all you ever wanted to know about european austerity plans…gesd.free.fr/sgauster.pdf · all you...

All you ever wanted to know about European austerity plans…

(…but were afraid to ask)

October 2010

Written by a non-U.S. research analyst not registered/qualified under FINRA rules THIS RESEARCH REPORT IS THE PRODUCT OF SOCIETE GENERALE (AUTHORIZED IN FRANCE BY THE AMF). PLEASE SEE IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION IN APPENDIX

Daniel Fermon Phone: +33 (1) 42 13 58 81

1

Austerity Plans - Kill or Cure?

1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010e 2015e 0%

50%

100%

150%

200%

250%

300%

UK Japan

0%

50%

100%

150%

200%

250%

300%

US

Source: SG Cross Asset Research, IMF

Public finances impacted by WW2

Start of Japan’s lost decade

Public debt/GDP – 1900/2015e

Question 1 Why is it necessary for European countries to deliver austerity plans?

“In the middle of every difficulty lies opportunity”. Albert Einstein

3

European government debt is held by non residents (%)

0

10

20

30

40

50

60

70

80

90

Japan UK Spain US Germany Italy Ireland France Greece Portugal

Source: OECD, IMF, SG Cross Asset Research

4

Fears of higher cost of debt fully justified

Senior 5-year CDS (bp) and austerity plan annoucements: a limited impact

Doubts on future of eurozone after S&P downgraded Greek debt to junk

Source: SG Cross Asset Research, Datastream

5

Debt remain a major threat for developed economies

Question 1

Why is it necessary for European countries to deliver austerity plans?

Answer 1

Because, if governments do not rapidly address their debt problems, the cost of debt could explode, as in Greece. Thus, fears of escalating interest rates and the resulting dire consequences for their economies are seen to justify the need for austerity measures.

Question 2 What do we really know about the different austerity measures? “Waiting is painful. Forgetting is painful. But not knowing which to do is the worst kind of suffering” Paulo Coelho.

7

Recap of austerity measures

y Country Debt to

GDP Budget Balance

Austerity plan details

2011e 2011e Size €bn

Size, % of GDP

Years Spending cuts Pension reform Tax increases

Greece 129.4 7.0 35 17 3 State salary freeze until 2014 Holiday bonuses partly abolished

Pensions freeze until 2012 Retirement age extended to 65

VAT raised from 21 to 23% Oneoff tax on companies

Italy 119.2 3.9 24 2 3 State salary freeze for 3 years

€13bn of spending cuts 201112 Retirement pushed back by 3 to 6 months

New taxes on stock options and bonuses Possible expansion of toll roads

Belgium 97.9 4.0 22 15 5 Elections and regional divisions are delaying a clear deficit reduction strategy

Portugal 86.1 4.6 11 7 4 5% pay cuts for public sector

Sell €6bn of state assets (e) VAT increased from 20% to 21% and

then to 23% Crisis tax created

France 87.7 6.0 45 3 3 3year freeze on public spending

State subsidies cut by 10% Retirement age raised from 60 to 62 by 2018

Top rate income tax to 41% Taxes raised on capital gains + life insur.

Ireland 92.8 11.1 4 2 2 3 austerity budgets over a year.

Public sector salaries cut by up to 15%

VAT up from 21% to 21.5% 2008 +2% on top income tax rate

Germany 69.3 3.8 80 4 4 Welfare spending cut by €30bn

Cut in public sector payrolls Taxes on nuclear power plants

Financial transaction tax UK 73.4 7.5 110 9 5 25% cut in government spending Retirement age raised from 65 to

66 VAT up from 17.5 to 20% Total of £40bn in tax increases

Spain 68.7 6.5 15* 1 2 Civil service payrolls cut 5% in

2010 €6bn cut in public sector investment

Pensions freeze VAT up from 16% to 18%, and 8% from 7%

Overview of European austerity measures

Source: SG Cross Asset Research *Agreed €15bn cost-saving plan in May on top of an €50bn package in January. So €65bn overall

8

Fears of 1937 rerun in the US at the end of economic stimulus

End of economic stimulus: consequences on equity markets

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1928

1929

1930

1931

1932

1933

1934

1935

1936

1937

1938

1939

1940

1941

1942

Dow Jones Industrial Average

End of economic stimulus


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End of Bush tax cuts for the US in 2011

European Union = 21% of global

GDPRest of the world

USA

Tax Increase

Spending cut Pension ref orm

Public lay -of f s

Dis

trib

utio

n st

ill u

nkno

wn

Greece 17%UK 9%

Portugal 7%Germany 4%

France 3%Ireland 2%

Italy 2%Spain 1%

Size of austerity measures in % of 2009 country GDP

End of Bush Tax cuts in January 2011 ?

