Evercore Pan Asset

In the last year China has been assailed by a wide range of bears making the case against Chinese shares.  First we were warned that Chinese inflation was too high, and they were not doing enough to correct it. Then we were told that China had applied the economic brakes too severely, and the efforts to curb inflation would do too much damage to output. Some worry about the banking system, saying there are too many bad loans outstanding. Some are concerned about the state of the property market.

We are far from starry eyed about China. It is true that there are bad loans in the Chinese banking system, just as there are in the western banks. It’s true that China took tough action to curb inflation last year, raising the reserve requirements for banks to hold, and raising interest rates.  It is true that property prices have been weak in many areas, and that money and loan growth have slowed as the government’s measures have taken effect.

This year the Chinese Stock market has performed a bit better than last year, but it remains on a low multiple of earnings. It has not been immune to the falls of recent days as world investors worry about the latest phase of the Euro crisis.  I find some of the negative language used by commentators talking about recent Chinese figures a little over the top.

The first four months of this year saw investment growth slow to 20%. On the most recent figures retail sales are up 14% on a year earlier, and industrial output is up 9%. By Chinese standards these figures are slow, but by anyone else’s standards they are good.  The official forecast for GDP growth this year is 8%, and most private sector forecasters expect China to be the fastest growing the major economies, even if they do think the total will come in a bit below this official figure.

The trade surplus has expanded again on recent numbers, with a low rate of import growth and a decent rate of export growth to non EU destinations widening the trade gap in China’s favour.  CPI inflation is down to 3.4% and core inflation is at 1.4%, showing the policies taken to cut inflation last year have worked as planned.  House prices are flat and sales are weak. Residential property is 40% cheaper relative to wages than in 2000.

It is possible that the output and spending figures continue to disappoint the high expectations of many market participants. The Chinese government has many policy options if so. It can cut the reserve requirements on banks several times more to stimulate more loan growth. They can cut interest rates. They can spend more money in the public sector, or stimulate more private sector expenditure.

Changes in the Chinese leadership are proving more public and contentious than usual, but we expect these matters to be resolved this year. With an equity market on a price to earnings ratio of 7.3 and a yield of 4.3% we think China looks cheap. We still expect it to be the fastest growing major economy this year, despite the slowing brought on by last year’s counter inflation measures.

Yesterday it seemed unlikely that Greece can form a government. New elections are likely to produce a government even more strongly against the current EU/IMF loan package and austerity requirements. If a government can be cobbled together at the last minute from the present Parliament, it will have to go to Brussels to request a change of policy. The political uncertainties are now dragging down world markets.

There are three possible outcomes following the formation of a new Greek government demanding a change of tack. One is that the EU/IMF say they can give no more. They have twice negotiated this package, and have accepted one large write down of Greek state debt owned by banks and other private sector individuals, companies and funds. They could take the perfectly sensible view that allowing another lapse in conditions of the loan would simply lead to other countries demanding the same treatment. It would undermine the discipline the zone needs, and would send a signal to all that there is no need to meet solemn requirements entered into. Either Greece has to back down and try to do implement the agreement, or they need to move quickly to arrange an exit from the Euro on this option.

The second possibility is we have another temporary fix. The EU/IMF would heave a sigh and give Greece some formula to relax the demands a bit. Maybe more debt could be written off. Maybe the timetable for meeting the requirements for reform and budget deficit cuts could be extended.  The ECB might issue yet more money to other worried banking systems to support other states in trouble. Just enough cash would be released for Greece to pay the basic bills and stave off full bankruptcy.  It would remain a matter of time before we had the same crisis again.

The third possibility is the Euro area moves more swiftly to fiscal union, with the richer areas accepting their responsibility to send much more money by way of transfer payments to the poorer parts like Greece. It is difficult to believe Germany would be willing to do this. Mrs Merkel has just suffered a bad regional election defeat and is unlikely to want to have to tell her electors in the run up to the German General Election next year that they are going to have to pay a lot more tax to subsidise the weak parts of the Euro zone.

