that ($1.8 trillion) in debt. Given the exposure that the debt creates, carrying large cash reserves should be viewed as an act of fiscal responsibility rather than unnecessary frugality. Sadly, like the rest of our struggling republic, many American companies are on the ropes, perhaps one good punch away from a knockout. With a high percentage of consumers and all levels of government still drowning in debt, it’s very fortunate that at least one sector has cash in reserve.

To be clear, high levels of corporate debt is nothing new in the United States, where leverage has been on the rise since at least the early 1950s. But in recent years the trend has accelerated dangerously, most likely driven by the same factors that are encouraging debt in other sectors, namely a distortive tax code and artificially low and distortive interest rates.

On the tax side, two factors that have helped play a key role in this story are the double taxation of dividends by the federal government, and the deductibility of interest expenses.

All corporations pay taxes on their income, typically at a rate of 35%. Out of what remains, many pay dividends to shareholders. But once a shareholder receives that dividend, it is taxed again (most taxpayers pay a rate of 15% on qualified dividends). The fact that the same dollar of corporate income can be taxed at two different times reduces corporations’ preference to raising equity when seeking to expand their business. Additionally, when a business takes out a loan or issues debt, the interest payments made to the lender or bondholder are generally tax-deductible. Together, the double-taxation of dividends and the tax-deductibility of interest expenses incentivize corporations to take on debt rather than issuing equity when they need to raise capital.

Of course, these factors have been in place for many years, and yet for much of that time, corporate debt remained within a fairly narrow range. In 1952, debts of nonfinancial US businesses amounted to roughly 30% of GDP. By 1981, these debts had reached about 50% of GDP; a bit on the high side, but certainly not terminal.

The variable that has likely caused corporate debt to balloon is the zero percent interest rates that have been, and will continue to be, the policy of the Federal Reserve for years to come. This ultra cheap money has made debt creation nearly irresistible. 

It is the Greenspan-Bernanke policy of historically low interest rates that has provided a catalyst for higher borrowing in recent years. When Alan Greenspan took over as Chairman of the Federal Reserve in 1987, the ratio mentioned above stood at approximately 60%. After dipping briefly in the 1990s, corporate leverage took off in the middle of the past decade and recently peaked at 80% of GDP – more than double the level of 60 years ago.

Despite the seemingly large amount of cash held by US corporations, their debts far outweigh the balance in their collective bank account. According to the most recent Flow of Funds report published by the Federal Reserve, US corporations have approximately $7.3 trillion in outstanding debt; the oft-quoted $2 trillion of cash sitting on corporate balance sheets pales by comparison. If borrowing costs were to rise, corporations would need every dollar of their available cash to keep from going under.

Another key factor that is under reported in the “cash on the sidelines” story is that up to $1 trillion of the cash held by US companies sits outside American borders, where it is essentially unavailable to fund US operations. While vast amounts of capital can move across international borders with just a few keystrokes, the repatriation of cash generated by US international subsidiaries could result in a huge tax liability. The balances reported in the press do not take into account these taxes. As a result, the amounts quoted by the press are overstated. But even if we ignore the impact of taxation, and simply assume that all cash is available to pay down debts, American businesses still owe far more in debt than the cash they have on hand.

The death blow to US corporations could come when US interest rates rise to historically normal levels. A four-percentage-point rise in the interest rates paid on debt by US corporations would cost them nearly $300 billion per year in additional interest costs. That amounts to 17% of corporate profits for all of 2010. When faced with rising interest costs that cut into profits, companies will likely look to cut expenses in all areas, including labor. This could start a vicious cycle of corporate cutbacks, declining household income, reduced aggregate demand, and slowing production, which would start the cycle all over again. 

In short, despite huge amounts of cash on their balance sheets, America’s largest companies are as broke as the rest of the country, and not only are they in no position to hire workers, but higher interest rates could result in more layoffs at a time when the nation can least afford it. Given these factors, economists, journalists and politicians should be applauding corporate cash reserves not deriding them. Given that a real recovery will not come until America as a country has paid down some of its debt, we should not be urging our corporations to throw caution to the wind. 