Source: SG Cross Asset Research

Many European countries on the road to austerity

10

Still plenty of fog

Question 2 What do we really know about the different austerity measures? Answer 2 At present all we know is that the austerity plans in Europe will represent more than €350bn or 3% of European GDP for the next four years.

http://blog.athos99.com/arbre-dans-le-brouillard/

Question 3 Do past examples fully justify these austerity measures? “Keep your eyes on the stars, and your feet on the ground”. Theodore Roosevelt .

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Fiscal adjustements take an average 8 years to succeed

Country & period of consolidation Duration of the plan

General government debt Structural primary balance Real GDP growth

Inflation Rate

Interest rates

Unemployment rate

Start Peak End Swing Start End Average over the period

In years As a percentage of GDP In per cent

Short duration

Denmark (198386) 3 65 77 72 13.4 6.4 7.0 3.9 5.4 11.8 6.8

Sweden (198187) 6 47 71 62 8.6 5.7 2.9 2.2 7.6 9.0 3.7

United Kingdom (19942000) 6 49 53 45 7.7 4.4 3.3 3.5 1.8 7.0 7.3

Sweden (19942000) 6 78 84 64 11.8 7.1 4.7 3.7 1.0 6.1 10.1

Long duration

Western Germany (198089) 9 29 41 40 5.2 3.7 1.5 1.9 2.9 7.8 5.2

Ireland (198089) 9 68 114 100 11.8 7.0 4.8 3.1 9.3 10.5 14.5

Japan (197990) 11 41 77 64 7.0 4.9 2.1 4.6 2.7 6.6 2.4

Italy (198697) 11 89 130 130 10.2 3.4 6.7 2.1 5.0 10.6 10.2

Canada (198699) 13 67 102 91 11.1 5.4 5.7 2.8 2.8 11.1 9.2

Belgium (198498) 14 107 141 123 10.3 3.6 6.7 2.3 2.6 8.3 8.9

Examples of successful large fiscal adjustments

Source: European Commission AMECO database; OECD; BIS; Datastream; national data; SG Cross Asset Research

13

First difference: interest rates already very low

4

5

6

7

8

9

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Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99

Canada Benchmark bond 10yr US Benchmark bond 10yr

Ann

ounc

emen

t &

esta

blis

hmen

t of

aust

erity

mea

sure

s

3

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Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99Sw edish Benchmark bond 10yr Germany Benchmark bond 10yrUK Benchmark bond 10yr US Benchmark bond 10yr

Ann

ounc

emen

t &

esta

blis

hmen

t of

aus

terit

y m

easu

res

Long-term interest rates: same pattern observed in Canada and Sweden


14

Second difference: austerity measures much larger with 21% of global GDP


Current economic cycle

Government debt

increasing

Capex M&A

Emerging Markets IPOs

4 2012-2013e

Economies slow

1 2007- 2009

Crisis in developed economies

Interest rate cuts

2 2009- 2010e

Recovery in emerging markets and rise in commodity prices

3 2011-2012e

Rise in consumption and investment

Improving consumer confidence

Inflation/ Interest rate hikes

Market stress

Yuan revaluation?

Previous economic cycle

1 2001-2003

US Economic Slowdown

2 2003-…….2004

Start of recovery 3 2004-2006

Recovery and Growth

4 2006-2007

Growth stabilising

Corporatedebt

reduction

Market Stress

Capex

LBO and M&A

Interest rate drop

Low interest rates: consumer borrows

Interest rates rising

High consumer spending and rising inflation

15

Third difference: further depreciation of western currencies takes time to materialize


16

All countries cannot win at the same time

Question 3 Do past examples fully justify these

austerity measures? Answer 3 No. Three major differences with

the situations observed in Canada and Sweden in the 1990s suggest that not all the austerity plans will be successful and point to a major risk on economic growth if governments implement austerity plans in an uncoordinated manner.

Question 4 Which variable should you look at to analyze the success of these austerity plans? “In matters of style, swim with the current; in matters of principle, stand like a rock”. Thomas Jefferson .