There is a paralysis in decision making at the heart of the zone. Just as this phase of the crisis blows up France is undergoing a major change at the top. The new central partnership of Merkel/Hollande is still to be developed. Mr Hollande will be pressing his domestic demands, fresh from the French election trail, at exactly the moment both need to concentrate on Greece.  More people are now saying Greece has to leave the Euro, but there is still no clear sign that that has become the prevailing view of the main players. To do it they will need speed, confidentiality and united purpose. They will also need a Greek government to deliver the Greek end of it.

It seems most likely we are in for another round of brinkmanship and temporary expedients. The worry some commentators are now expressing is that talk of Greek exit could lead to yet more money being shifted out of Greek bank accounts. The more the political leadership of the problem drifts, the more damage the markets can do. The drain on Greek bank deposits so far has represented a further tightening of cash and credit for the Greek private sector, at a time when that sector needs more money to grow to start to ease the pain.

We continue to recommend avoiding all Euro risks whilst the crisis rages. We are also cautious about other risk assets, as there is fall out to the rest of the world from worries about the Euro banking system.

Markets have been falling again, as we feared they would. The Euro crisis is still far from resolved. This week you can worry about the lack of a new government in Greece to meet the requirements of the bailout, or about the state of the Spanish banks. If that’s not enough to put you off investing, there is how the new relationship between Mr Hollande and Mrs Merkel will work out.
 
On the other side of the world the Chinese authorities are still jockeying for position in the new government line up later this year, and there are worries over the state of some of their banks. The Stock market looks cheap. In India shares have taken another tumble, where we thought they looked dear. The US recovery continues, but sometimes the moderate pace upsets the markets, which are now expecting quite a lot from the world’s largest economy.
 
The latest debate is between austerity and growth. In the German corner they say heavily indebted countries need to rein in their deficits as a prelude to growth. They add that countries with weak banking systems need to raise more capital or restrain lending to get them into better shape. In the French led growth party, they say it would be a good idea for public sectors to spend a bit more now on more borrowed money. This they think would kick start growth and boost tax revenues.
 
German public opinion resents the idea that hard earned and well saved German money should be used for yet another attempt at public sector led reflation. Many Germans are nervous about the German surplus deposited at the European Central Bank. They do not like the thought of more Euros being printed, partly in their name, to try to inflate the south of the Eurozone out of its difficulties. The south thinks Germany should allow them to open the purse strings more, to deal with the mass unemployment and recessionary conditions now stretching out across the zone.
 
The truth is deficit reduction and growth go together and reinforce each other. There is no guarantee that printing and spending a bit more in the public sector will transform the economies in trouble. They are, after all, spending and borrowing on a large scale already. They need private sector and export led recoveries. More state spending and borrowing might just push interest rates up to crippling levels, or might like the last rounds of such stimulus have little overall impact.
 
We expect Mrs Merkel and Mr Hollande to produce a Growth Pact after some more arguing and posturing. Mrs Merkel will want supply side reform, measures geared to helping the private sector. Mr Hollande will want government spending. There will doubtless be a little of each. What we will be watching more closely is what happens to Euro area monetary policy and what is done by the ECB. The markets want another injection of cash, like the two rounds of LTRO loans to the banks so far. That would be a generous German gift to the rest, at a time when Germans are worrying about their own inflation rate. If it comes it will generate another rally, but it will not solve the underlying problems of weak banks and weak states.  The banking system will continue to worry, and continue to depress European output.

The EU’s response to the French and Greek elections will be different. In the case of France Mrs Merkel will seek to smooth over the differences between herself and Mr Hollande. There will be efforts made to draw up a “Growth package” to complement the fiscal Treaty. As always, the two leading countries of the EU will want to stitch together a compromise, a new version of the Stability and Growth Pact. Germany always urges the stability,low deficits and low inflation. France always argues for the growth. As always, neither will get what they want. As always the EU will have neither much stability nor much if any growth.

