Surviving Austerity

January 27, 2014

With the Standard & Poor's 500 Index having posted a 30% gain, it's easy to assume that U.S. stocks easily led the world in 2013. But as it turns out, the stimulus-loving U.S. markets had plenty of company. Surprisingly, this includes countries supposedly saddled by the scourge of austerity.

The Irish Stock Exchange Quotient (ISEQ), gained 33.6% in 2013. Close behind were the 28% jump in the Athens General Share Index, and the 21% rally in Spain's IBEX 35 Index (IBEX). Factoring in the 4% rise of the euro over the calendar year and these returns look even better from American eyes. Europe was supposed to be the economic dregs in 2013 and these three charter members of the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) were supposed to be the worst of the worst. Yet, they saw big rallies on their stock markets. Despite all we have heard about how callously imposed austerity had threatened to knock these fragile economies back into the Stone Age, the policy has not been as toxic as advertised. In fact, we would argue that it has helped these deathbed economies get partially back on track.

The Luck of the Irish

You may have missed it but back in December Ireland became the first troubled euro zone state to exit its rescue program completely. Three years ago, amid the collapse of the country's property market and large losses in the banking sector, Ireland received a 67.5 billion euro loan from a lending troika consisting of the International Monetary Fund, the European Commission and the European Central Bank. In exchange, Ireland was required to impose a series of spending cuts, tax increases, asset sales, and banking reforms. Although these measures made the Paul Krugmans of the world shudder, they appear to have worked for Ireland.

A turning point came in March of last year, for the first time since November 2010, Ireland successfully floated sovereign debt on the international market. Demand for its 10-year bond was so strong that Ireland increased the size of the offer to 5 billion euros from the original 3 billion euros. Then in the new year 2014, things got even better when Ireland was able to raise another 3.75 billion euros at an even lower rate (3.54%). In December 2013, ratings firm Standard & Poor's affirmed its long-term credit rating of BBB+ and said the outlook remained positive. Ireland appears to be out of the financial doghouse.

In another positive sign, Ireland's housing market appeared to have turned around after having fallen about 50% during the crisis. In June of last year, "national residential prices recorded their first year-on-year increase (of 1.2%) since January 2008," said the Central Statistics Office. Additionally, October saw prices rise 6.1% year-over-year. Finally, the unemployment rate had fallen again in December for the 18th consecutive month, registering the lowest rate since May 2009. In the third quarter of 2013, the seasonally-adjusted rate fell to 12.8% from 13.6%, and more than two percentage points below its early 2012 peak.

The falling unemployment rate has been helped by American technology companies expanding their Irish operations. In 2012, Apple announced it would build new offices at its Cork headquarters and would hire 500 people. Then in December, Microsoft invested170 million euros to expand its Dublin center. All of this happened during a period of austerity!

The Drain in Spain

Spain agreed to its rescue package in July 2012, about 19 months after Ireland, but it expects to exit its bailout program in less time (the country expects to transition in early 2014). While the euro zone partners authorized a rescue package of 100 billion euros, Spain only took 41 billion.

Like Ireland, Spain was forced by the lenders to make budget cuts and structural reforms in the financial system, and while the measures have bitten, they have led to improvements. In the third quarter, the Spanish economy emerged from a two-year recession and posted growth of 0.1%. While this is below the euro zone average, it is not the catastrophe that some had predicted. In November, Standard & Poor's raised its outlook on Spanish debt to stable from negative, and kept its debt rating at BBB-, one notch above junk-bond status. By year end 2013, Spain's government bond market stabilized with yields on 10-year bonds falling to 3.9% from 6.4% in July 2012.

In its November report on the European economy, the European Commission said Spain's domestic consumption and equipment investment began to stabilize in the second quarter of 2013 and that it expected these trends to continue, with the composition of growth becoming more balanced as domestic demand strengthens.

The European Commission expects the Spanish economy to finally expand in 2014 with growth of 0.5%, and 1.7% in 2015. And while unemployment fell from its first-quarter peak of 27.2%, it remains extremely high at 26%. While these jobless numbers seem unimaginable to Americans, it must be remembered that Spain's highly restrictive labor laws have driven a large portion of the nation's jobs into the opaque world of the under the table economy.

 There can be no doubt, however, that Spain is still in the thick of it. Based on its historic housing boom of the last decade, the country's real estate market has yet to show signs of a true bottom, and will probably continue to contract in 2014. Still, the European Commission said, "overall, the adjustment process is progressing, but challenges and vulnerabilities remain significant." Apparently that was enough for investors.

Greek Trajectory

The situation in Greece remains much riskier for investors than either Ireland or Spain. The country is nowhere near exiting its bailout. Actually, it's expected to receive another 1 billion euros as part of its bailout program before the end of December 2013. The country is currently in the sixth year of a recession, and since 2010 has received 240 billion euros from the lending troika. (That's more than 21,000 euros per resident). But its fiscal picture is improving.

In December, the Greek parliament approved the 2014 budget in which it expects its first surplus in a decade, 812 million euros, double the previous estimate. Although the surplus excludes debt payments, it may be likely the country will meet next year's fiscal targets. Meanwhile, Greek bond yields have plunged to 8.28% from 25% in August.

While the European Commission expects Greece's GDP to contract by 4.0% in 2013, this is still an improvement over the 7.1% decline in 2011 and its 6.4% contraction in 2012. Going forward, the Commission expects Greece's GDP to grow 0.6% in 2014 and increase to 2.9% the following year. Last summer, the tourism industry staged a strong revival as it proves to be a much cheaper destination compared to other vacation spots. 

However, the austerity measures have required the government to eliminate many public-sector jobs from Greece's famously bloated bureaucracy. This transition to a sustainable model is causing much current dislocation. The unemployment rate jumped to 27% in 2013 and with the lending troika demanding more austerity from the government, it doesn't look like this problem will get better in the very near term. But investors may be looking past these numbers.

According to the commission, "In 2015, the recovery is forecast to gain strength, as investment becomes the main engine of the recovery. ... With consumption no longer being a drag, real GDP growth is projected..." Given how woefully awful the Greek economy was widely understood to be, this forecast is actually a fairly acceptable prospect.

Austerity Bites? 

Clearly all three economies are still in a shambles. But given how wildly unsustainable the debt growth had become for all three the recent stabilization should be celebrated. Given their problems, it would have been impossible to conjure a pain free solution that stood a chance for the long term.

While economists such as Paul Krugman have been at the forefront of the chorus that says austerity doesn't work, these measures have not stopped these countries from improving their fiscal positions while setting a sustainable course. Although unemployment remains high in Greece and Spain, the falling unemployment rate in Ireland shows that restored faith in government responsibility leads to investment. Krugman and his brethren are similarly wrong when it comes to the devastating effects that are supposedly delivered by deflation.  

The improvements in these "basket case" economies remind us of the emerging market economies that came out of the Asian debt crisis with a new lease on life. For those who can tolerate the risks and volatility, it may be a good time to look deeper.

Man has had the ability to separate silver from lead for as far back as 4000 B.C.

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