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from MacroScope:

Euro zone may struggle with its own Lost Decade

Additional Reporting by Andy Bruce and polling by Rahul Karunakar and Sumanta Dey.

As Europe’s crisis drags on, the prospect of a Japanese-style lost decade of economic malaise is becoming increasingly real, according to a new poll. Half of the bond strategists and economists surveyed by Reuters are now expecting just such an outcome.

Many market participants have dismissed the fall of two-year German bond yields below their Japanese counterparts as being merely a result of a crisis-fueled flight to quality bid. Two-year German yields are now close to zero, offering returns of only 0.02 percent. By contrast, equivalent Japanese bonds are yielding 0.11 percent.

But a significant portion of analysts in a Reuters poll see something more sinister in the rapid narrowing of the premium investors require to hold German debt over Japanese bonds. One half of those polled – 12 out of 24 – said it is likely the euro zone is close to entering a period of prolonged low or no growth and inflation and low interest rates, with the other half saying it was unlikely.

According to Stephen Lewis, chief economist at Monument Securities:

I don't really see an early end to the financial crisis in the euro zone. I think it's very unlikely that Germany and the other countries will see eye to eye in the course of this year. That's going to keep the euro zone economy looking very weak for the next several quarters.

Europe's economy stagnated in the first quarter of 2012 and is expected to shrink 0.4 percent this year, according to another recent Reuters poll. Data on Thursday certainly pointed in that direction, suggesting even wealthier countries like France and Germany are also starting to feel the pinch.

from MacroScope:

Manifest currency? U.S. dollar’s global dominance not set in stone

Incumbency, it is often said, confers many advantages.

Sitting U.S. presidents certainly have reaped its benefits – in the past 80 years, only three have been unseated.

Most economists believe the same benefits apply to reserve currencies. Yes, the U.S. dollar may one day be supplanted as the leading international currency, the thinking goes, but that day is many decades away.

Then again, maybe not.

A new working paper from the National Bureau of Economic Research that looks more closely at the dollar's own rise to the top in the 20th century suggests, among other things, that "the advantages of incumbency are not all they are cracked up to be."

By looking at the currency denomination of foreign public debt issued by 33 countries from 1914 to 1946, the authors – University of California-Berkeley professor Barry Eichengreen and Livia Chitu and Arnaud Mehl of the European Central Bank – find that dollar-denominated bonds were nearly equal to those priced in sterling by the late 1920s. That's about two decades earlier than the date assumed by previous scholars.

When stripping out Commonwealth countries that had strong commercial and political links with Britain, the dollar overtook sterling in 1929.

from Breakingviews:

Hot infrastructure auctions drive down returns

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The market for infrastructure assets is heating up. Yield-hungry investors are keen on large, predictable businesses in the less rickety bits of Europe. So auctions like E.ON’s sale of its German gas pipes run pretty hot. Even if the bets are less extravagant than during the credit boom, returns will suffer.

The 3.2 billion euro price tag for E.ON’s “Open Grid Europe” doesn’t look hair-raising: it’s in line with book value, and about 10 times EBITDA. Low-cost debt helps: Macquarie’s infrastructure fund, which teamed up with a Canadian money manager, Abu Dhabi’s sovereign fund, and a German insurer, got banks to stump up 2.2 billion euros or so of cheap loans, ahead of a likely bond sale.

Nonetheless, robust auctions tend to mean higher prices. To win, Macquarie had to fight off three other serious consortia. Rivals and sector-watchers reckon the Macquarie group paid at least 200 million euros more than the next bidder, and question how it will achieve its target 10-percent plus internal rate of return from the investment.

Of course, business plans differ, although regulators probably limit a buyer’s wiggle room. Macquarie may also be more optimistic about an eventual exit price. And today’s low-yield world is undoubtedly compressing return expectations for all investors, not just in infrastructure.

Still, lower anticipated returns also reduce the margin for error. Like Vattenfall’s sale of its Finnish assets late last year, the E.ON disposal is a reminder of how much cash is chasing assets. That appetite comes both from infrastructure funds and from other enthusiasts for long-term investments, such as stewards of pensions and petrodollars.

from Breakingviews:

Eurovision a good metaphor for lack of euro vision

By George Hay

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The euro zone crisis is everywhere. The political and economic plight of Greece and Spain has reached fever pitch. And now awareness of the splintering currency area’s economic realities has reached the Eurovision Song Contest.