The truth is that Mr Hollande understands the public mood well. French electors, like electors in many other European countries, are sick and tired of austerity. They want to look forward to more jobs for their children and grandchildren, and more take home pay for themselves. State sector workers are against cuts in public spending. Private sector workers are against the current high level of taxes needed to pay all the bills. Both could have what they want if the economies grew quickly, bringing in more tax revenues without the need for so many taxes or such high rates of tax. The sad truth for Mr Hollande is there is no easy way out of the current French problem. He thinks more state spending is the answer to stimulate growth. The markets will think more state spending and borrowing is the opposite of what is needed.

We suspect that France and Germany will carry on working together despite the new tensions at the top. Mr Hollande’s honeymoon may be short lived, as he will soon discover that his words, so freely given in opposition, now come with a market price each time they are uttered. Every nuance different from Germany’s is a potential flaw in the Euro scheme. Every row with austerity Germany is another weakness in the fabric of the single currency. Mr Hollande will discover that Mr Sarkozy was locked in to a policy that produced poor results, and that he Mr Hollande has no easy exit.

Meanwhile in Greece, the EU establishment will get tough with the new Parliament. Briefing has already begun to denigrate the people elected for the  anti austerity parties. The fact that two thirds of Greeks voted against current EU policy will not change the EU authorities. The Greeks will be told again that there is no alternative. All the time they remain in the Euro they have to borrow large sums from the IMF and the EU. All the time they need to borrow they have to attempt to carry out the required policies. It is unlikely to work, but that is unlikely to change the EU policy. They may offer an olive branch if a government emerges they can tolerate, but it will not amount to much alteration in the basic facts. The Greeks have to spend less and borrow less. Higher tax and lower state spending is the only menu on offer. Anopther Greek election is one likely outcome. A simmering dispute between Greek Parliament and EU officials is another. Greece will have to largely stick to the plans given to it. She is unlikely to hit the borrowing targets, and there will need to be a renegotiation of terms sometime. The EU will wish to delay this for as long as possible. it will not wish to reward the anti EU policy parties should they manage to form a government.

We advise investors to avoid Euro risks, and to expect more trouble for world markets from these new but not unexpected uncertainties.

The Governor of the Bank of England gave a lecture this week on what went wrong with Bank regulation in recent years. He then told us how the Bank would use its new regulatory powers going forward. The lecture was remarkable for how little it said, and for the lack of the ideas going forward to deal with today’s problems.

The Governor thought that the last cycle was a bust without a boom. As far as he was concerned inflation stayed relatively low, and the economy was growing at what he thought was around trend. The rest of us saw a wild asset bubble, a boom in bank credit and in financial instruments, and a nasty blip in inflation which followed. It looks as if the trend rate of growth of the economy had been inflated itself by large extra amounts of credit puffing up the financial and property sectors, which delivered the excess growth.

The Governor argued that the Bank of England did not have powers to stop the bubble, as banking supervision had passed to the FSA. The Bank did have power to put up interest rates, which would have slowed credit growth and sent a clear warning. It had overall responsibility for the banking system. It could at any time have asked the Chancellor to chair a meeting of the tripartite regulators, the Treasury, the Bank and the FSA, to get the FSA to take action to rein in individual large banks that the Bank says it saw were growing too fast. It did neither of these things.

The Governor admits to the mistake of not shouting loudly enough about the excessive risks he saw in the system before it went down. He says nothing about the extraordinary decision of the Bank to cry moral hazard and to starve the money markets of funds when wholesale funding in the normal way was drying up. It was the decision not to release more money early enough which was behind the collapse of Northern Rock. It would be good to have heard from the Governor  why he thought it wrong to supply liquidity before the collapse, but changed his mind afterwards and supplied plenty.

The Governor has three proposals going forwards. They are all designed to prevent another credit bubble. He recommends more banking capital. He proposes living wills and resolution mechanisms of the kind some of us wanted for RBS last time round. He wants to split risky Investment banking from clearing banking. Some of this makes sense, if and when the problem is starting to emerge again of excessive credit creation. For the time being the problem is rather different. It is how do we promote economic growth when banks are trying to get their balance sheets down and are out to restrict their lending to comply.

Unfortunately the Governor has no words of comfort on how to sort out today’s mess. Today’s mess is too little growth and too little credit, not the reverse. We await a new Governor to tell us how to deal with that fundamental problem.