Neeraj Chaudhary is an Investment Consultant with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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J’Accuse! French Debt Threatens
By: Andrew Schiff, Director of Communications & Marketing

As the debt crisis continues to roll across Europe, there has been a fairly reassuring theory that the majority of the problems has been, and will continue to be, contained in the most flagrantly indebted countries like Greece, Spain and Italy, and that damage in the northern tier would fall primarily on northern banks that had foolishly loaded up on the sovereign debt of the offending southerners. According to this belief, the Eurozone will benefit from the solidity of its two main pillars: France and Germany, its two largest economies and the biggest supporters of the European Financial Stability Fund (EFSF). Unfortunately, one of those pillars has deep cracks of its own. A recent report issued jointly by Brussels-based think tank, The Lisbon Council and the Berenberg Bank states that France has fallen to 13th out of the 17 Eurozone countries in terms of economic health.

The Lisbon Council Report, released on November 15, details how France has the largest share of government expenditure as a percentage of GDP in the Eurozone. It also ranks the country 15th in competitiveness, 14th in fiscal sustainability, and 11th in growth potential. In terms of overall health, France is one place ahead of Italy but behind Ireland and Spain, both of which are believed to be near bankruptcy. Perhaps more damningly, France ranked 15th among member states in what the Council terms “adjustment progress,” which it defines as steps that Eurozone members have taken to improve long term financial sustainability in the years since the debt crisis came into full view in 2008. In other words, while formerly "do nothing" countries like Italy have shown some willingness to take drastic steps, Europe’s second biggest economy is burying its head in the sand.

The Lisbon Council report reiterates some of the concerns first raised by Moody’s in October when the rating agency warned that it might change its stable outlook on France’s rating to negative. Since the release of the Lisbon Report, the three top ratings agencies have all warned that France’s AAA rating may be downgraded if economic conditions worsen.

The markets have indeed taken notice, and are already treating French sovereign debt as if the downgrades have already occurred. Bill Blain, a strategist at Newedge Group in London, was quoted in Reuters on November 22 saying that, “France isn’t trading like a AAA,” and that, “The market has made its judgment already.” (For those who may have been confused by the rally in US Treasuries that recently occurred after the downgrade of the United States, typically, a lower debt rating causes prices of the offending paper to fall.)

On November 17, the gap between French and German 10 year bonds was 200 basis points, the largest difference since 1990. In April, the gap was only 28 basis points. As of November 23, the difference had fallen slightly to 168 basis points but French 10-year bonds were still yielding 3.69%, over a full percentage point higher than UK bonds. These are significant movements, which perhaps have been somewhat obscured by the much more watched yield spikes in Italian sovereign debt, which has recently closed in on the scary 8% level.

French President Nicholas Sarkozy has promised to maintain the country’s credit rating. According to Bloomberg, he recently announced 18.6 billion euros in tax increases and spending cuts aimed at decreasing the country’s deficit to 3% of GDP next year. This may be just a drop in the ocean. France has one of the most fully realized welfare states in all of Europe, and many powerful political blocs in the country have become extremely active in their defense of the status quo. The ire of French unions is legendary, and no one doubts that they will flex political muscle when the time comes. In the meantime, the country has debts equaling 85% of GDP, the highest among top rated EU member states. French banks also hold the largest amount of debt from the five EU countries hit hardest by the debt crisis, at 681 billion euros. If the country’s nearly 160 billion euros in guarantees to EFSF are called in, its debt will climb to around 95% of GDP, a number that approaches Greek proportions.

Right now, no ratings agencies or outside observers are guaranteeing a downgrade in France’s credit rating. That being said, the country’s financials are clearly a lot flimsier than they should be and the French government is very exposed to the European debt crisis. Hopefully, if French debt continues to fall in value and debt services threaten to overwhelm the country’s fragile financial sustainability, the French government and its notoriously squabbling political players will recognize the ugly reality, get down to brass tacks, and make difficult choices. But a country that is famously enthralled with its own exceptionalism may feel that it has prerogatives that lesser nations lack. In that sense, France and the United States may be much closer in temperament than either nation would care to admit.

But if France refuses to change its ways, and fails to take significant steps to improve its “adjustment progress,” the crisis in Europe could be greatly accelerated and magnified. From my perspective, a 6% yield on French 10 year bonds may be enough to bring the Eurozone crisis to its dénouement. If the French need a bailout, the party will be over.

Andrew Schiff is Director of Communications & Marketing with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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Commodities Run in Supercycles
By: Euro Pacific Capital Research