18

Unemployment rate jumped in many countries during the 2009 recession

Unemployment rate in major countries

2008 2010e Increase over the recession

Germany 7.40% 8.01% 8.24%

France 7.90% 9.50% 20.25%

Italy 6.80% 8.30% 22.06%

Portugal 7.60% 9.45% 24.34%

Greece 7.60% 9.50% 25.00%

UK 5.20% 7.80% 50.00%

USA 5.80% 9.30% 60.34%

Spain 11.30% 18.20% 61.06%

Ireland 6.10% 12.00% 96.72%


19

Property bubble reveals the risk associated to austerity plans

1996 2001 2006 2011 2016 2021 2026

50

150

250

350

450

50

150

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350

450

1980 1985 1990 1995 2000 2005 2010Japan lost decade UK Ireland Spain

OECD off icial data w ith 2009 and

2010 estimates

1996 2001 2006 2011 2016 2021 2026

50

150

250

350

50

150

250

350

1980 1985 1990 1995 2000 2005 2010Japan lost decade ItalyFrance Germany

OECD off icial data w ith 2009 and

2010 estimates

Nominal residential home price

Source: SG Cross Asset Research, Datastream, OECD

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Unemployment rise and saving rates major variables to analyze the success of austerity plans Austerity plans and social risk


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Confidence in the future is essential

Question 4 Which variable should you look at

to analyze the success of these austerity plans?

Answer 4 Unemployment trends, saving

rates, social movements and property markets are the key variables that can be analysed to forecast the chances of success of the austerity plans. Depending on the country, the austerity plans could be devastating.

Question 5 How to invest under an austerity plan scenario “You only have to do a very few things right in your life so long as you don’t do too many things wrong”. Warren Buffett .

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What is discounted by these plan so far

Successes (bp)

Failures (bp)


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Worried about inflation? Austerity plans suggest deflation more of a risk for 2011

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72003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023

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1929 1931 1933 1935 1937 1939 1941 1943 1945 1947 1949

US Government Bond Yields from 1929Prime bankers' acceptances, 90 days from 1929US Government Bond Yields from 2004US FED FUNDS MIDDLE RATE from 2004

End of f iscal stimulus

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40

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100

2000 2002 2004 2006 2008 2010 2012 2014 2016

10

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1930 1932 1934 1936 1938 1940 1942 1944 1946S&P Composite Real (Inflation-adjusted) Price - 1929 peak through 1945S&P Composite Real (Inflation-adjusted) Price - 2000 peak to the present

Comparing 1929-1950 period with today’s US 10YR bond yields

Comparing the S&P today and the S&P in the 30s


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Key recommendations summary

Recommendations from a European austerity standpoint

Asset class Impact = +

Fixed income – overall positive Spain USA Portugal

UK France Greece

Ireland Germany Italy

Equities – overall negative

Spain UK Portugal

Ireland France Germany

Italy

Greece

USA

Currencies – overall neutral Expect emerging market currencies to continue to revaluate


26

UK and Spain: risk not priced in

Question 5 How to invest under an austerity

plan scenario Answer 5 Risk-reward is positive for the

Greek, Italian and Portuguese bond markets. The execution risks inherent in austerity plans make us more cautious on bond markets in Ireland, Spain and the UK. The UK could benefit from renewed currency depreciation if its austerity measures have an overall negative impact on the economy.

All you ever wanted to know about European austerity plans…Austerity Plans - Kill or Cure?Question 1�Why is it necessary for European countries to deliver austerity plans? European government debt is held by non residents (%)Fears of higher cost of debt fully justifiedDebt remain a major threat for developed economiesQuestion 2�What do we really know about the different austerity measures?Recap of austerity measuresFears of 1937 rerun in the US at the end of economic stimulus End of Bush tax cuts for the US in 2011Still plenty of fogQuestion 3�Do past examples fully justify these austerity measures? Fiscal adjustements take an average 8 years to succeedFirst difference: interest rates already very low�Second difference: austerity measures much larger with 21% of global GDPThird difference: further depreciation of western currencies takes time to materialize �All countries cannot win at the same timeQuestion 4�Which variable should you look at to analyze the success of these austerity plans?�Unemployment rate jumped in many countries during the 2009 recession�Property bubble reveals the risk associated to austerity plans�Unemployment rise and saving rates major variables to analyze the success of austerity plans�Confidence in the future is essentialQuestion 5�How to invest under an austerity plan scenario�What is discounted by these plan so far�Worried about inflation? Austerity plans suggest deflation more of a risk for 2011�Key recommendations summary�UK and Spain: risk not priced inAPPENDIX -- DISCLAIMERSG leader in Global Cross Asset Research

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