Along with US sequester, global uncertainty rises
A 66 basis point increase in borrowing costs for Italy two days after its electorate plumped for former comedian Beppe Grillo—it raised $6.5 billion on Wednesday in 5- and 10-year bonds at yields that were 66 bps more than those in the January sales—is probably the lowest estimate of what the anti-austerity vote will cost the country, and the world. While Italian voters who gave Grillo and Silvio Berlusconi over half the vote may have felt this will force Germany to back a smaller austerity-driven package for Europe, the immediate consequences could be severe—and there’s little certainty Chancellor Merkel is going to change course. Before European Central Bank (ECB) President Mario Draghi outlined his unlimited bond purchase plan last September, both Italian and Spanish bond yields were skyrocketing, threatening to take Europe down in case of any downgrade since it was clear none of the stabilisation funds available—including with the IMF—had the kind of firepower required. While Spain’s debt is euro 730 billion, Italy’s is euro 1.9 trillion. Though Spain has begun to reform—the EFSF’s investor-presentation shows Italy is the least-reforming country—it has a lot more austerity ahead and needs to cut spending 6% of GDP this year if it wants to keep debt levels under control. Doing that in the face of a 27% unemployment level and at a time when Europe is set to contract for another year is difficult, the growth of anti-austerity sentiment can only make things much worse. If the ECB defers bond purchases, as looks likely in the absence of strong pro-austerity commitments, and bond spreads start rising again, that sets back an eventual European recovery and also increases the risk of things going wrong.
Across the Atlantic, it’s easy to dismiss fears of the US sequester by arguing US politicians have always got their act together. At one level, the $85 billion cuts that automatically came into effect from March 1 when the political class couldn’t reach an agreement on what to cut will reduce US GDP by around 0.6 ppt. The greater fear lies in the possible shut down of parts of the government on March 27 when its temporary spending authority comes to an end and, once again in August when the debt ceiling gets breached. Not surprisingly, shares of defence contractors like Northrop Grumman, General Dynamics and Lockheed Martin have fallen 5% this year (defence bears the brunt of the sequester) and earnings forecasts from consumer companies like Wal-Mart, Burger King and Kraft Foods are also down with the 2% increased payroll tax coming into effect. For an economy that grew 1.6% in 2012—Fed 2013 projections are 1.7-2.4%—the cost of the sequester is large. But, even if the Republicans and the Democrats reach a compromise, the expenditure cut needs to be made anyway. So the real issue is whether US private investment will take up the slack—in Q4 2012, while private consumption rose 2.1% over 1.6% in Q3, government expenditure fell 6.9% versus a growth of 3.9% in Q3. Private investment, on the other hand, fell 1.5% versus a 6.6% growth in Q3. In other words, the US is looking a bit shaky too. While that’s bad news for Indian exports, including of services, the good news is that this means there’s no danger of the Fed reducing liquidity.