This annual musical cacophony, which dates back to 1956, features execrable europop sung by a succession of bizarre d-list pop stars who have somehow been deemed representative of their national culture. Voting takes ages and is conducted by hapless TV anchors of the host nation beaming live to all 26 participating countries in turn. In terms of efficiency, it has a lot in common with the actual euro zone.

This year it’s hard to resist hunting for subliminal messages in each nation’s songs. Part of the sober Finns’ entry translates as “Close Your Eyes”, summing up what most taxpayers in Helsinki want to do at the thought of fiscal transfers to the indebted periphery. On the other hand, Slovakia’s entry underlines the difficulty of getting all 17 members to reach a consensus: it’s called “Don’t close your eyes”.

Other entries are even more revealing. The Spanish have submitted “Stay with Me”, a transparent plea to German chancellor Angela Merkel to not abandon them. Germany’s own effort sums up its ponderous approach to the crisis. It’s called “Standing Still”.

But one entry actually addresses the crisis directly - and that country isn’t even in the euro zone. Montenegro’s song, “Euro Neuro”, is three minutes and five seconds of ostensible gibberish rapped by a middle-aged Montenegrin who goes by the unlikely name of Rambo Amadeus. But it contains a compelling message.

from Breakingviews:

Euro stocks discount lion’s share of new fear

By Robert Cole

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s hard to be bullish about European equities. The economies look weak both inside and outside the euro zone and the single currency’s crisis only seems to get worse. But the share prices may be discounting even more bad news.

The STOXX 50 index of leading euro zone shares has lost all the tentative gains made in the first part of this year and is standing at not much more than half the level of five years ago. The total return since then, including reinvested dividends, is a depressingly high loss of 35 percent. In the United States, the total return of the S&P 500 over the same period is slightly positive.

Some underperformance is justified by Europe’s weaker economic performance and by the euro zone’s problems. The relative weakness on the eastern side of the Atlantic is reflected in earnings expectations for 2012. Thomson Reuters data indicate a 5 percent gain in the euro zone and 10 percent in the United States. The most recent economic news suggests the gap could widen.

But European share prices may reflect too much pessimism. European equities have usually been cheap by American standards; right now the discount of forward earnings multiple is above the post-1987 average. And not only is the 9.5 price-earnings ratio one-quarter less than the equivalent U.S. figure, it appears to discount no earnings growth at all in the next five years and no increase in valuation.

There could be big rewards for those brave enough to buy. If euro stocks’ earnings rise at half the post-2005 annual rate of 10 percent over the next five years and p/e ratios move only halfway back to the long term norm, then investors will earn inflation-adjusted annual returns of 11.6 percent.

from MacroScope:

Risk of contagion if Greece exits euro: WestLB

What happens if Greece leaves the euro? No one can say for sure. But John Davies at WestLB, finds it difficult to envision a benign outcome.

Greece’s economy, at around $300 billion, is very small compared to the euro zone as a whole. The problem is if other countries follow suit – or are pressured in that direction by stubborn financial markets.

Such a scenario doesn't bear thinking about because it is so horrible.

There is a good chance that the market would immediately trade Portugal towards pre-debt swap Greece levels. The next in line would certainly be Ireland and Spain.

Initially you have got to assume that spreads would become even more dislocated. As you are moving out and down the credit curve the ones with the weakest credit ratings will likely suffer worst, at least initially, because we are moving clearly into the world of the unknown and that's precisely what the market doesn't like.

The Greek elections have left a political vacuum that is raising speculation that the country may eventually exit the euro. Last Sunday, Greek voters punished mainstream parties that supported harsh austerity in exchange for international bailout cash. That left the Greek parliament with a jumble of minority parties that have been unable to form a government.

The leaders of Greece's once-dominant conservative and socialist parties made a push on Friday to avert new elections and prevent a victory by a radical leftist who has promised to tear up its international bailout deal.

Inability to implement the reforms set out by international lenders amid this political void could compromise the country's life-support bailout money and lead to a default. This could make the country's membership of the euro increasingly unsustainable, even though those very reforms risked choking growth further in an economy suffering its fifth year of recession.