A victory by Mr Hollande in the French Presidential election seems likely this week-end. Such an event will lead to a flurry of Euro area diplomatic activity, as officials seek to create a new Franco-German alliance around the new characters. They are likely to allow Mr Hollande to help draft a Growth Strategy to add on to the austerity Treaty. Mrs Merkel will be unwilling to ditch the Treaty which was crafted with difficulty towards the end of last year, largely to keep a potentially restless German audience happy. She will understand Hollande’s need for something more, and for something generally more positive for the Euro area outlook. Whatever is in the Growth package, both leaders will have every interest in playing it up. Doubtless the EU funds will be searched for “new money” for eye catching public spending led programmes. More promises may be made about strengthening and deepening the single market, and further joint attacks on the financial markets could add to the cocktail. This will be a regulated and public sector led style of growth package to share some of Mr Hollande’s rhetoric from the Presidential campaign.
 
Meanwhile, in Greece they will be forming a new Coalition government from the various parties that are contesting their fraught election. Maybe the parties who support the last bail out will have enough seats to carry on with business as usual. Maybe the anger of the Greek people will produce a government that is unhappy about the past deal. Either way, the prospects do not look good for any new government to hit the demanding EU targets. Renegotiation of the Greek problem may be speeded up or delayed by the election results, but the election is unlikely to change anything important for the poor prospects of the Greek economy.
 
The Spanish government, with a lot of help from the European Central Bank’s various programmes, has kept up with the need to raise money to pay its bills without yields staying above 6% for any length of time. However, the Ratings Agencies are chipping away at the Spanish banks. There is a general feeling that the Spanish property crash and the recession will lead to more bad debts and difficulties for the banks, and a feeling that not enough of the potential losses have been provided for. In addition, there is now a possibility that the banks will lose money on their enlarged holdings of Spanish government bonds. Weak banks supporting a weak government in turn supporting weak banks is not a winning formula. Only strong growth in the economy and strong growth in tax revenues can start to right such a situation, and so far the Spanish economy is headed in the wrong direction. Unemployment levels are now very high.
 
We do not see the possible changes of political leadership in France and Greece making much positive difference to the prospects of the Euro zone. The change of administration in Spain to a government that believed in austerity failed to succeed in lifting prospects. Electing governments committed to Growth packages is also unlikely to make much difference, unless and until something is done to change the constraints imposed by the fixed exchange rates within the Euro for each country, and to alter the weak state of the overall banking system. Under the next President, whoever it is, France is likely to try to get Germany to accept more money printing and to pay more of the bills for the rest of the zone. All the time Mrs Merkel is in charge and conscious of the unpopularity of those policies with many German voters, it will be done by stealth, and will probably be too little too late as we move from mini crisis to mini crisis.

In recent weeks markets have become more concerned about Spanish finances than Italian ones and the news this morning that Spanish debt has been downgraded by credit ratings agency S&P brings more speculation of a deepening crisis. Spanish electors have played their part and voted in a new government even more committed to the austerity policies of Euroland than the outgoing one. The new government willingly signed up to the new Treaty of the 25 to enforce more austerity and budget discipline on themselves. Then things started to go wrong.
 
The government confessed that there had been slippage last year under their predecessors. The 2011 budget deficit turned out to be as high as 8.5%. Worse still, the new government said they could not hit the tough targets for 2012. After discussions they ended up with a revised target of 5.3% of GDP for extra borrowing.
 
Just to hit this target they had to announce a more austere austerity budget with additional tax rises and spending cuts last week to try to reassure markets that they would keep to these new estimates. There were cuts in spending. The main cross government items were a further wage freeze for civil servants, and a ban on external recruitment. There were tax rises, including confirmation of a very unpopular property tax. There were more promises to clamp down on avoidance. They will offer an amnesty and a light tax rate to people who want to regularise their affairs. They are out to close various legal loopholes that companies have been using. The billing of the budget as the most austere ever probably outran the reality, but the direction of travel is clear for all to see.
 
