Saxo Bank Head of FX Strategy John Hardy reports that the euro continues its ascent despite Italian yields continuing to rise with key EURUSD flashpoints at 118.25, 119.25, and of course 1.20.
Article / 08 May 2012 at 13:34 GMT

Hope lies on the far side of a European Summer of Discontent

Chief Economist & CIO / Saxo Bank

We are entering an extremely difficult period for EU policy and its favourite panacea: extend-and-pretend. The event risk calendar is chock full, which means that both tail-risk and systemic risk has risen, which in turn is likely to mean that “risk-off” becomes the main macro theme.To set the scene for the next few months, it’s important to understand where we are in this political crisis. A crisis has three phases.

Phase one is denial: it's someone else's problem, or it’s only Greece (remember the claims that not even Greece would ever leave he EU?). In this phase, no one admits the growing crisis, nor takes ownership: it's always your neighbour’s problem. We’re well through this phase of the EU crisis.

Phase two is protest: as it increasingly becomes impossible to ignore the crisis, everyone looks for scapegoats. In this phase, the easiest (and often most appropriate) targets are the politicians – after all, they are the our countries’ leaders. This leads to protest votes at the polls – voting out who-ever was on watch as the crisis grew, even if the new leaders aren’t promising anything new, and at worst make naïve promises of a return to yesteryear.

This past Sunday we had a nasty anti-austerity/anti-Merkel/anti-EU vote across Europe, including not only the well covered French and Greek elections, but also local elections in Germany and Italy. And these elections are a deepening of election trends already seen in Spain, Denmark, Finland and even the UK.

But the worst part here is not that EU voters are upset, the worst part is that no leaders have stepped forward with a message in favour of restructuring and reform. That’s because they know they won’t find support amongst voters! That's the Europe of today: everyone’s upset, but no one wants to contemplate the real change and reforms required to get our economies back on track. In short, we we have the politicians we deserve!

Mandate for change
Finally, phase three – a mandate for change. This is the phase we have not yet entered. Once we realize we have voted a bunch of opportunists into power rather than bold new leaders, a new impulse will sweep through Europe to boot out the old order and sweep in the new. The last time we saw a real mandate for change granted in Europe was some 30 years ago – to Great Britain’s Margaret Thatcher, who took over only once a completely failed and abject “Sick Man of Europe” had simply had enough and a broad mandate was issued to Thatcher for sweeping privatization and liberalisation reforms. 

The next six to twelve months are likely to see the dawning realization that since the 2008 crisis hit, we’ve yet to change our ways and that drastic, even if painful change is necessary because it is the only way forward if we want to see a sustainable new positive economic cycle.

Where we are, where we're going
So with the crisis phases as our guideline, we can readily identify that we are in the heart of the protest phase. The attempt to implement austerity programs was a clumsy denial phase attempt that has resulted in our current protest phase response: no more austerity, we want growth! Perhaps they and the politicians don’t realize, however, that, as Jeffrey Sachs stated yesterday, “Growth is a result not a policy.”

Europe can’t define a growth policy, but they can implement drastic reforms that might eventually see growth down the road (if they had the mandate, that is!). Those reforms could include necessary changes combining economic reforms (mainly privatisation, higher retirement ages, labour market reforms) with fiscal breaks to write off debt and either an external or internal Euro devaluation to improve competitiveness where it needs improving. As we discuss, above, however, this will not happen in this phase of the EU crisis because the preferred reaction at the moment is the Phase Two protest version of extending and pretending some more.

The economic situation in Europe looks like a lost cause at the moment, but I am not as pessimistic in the long-term as the eventual reforms will inevitably come, the main question being one of timing. In the meantime, the micro economy is always resilient and ready to take over once the macro mistakes are admitted and put behind us. This has happened before in history and will do so again despite the headwinds of Dirigisme and Keynesian policy.

The political agenda/climate:
The EU political situation is very tenuous. Germany is now sitting, albeit involuntarily, as the leader of Europe. Not only do all decisions need Ms Merkel’s approval, but Germans are now sitting on almost all the top jobs in Europe: the heads of the European Investment Bank and EFSF rescue funds are both German and the coming head of the Euro Group will like be German as well.

I do not mind the Germans running European finances, not at all, but having one nation atop too many posts is not pluralist and it results in the inevitable scapegoating. The European Union is supposed to showcase the cooperation of 27 independent nations, instead, we’re seeing Germany we’re seeing too much German dominance. That’s what protest vote against German disciplinarianism is all about.

My biggest concern for the moment is Greek event pipeline. On June 10th or 17th, we will have a second Greek election. It looks like Syriza will become the biggest party and thus secure an extra 50 seats. That will lead to either a minority government with broader political support, or an outright leftist government (if the Communists change tactics). That's bad news! They all want to cease payment of debt and want debt forgiveness.

Furthermore, Greece needs to find EUR 11.5 billion of cuts before the end of June in order to comply with Troika demands - failure will put the next aid distribution payment to Greece in question. Odds are three to one that Greece leaves the Euro, and sooner rather than later. My guess on timing? End of July, early August.

France - when will the market call President Hollande?
In France things are getting complicated as President Hollande’s first challenge will be the appointment of a new Euro group President, as Luxembourg’s Juncker wants to retire by June. Germany's finance minister Schauble remains the favourite. Will Hollande accept this?

After this, Hollande is due to seek a full mandate for... rolling back the existing non-reforms in the Parliamentary election on June 10 and 17th. He seems to have gained the support not only of the left but also the more centrist Bayrou. To me it looks like Hollande will get enough of a mandate to implement some of this traditional, leftist promises, which will be bad for EU but mostly for France. France desperately needs labour reform, more privatisation, a more dynamic environment for SME’s, and a higher retirement age.

Finally, Hollande has promised to work to change the EU “fiscal compact” that has yet to be ratified and promises to hold an extraordinary parliamentary session from July 2nd to August 4th to start his attack on his declared main enemy - the banks, and to roll back among other things the VAT increase that was due in October. This is a big agenda for someone without any management credentials.

Italy - election soon?
In Italy I see a call for an election before the summer is over. Caretaker Prime Minister Monti is under attack. Even the PDL party, which is a major support party for his coalition, is calling for a change to the fiscal compact.. They are calling for a change to the fiscal compact. I guess they can spot a trend?

Germany - to pay or not to pay?
Finally in Germany, the Bundestag and the Bundestag need to ratify the ESM rescue mechanism, which unlike the EFSF is not an insurance scheme, but is intended to be backed by real funds. The session is scheduled for last week in June. This is after the French election and close to the decision on Greek compliance to Troika demands.

So far it has been relatively cheap for Germany to save Europe again and again, but now the price is becoming theoretically infinite liability: a true fiscal union of Europe. Germany agreeing to a full fiscal union is rapidly becoming the only solution to buy more time for the EU.

Europe – a summer of discontent?
The latest themes are arguments in favour of a “growth compact” and agains austerity and the fiscal compact with not one shred of credible means for paying for said compact, unless the ECB is given wider powers to print more money. In Spain, a bad banks bail-out is on the agenda.

It is clear that the politicians are scared and lost and the voters want heads to roll, and no one wants to talk about reforms and real change. This will guarantee an escalation of the crisis and a bring us quickly to a new low point for both politics and the economy – we might even one day call it a European Summer of Discontent. That sounds bad, but the good news is that it might be so intolerable that it finally provides the impetus for real change. In the UK, Thatchers rise came swiftly after the disastrous “Winter of Discontent” of 1978-79. Should we look for a promising path to change in Europe as soon as this fall? Let’s hope so.

Investment environment in coming months
The main thrust of the outlook in the coming months is risk off as markets hate uncertainty. This will generally favour the downside in particularly European equities, even more so for non-German equities in Europe as investors will fret the risk of a longer term currency devaluation. The US dollar should perform well in this environment, as it usually does as the flipside of risk appetite. The outlook for the Euro currency is generally negative, though some of this is priced in and until further notice, it is tougher for the ECB to print money than, for example, the US Fed or BoJ.


benlouro benlouro
very good again! I know that Portugal is not in any case a "thing" to take in equation... but from all "the rest" (of europe) in this specific time is probably to consider as a "good example", don't you think?
Jozsef Jozsef
Great analysis. Doubtful, however, that the suggested policies (labor reforms, privatizations) would offer any solutions? Also, the painful, agonizing exit process can last longer than July/August in case of Greece.
loccogr loccogr
It is good for you all to analyse to death - however, in reality in Greece the governments never really took measures to attack the deficit gap either by not closing down uneeded public sector organisations or stopping wastage, etc. However, at the same time it is OK to spend billions in buying German, French and American guns, submarines. As a Greek I feel that I been lied to every single day of my life by people who make money behind my gap - unfortunately there is no Greek version of Margaret Thatcher.
stupormundis stupormundis
.... watching Michael Portillo on BBC4 I was stunned by the universal support for the Euro among ordinary people in Germany and Greece even though the sytem is manifestly broken. In contrast with universal Euro(as in the currency)-scepticism in the UK I felt more disconnected from the EU than ever. We seem to be held hostage by all our dogmas.


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