Even Germany, the key driver of growth in the euro zone, might eventually be threatened by worsening financial and economic conditions around it. And what of the bullish German Bund market which seems to know no bounds? Davies again:

from Global Investing:

Big Fish, Small Pond?

It's the scenario that Bank of England economist Andrew Haldane last year termed the Big Fish Small Pond problem -- the prospect of rising global investor allocations swamping the relatively small emerging markets asset class.

But as of now, the picture is better described as a Small Fish in a Big Pond, Morgan Stanley says in a recent study, because emerging markets still receive a tiny share of asset allocations from the giant investment funds in the developed world.

These currently stand at under 10% of diversified portfolios from G4 countries even though emerging markets make up almost a fifth of the market capitalisation of world equity and debt capital markets.  In the case of Japan, just 4% of cross-border investments are in emerging markets, MS estimates.

But change is on its way. MS surveys show most classes of global institutional investors intend to boost allocations to emerging markets, including the more conservative investor groups -- Japan's $1.3 trillion government pension insurance fund, for instance, plans to start buying emerging equities later this year.  MS analysts calculate allocations to emerging markets could rise 3.5% over the next five years.

That may not sound like much until one realises the true scale of the global pool of investable institutional assets and compares them with current market cap values in developing countries . These assets currently exceed $212 trillion, meaning a 3.5 % allocation increase will bring over $2 trillion into emerging markets. That's over half the capitalisation of EM equity market, more than 80% of bond markets and a third of the combined market cap of both sectors.

Take a look at some more numbers:

-- Based on current market values, a 1% increase in allocation to EM by pension and insurance funds represents a $524 billion flow to EM assets.

from The Great Debate UK:

Democracy vs. austerity

By Kathleen Brooks. The opinions expressed are her own.

Throughout history it has always been difficult to take something away from someone once you have given it to them. Europe is finding that it is extremely difficult to reign in public finances once they start to go out of control. Democracies don’t like to vote for austerity, which is why Sarkozy lost the Presidency in France, why a radical left party came second in the Greek elections and why the Conservatives got a drubbing at last week’s local elections in the UK.

This tells us something about democracy in the western world. Governments have to manage the public finances directly – they have to sell the debt, do the sums and present budgets. However, the people who vote them into (and out of) power are the public, who rightly in most cases, believe they have worked hard, paid  taxes and deserve the services and retirement promises made to them.

So here we have the problem: some governments in the West have unsustainable debt loads and deficit levels and yet they don’t have the popular mandate to try and bring that under control. That isn’t the story all over the west. The Germans and the Dutch agree that the government books should be balanced. But if you asked the rest of Europe if they wanted to reduce public debt levels to make country finances more sustainable at the expense of public services and jobs, the recent election results suggest that you would get a resounding no.

So there isn’t one unified way of thinking about austerity in the West. Some people see it as a virtue, others as a type of hell. So what to do? Europe’s one-type fits all model that is largely designed by Germany could lead to social disorder and radical political parties grabbing the reins of power in Greece. However, the more people fight against austerity the more unlikely it is that their governments can attract enough investors to buy their debt to fund their public spending needs.

So where does this vicious circle end? The answer is that no one knows. Now that the true state of public finances in Europe has been revealed it can’t be brushed under the carpet and the Greeks et al can’t go back to the pre-2007 ways of living and spending. However, the opposite – harsh austerity designed to reign in public finances at half the time it took to amass the debt in the first place - isn’t working either.

A more sensible plan is for Europe to reach some sort of compromise. Germany and Greece (as the two extremes) need to realise there are multiple views about what a democracy should provide and how public finances should be controlled. The next step is to plan a fiscal pact that allows countries to reign in public spending at the same pace as it amassed it in the first place – and fiscal targets should be spread out over 10 years rather than the current demands to bring down deficits to 3 percent of GDP by the next fiscal year. The UK could probably follow suit and realise that the debts took two parliaments to accumulate, thus it should take two parliaments to rein them in.

from John Lloyd:

A London divided against itself

London voted for its mayor last week and voted, narrowly, for Boris. Boris Johnson was the Conservative incumbent, a 47-year-old upper-middle class, Eton- and Oxford-educated former journalist, a classics-conversant, high-IQ prankster with a streak of political intelligence and ruthlessness that reportedly has Prime Minister David Cameron worried for his job.