So are the problems. Some in the markets worry that the tax rises on the private sector combined with the spending cuts for the public reduce demand and output further, which in turn means downwards pressure on tax revenues and upwards pressure on benefit budgets for the unemployed. With 23% out of work and almost one half of all young people without a job these are tough times for Spaniards. If the economic output falls more than expected, or continues to disappoint in later years, the government will not hit its estimates of revenue and may have to spend more.
 
There is also the problem of the Spanish banks. They are nursing various loans against land, buildings and construction projects that have been damaged by the savage downturn in these areas.  The government wants the banks to make more provision against future losses, and has asked the banks to come up with another €52 billion this year in extra provisions and capital to make the position more secure. If the state is dragged into supporting the banks more, that will weaken state finances more as well. The state of the banks will limit new credit for new projects, making fast recovery that much more difficult to achieve.
 
The EU forecasts a 1% fall in Spanish output this year, and the IMF a 1.7% decline; S&P now agrees, revising its previous forecast of 0.3% to a 1.5% decline. We will keep the Spanish 10 year bond yield on our watch list. The combination of a past property crash, some weak banks, Euro membership and stretched state finances is a worrying mix. There could be another phase to the Euro crisis where markets show more concern about the pain in Spain.

The rolling Euro crisis contains a couple of dangerous ingredients. Firstly, there is that toxic combination of weak banks propped up by a weak state, which in turn needs to borrow from those same banks.  Spanish state finances are stretched, though better than Greece or Portugal. If the banks need substantial new capital to repair loan losses on construction and property, that will be difficult for the state to find. In the meantime, the need to rebuild bank balance sheets is restricting credit growth and general growth. The lack of competitiveness amongst the weaker economies adds to the tensions. Spain had too much inflation relative to Germany in the first years of Euro membership. It has left her struggling to find work for people and to balance her economy.
 
So far Spain has been able to finance her state deficit and her weak banks without needing special loans from the EU and IMF. Whilst Greece, Portugal and Ireland have been forced to seek subsidised borrowings and submit to an IMF programme, Spain has been able to manage her own affairs in the bond markets. It is generally thought that a Euro country can just about afford borrowing under 7% for 10 years, though 6-7% is getting dear. Spain’s ten year rate has been drifting up, and after this morning’s news pushed over 6%. So far this year the Spanish government has been able to raise all it needs to borrow, and is a little ahead of its programme, but most of the money raised recently has been short-term loans. This means it will need doing again all too soon. The significant thing is that recently Spanish borrowing costs more than Italian, reversing the position of last year when Italy seemed more at risk. The government has to do more to reassure markets that deficit reduction targets will be hit and the economy will be able to grow again. Otherwise the bond markets could prove difficult to manage.

Recent days have been difficult ones for the Euro. As if trouble in Spain was not enough, French voters last week-end voted mainly for parties that favour a change of policy over the Euro and EU economics. Austerity is getting a bad name. Voters either want some socialist spending boost for their slow growth or no growth economies, or they vote for parties that are against the establishment EU consensus generally. 

We are staying with our view that Mr Hollande is the likely winner of the French Presidency. That view has not been strengthened by the first ballot result, as the vote of the National Front was higher than expected. More of these voters are likely to switch to Mr Sarkozy in the second round, though some might well abstain, wishing a plague on both houses. It still looks as if there are more votes on the left, and more votes for change than for more of the same. The election as a whole communicated a certain weariness with current Euro policy. The Netherlands too has suffered government change as a result of the growing antagonism to austerity policies.

The Euro is newly buttressed by more IMF money which was successfully negotiated from many countries last week-end. This is on top of the firewalls fund in the EU itself, and on top of the large sums the ECB has already made available to member states’ banks. The EU hopes the fact that around 1 trillion Euros is theoretically available to help bail out any country in difficulty will be enough to forestall such an event. Unfortunately good news often comes twinned with bad. The performance of the real economies in Euroland is weakening, which makes cutting budget deficits that much more difficult. The combination of higher taxes to cut deficits, weak banks, and requirements for more banking capital is still not a winning one. It is driving electorates to oust the architects of their current discontents, at the very point where markets want stability and firmness of purpose to get the deficits under control. We continue to avoid Euroland investment, given the difficulties.

This week-end sees the first round of the French Presidential election. Polls say this round will be close between the incumbent and the challenger. The second round is likely to produce victory for Mr Hollande, the socialist candidate. If he wins there will be quite a few changes in French and EU policy. He is pledged to renegotiate the latest austerity Treaty signed by the 25. He talks of breaking free from the tax rises and spending cuts of current French and EU policy. He is keen to tax the rich more- and maybe rich companies, with confiscation of pay above 350,000 Euros. Such an agenda in the EU is likely to cause turbulence for markets.

Doubtless if he wins he will be persuaded to tone some of it down in the interests of EU solidarity. He will need to build a relationship with Frau Merkel of Germany, though it will start very badly after her support for Mr Sarkozy in the election. He will need to compromise on the Treaty and on austerity measures. He may well be forced into more of his own cutbacks in France, as the French economy too is fighting deficit problems and has lost some of the lustre of its good credit rating. It is difficult to see that he will be able to develop a pro-growth agenda for the whole EU. He will not philosophically wish to deregulate or cut public sector costs. His wish to spend more will be constrained by the fiscal reality. He may find that the rich do not yield a large dividend to pay for many of his plans. He wishes to regulate and tax the financial markets more, as he blames them for most of the current ills. This too will require the co-operation of Brussels, and will bring him into dispute with the UK.

Meanwhile, back on the northern side of the Channel, the latest inflation figures have been a bit disappointing. We are now in a phase when UK private sector interest rates for both savers and borrowers are drifting upwards. The pound has strengthened a little,, as more market participants now think that there can be no more quantitative easing at the end of the present programme, given the way inflation remains obstinately high. The Coalition government won all its votes to secure contentious VAT increases following the budget, but not without rebellions and lively debate against its proposals from its own side. The UK economy is showing some signs of life, with some better news on the housing market and some retailers reporting better sales volumes. However, the latest earnings figures show very low growth, well behind the rate of price increases. This means demand is still being held down throughout the private sector by the falls in real incomes which are a persistent feature of the landscape.

We have had more days of rising ten year Spanish government bond yields. Markets are concerned that the Spanish economy remains mired in recession. They are worried that the government will need to borrow more than planned as a result of poor economic performance. Some are concerned about the state of Spain’s banks, which overall were borrowing €316 billion from the European Central Bank in March. Spanish ten year bonds now yield more than 6.1%, despite past Spanish banks buying using borrowed funds from the ECB.
 
This week-end the IMF and World Bank meetings will have to consider Spain and the Euro area yet again. The Euroland countries are hoping other IMF members will now pledge more funds to a possible Euro bailout fund, to top up the European firewall established through the planned European Stability Mechanism. There are signs that Japan and China will make contributions, as they wish to avoid dependence on a single major world reserve currency, the dollar, and wish to keep the Euro up for their own competitive reasons. The USA is unlikely to budge from its view that it will not contribute to Euro bail outs by the IMF in view of the level of contributions from the EU itself. The USA thinks the Europeans could and should do more for themselves.
 
The Europeans have produced a fund of €800 billion in outline. Much of this will have to be borrowed on the strength of the collective covenants of Euroland members. €300 billion of it is inherited commitments and fund raising by the existing European funds, so not all of it would be available as new money in a crisis.
 
The IMF and the Euroland countries would be well advised to spend more of their time thinking about how they can solve the underlying problems in Spain and Italy, and how they can move Ireland, Greece and Portugal back to normal market financing. Large funds to offer subsidised and special finance can buy time but does not solve the underlying problems. They need to tackle the lack of competitiveness, the recessionary forces unleashed, the weak banking sectors and the lack of growth. There is no sign yet of the move of Greece or Portugal to self-sustaining better economic performance. Nor is there any early sign of recovery in Spain. Without some change of economic fortunes in these countries, they will need bigger and bigger funds to offer subsidised loans. European finance will continue to be gripped by spams of market worry, and by the need to beef up the firewalls.