Boris beat Ken (Livingstone). In London, the two main contenders for the mayor’s seat are known, with or without affection, as Boris and Ken, perhaps a reflection of the fact that they are seen, still, as not quite serious people. (The London mayoralty doesn’t have much power, and nothing like that enjoyed by Michael Bloomberg in New York, who isn’t universally called Michael.) Indeed, they are not seen as entirely serious by themselves. Both have deserved reputations as comedians. Ken used to appear on comedy quiz panels, Boris wrote witty columns for the Daily Telegraph.

Ken Livingstone is a 66-year-old Labour veteran, a working-class-born ideologue of the left, by far the most experienced figure in London politics. He ran the Greater London Council from 1981 till its abolition in 1986 and held the mayoral seat from its creation in 2000, for two terms, until 2008 – when, with Labour’s stock diving, he was beaten by Boris. Experience didn’t count enough this time, though. Everywhere else in the UK, the Conservatives and their Liberal Democrat allies in government were pounded, losing hundreds of local government seats. Labour surged back. Except in the capital.

Even allowing for election hype, London is one of the world’s great cities, though great cities have great problems. But before we come to its deficiencies, it should be said that London is beautiful in parts, and it has no peer in England. It’s the political, financial and media center of the country. It has the fifth-largest city-GDP in the world, with an estimated $565 billion in 2008, a sliver ahead of Paris, behind Tokyo, New York, Los Angeles and Chicago. As Britain stagnates in a double-dip recession, the London Chamber of Commerce says its city is beginning to boom.

And it has the Olympics, coming on July 27. The new mayor won’t have a honeymoon – political leaders in European states don’t get honeymoons anymore, life is too uncertain and frightening for that – but the Olympics will serve as a global stage upon which to celebrate a large part of Boris’s (second) first hundred days. The event will mask the sheer difficulty of forcing change in places as complex, as full of well-protected groups with so many overlapping layers of democratic and appointed authorities, as is London.

And the Olympic Park, the central venue for the games, has masked, to a degree, London’s blemish: the arc of poverty and deprivation that still besets its eastern districts, the vast, largely working class (or out-of-working class) area that enfolds the once-huge docks on the Thames. This was once a river – the river – of mercantile supremacy, naval superiority and imperial muscle. Now, with all of these diminished, the trading moved way downriver to container ports near the river’s mouth, leaving behind the splendid Greenwich naval college as well as acres of warehouses and factories. The best of these are now chic apartments, the unsalvageable have been left to molder.

from MacroScope:

NYC Mayor Bloomberg: Highly-indebted U.S. could go the way of Europe

New York City Mayor Michael Bloomberg slammed the federal government for following the same fiscal path that has cost European governments so dearly, perhaps offering Democratic President Barack Obama and Republican challenger Mitt Romney hints about what policies he would like to see from them to win his endorsement as a moderate independent. Bloomberg’s seal of approval carries added weight because he is a billionaire businessman with close ties to Wall Street, a source of donations as well as a powerful force in the economy.

I think it is clear that we have a deficit problem that is going to hurt this country dramatically and unless we do something about it is a cloud on the horizon. It doesn't mean America is going to go to zero... But I think if you take a look at Europe and other places and it shows you when you live above your means –  It’s different than the city, the deficits we project are aspirational deficits, in the end we balance our budgets, the federal government does not.

The city by law must close any deficits. In contrast, the U.S. government can borrow to fund its operations – and at very low rates in recent years.

The mayor, now in his third and final term, was presenting an update to his $68.7 billion budget plan. One reason private employment in New York City has broken the 1969 record high is the city's budget discipline, he said.

"We have to give people the clarity and confidence that we are going to face fiscal realities," he said. The country's failure to wrestle its deficit under control is curbing businesses from growing, he said. "Nationwide, there are some real questions in people's minds and they are not willing to do that."

New York City has regained about 180 percent of the private sector jobs lost during the Great Recession; the nation has only won back about 40 percent, he said. Private employment has climbed to 3.291 million, topping the decades-old high of 3.275 million. "We're part of America; we want America to grow," Bloomberg said.

Disappointing profits on Wall Street – the city's economic motor – forced the mayor to slice his forecast for tax revenue by $352 million in the current budget and the new one that starts on July 1. The city is home to some of the world's wealthiest individuals – including the billionaire mayor himself. Added Bloomberg: