Another Day of Carnage

Just pictures...
And this is the day of rates cuts: ECB down 50bps (should have been down 75-100bps, but hey, when was the last time Germans had any guts for serious actions?) and BofE down to 0.5%... If anyone needed a proof that the markets are not treating Irish banks shares as a part of the broader world, preferring instead to price them as sick puppies, here it is:
So is the next stop for this train of sorrow 'Nationalization II: Bank of Ireland'?

Some housekeeping: a handful of updates

A cleaning up of some of my emails provided for a digest of interesting updates on the topics already covered in other posts. Here is an attempt to combine these...

To the QNHS (here) and Live Register data (here):

Per Davy note: "The worst affected areas [of unemployment] are building and those service sectors related to construction and the global financial crisis. Construction employment slid 7.6% quarter-on-quarter, followed by hotels and restaurants (- 3.2%), retail/wholesale (-2.3%) and financial/business services (-1.9%). No pain-sharing is evident in the data: private sector employment dropped 97,400 over the last 12 months while public employment increased by 10,000."

Last night I was a guest on a Late Debate (RTE Radio 1) alongside a SIPTU rep who was clearly traveling in some parallel reality claiming that:

• public sector took all the pain of adjustment to-date;
• those on higher incomes took no pain to date; and
• layoffs in public sector would be equivalent to layoffs in private sector.

Per point 1 - Davy note says it all, but an update on Exchequer results below also highlights the same.
Per point 2 - October Budget 2009 and its update, November Finance Bill II, both imposed progressively increasing Income Tax Levy on higher earners.
Per point 3 - two facts: (1) wage to value added ratio in Public Sectors (average) is ca 30% lower than in the Private Sector and some 1/3 lower than in the Financial and Business Services, and (2) wage to value added ratio in majority of public sector categories is close to or less than 1, so cutting 1 person out of the public sector would cost economy nothing (for ratio of 1) or would save economy some resources (for ratio is <1).
One caveat - of course, within Public Sector there are people who are highly contributive to the economy. For example: both IDA & Enterprise Ireland are aggregated into the above averages. These agencies have been significant contributors to the economic welfare in this country. Similarly, within each category, there is little understanding as to the variance of wage/ productivity ratios. E.g, do higher salaries in our flagship Universities relative to the second-tier third level institutions correspond to the productivity differentials? Knowing internal operations of Trinity, not exactly, but fairly closely. Thus, raising taxes in a 'proportionate' way as the Unions insist will hurt disproportionately more those who earn higher wages because of their higher productivity, even in the public sector.
Per Unions' 'Alternative Universe' - I got a general sense that our Unionists simply do not understand that in all instances, public sector workers depend for their wages on private sector earnings. Somehow, the Bearded Men of SIPTU/ICTU/CPSU/TGWU and the rest of the alphabet soup do not get the concept of who pays for what in this economy.

Per Exchequer Returns, February 2009 (here): there is significant evidence of deep wage cuts in private sector as income tax revenue continued to slide in January and February, despite the introduction of the income tax levy. In addition, current (non-capital) spending was up 3% y-o-y in February 2009. 2009 current spending is now on track to reach over 38% of Irish GNP - matching the record high achieved in 1983. Pure waste!

Financials and Other Stocks: as Davy puts it in a recent note: at the end of February 2009, the entire Irish Financial Sector accounted for only 3.5% of the Irish Stock Exchange capitalization as compared to 37.5% a year ago. This is diversification through attrition. The ISEQ dropped 10.3% in February - its sixth successive monthly decline. This was "the worst February performance in its 25-year history. It underperformed the FTSE Eurofirst 300 index, which also experienced its worst February performance, by 0.6%." A picture is worth a 1,000 words (all courtesy of Davy):
The last chart of course shows that Ireland is a absolute under-performer in its peer group. Davy do not analyse earnings in this context, but the above valuations are hardly making the shares cheaper. Earnings declines are now precipitous for all companies and my suspicion is that P/E ratios are falling. In other words, there is a question to be asked if there are any bargains out there given the earnings projections?Lastly, Davy provide a good snapshot of the bond markets dynamics in the chart reproduced above. Spot the odd-one-out? Note the timing of our departure to the Club Med of Near-Insolvent States - bang on coincident with Mr Lenihan's Budget... This should be a warning to everyone who is desperate for this Government to do something about the crisis: doing 'something', as opposed to doing the right thing, will make matters worse. Clearly, the markets are not seeing higher taxes and a lack of spending cuts (Budget 2009) as 'doing the right thing'.

Mansergh Calls for 'Celtic Tiger' Fat Cubs to pay their share in the downturn: Mr Mansergh - Bertie's pet in the Dail and a Junior Minister in the Cabinet - called yesterday for the tax measures in the mini-budget to focus on making sure that those who benefited most during the Celtic Tiger era pay more in taxes. Great idea from the Grand Weasel of Irish Politics. How about we start with Mr Mansergh himself - a person whose ministerial salary is out of touch with reality, and whose pension benefits are so lavish, that some bankers would envy the returns on so few years of such a non-demanding work as that of a Junior Minister for State with responsibility for the Arts. Mansergh serves in the cabinet which, with exception of 3-5 Ministers, is remarkable for its inability to do its job at a basic level. Yet the cabinet is being paid more than its counterparts in the US, UK, EU15 or indeed anywhere else in the developed/ democratic world. So, be my guest, Mr Mansergh - pony up, say 50% of your own income - you and your colleagues and their senior public service underlings are the Fat Celtic Tiger Cubs.

Live Register: another month, another record

Remember a record rise in the unemployment benefits claimants of 33,000 in January? Today’s figures show that the new claims rose by an additional 26,700 in February. But do not get your ‘Out of the Recession’ placards yet. January figures were negatively impacted by the cumulative lay-offs following the Christmas holidays. In other words, when seasonal factor is controlled for, February layoffs were probably as bad, if not worse, than the already abysmal January numbers.

Overall, the Live Register now stands at 352,800, the largest on record up 165,000, or almost 90% y-o-y. Now, each new 1,000 claimants cost the Exchequer some €15ml in social welfare and lost tax revenues. This implies that y-o-y the Exchequer lost €2.475bn. Surely, raising taxes (and thus undercutting employment in the private sector) is not a way forward?

Even without any new tax measures, I expect that the number of unemployment benefits claimants will rise to 450,000-480,000 by the end of 2009 (in annual average terms – 465,000). This will imply a social welfare spending overshoot of some €1.3bn and a tax loss of ca €630mln relative to January DofF budget estimates (here).

The Live Register-based estimate of the unemployment rate was 10.4% in February, up from 9.6% in January. We are back in 1997 world and falling.

Without too many dull details, the official unemployment figures (QNHS) show an unemployment rate of 7.7% for September-November 2008 (just like everything else in the world of the CSO’s apparatchiks, Q4 in unemployment statistics is not the same as Q4 in the real world). Now, the Live Register for this period showed 7.4% unemployment rate – an underestimate on QNHS. And we are now seeing the second quarter of continuous underestimates of the true unemployment rate being produced by the Live Register.

What does this mean? Well, it means that an army of part-time workers that resulted from ‘hidden’ layoffs in 2008 – when large number of construction and other workers were forced into part-time employment – is now becoming full-time unemployed. And the labour force itself is shrinking. By 15,000 in Q4 2008.

Hmmm… Ulster Bank now predicts 14% unemployment rate by the end of 2009. In January, I claimed that the unemployment will rise to 11-12% by December. Oh, how wrong was I. My new estimate – in light of Live Register for the last two months and QNHS for Q4 2008 is that we will be somewhere around 13.8-14.6% and that is assuming that laid-off foreigners leave in bus loads…

And, sadly, that is the fate of our fabled uber-educated Irish labour force, as the Government likes to point out… In immortal words of the Hitchhiker’s Guide:
"Please relax," said the voice pleasantly, like a stewardess in an airliner with only one wing and two engines, one of which is on fire, "you are perfectly safe."

Oh, no, we are not!

How bad will it get? IMF study

Here is a new insight into recessions dynamics. This time from the IMF (see link here).

What Happens During Recessions, Crunches and Busts? by Stijn Claessens, M. Ayhan Kose, and Marco E. Terrones (IMF WP/08/274) looks at "the linkages between key macroeconomic and financial variables around business and financial cycles for 21 OECD countries over the period 1960–2007."

Data set covers 122 recessions, 112 (28) credit contractions (crunches), 114 (28) episodes of house price declines (busts), 234 (58) episodes of equity price declines (busts).

The authors "find evidence that recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions... Episodes of credit crunches, house price and equity price busts last much longer than recessions do [4 quarters on average]. For example, a credit crunch episode typically lasts two-and-a-half years and is associated with nearly a 20% decline in credit. A housing bust tends to persist even longer—four-and-a-half years with a 30% fall in real house prices. And an equity price bust lasts some 10 quarters and when it is over, the real value of equities drops by half."

Of course we are experiencing far deeper contractions in house prices and equity valuations than an average bust.

"Most importantly, recessions associated with credit crunches and house price busts are deeper and last longer than other recessions do. In particular, although recessions accompanied with severe credit crunches or house price busts last only three months longer, they typically result in output losses two to three times greater than recessions without such financial stresses. There is also evidence that the extent of declines in house prices appears to influence the depth of recessions, even after accounting for the changes in other financial variables, including credit and equity prices, and various other controls."

Where is Ireland in all of this? We have:

• housing bust;
• credit bust;
• equity market bust;
• severe recession.

16-23% contraction in real output in Sweden and Finland in the recent past is a guide, according to the IMF study, for the type of recession we are in. Overall, there were only 4 episodes of coincident credit, equity and house prices busts.

Using econometric estimates (Tables 13.A and 13.B in the paper), we can parametrize the IMF model to estimate the expected contraction in Irish economy during the current crisis. Table below lists the underlying assumptions (in % changes) and results.Thus, under benign Scenario 1 assumptions, overall income contraction in Ireland over the recessionary cycle is expected to reach 13.5%, while under more severe Scenario 2 the contraction can result in a fall in real income of 16.1%. My personal view - we are going to see the latter rather than the former.

IMF study allows us to estimate the share of overall contraction that is attributable to the housing shock absent credit bust - in other words, due to purely domestic factors. This ranges from 66.6% in Scenario 1 to 63.5% in Scenario 2 - in both cases, a lion's share of the recession-induced economic pain is due to 'domestic' causes. At the same time, the share of recessionary decline in income that is attributable to 'external' or global factors (all shocks net of housing price bust) is ranging between 12.7% and 20.7%.

So much for the argument that we are in trouble because the rest of the world.

The Latest Exchequer Figures: can Biffo turn Gruffalo?

Gruffalo is a marvelously hideous and not-so-bright character in my son's favorite books. Today's Exchequer figures and the talk about the need for higher taxes and courageous Government policies remind me of this imaginary animal.

The preliminary Exchequer receipts show that we are on track to deliver on my forecast from February 8 (here) that estimated a tax revenue this year between €33.3bn (moderate case) and €34.5bn (benign scenario). Ulster Bank's Pat McArdle - an excellent economist with good knowledge of the budgetary nitty-gritty - agrees (his forecast produced today is €34bn). Of course, to remind you, DofF official forecast revenue is €37.7bn. Ya wish, baby!

It feels good (even in these sad circumstances) to be the first to deliver a correct prediction. The post - linked above - and the precedent ones (Update I and the original post) were bang on the money. The mini-budget is now inevitable by the end of March - spot on my prediction for tax increases before April made in December issue of Business&Finance and here.

Ulster Bank note (full credit to Pat McArdle) shows the rate of DofF's descent into forecasters' hell:

Forecast date: 6 Dec 2006 - €56.3 billion

Forecast date: 5 Dec 2007 - €51.8 billion

Forecast date: 14 Oct 2008 - €42.8 billion

Forecast date: 9 Jan 2009 - €37.0 billion

Current figures: Ulster Bank - €34.0 billion, my - €33.3-34.5 billion

As of today, we are some €22-23bn ahead of DofF-forecast for the shortfall. This, as McArdle rightly points out (I produced the same figure back in February) is approximately what we have to find to plug the hole in the side of our public spending Titanic.

Think about it: the hole is almost 70% of the entire revenue projected for this year. Can we plug the hole with a Gruffalian (draconian) 50% income tax increase?

Here is the breakdown of the revenue figures (again from Ulster Bank note):

I've said time and again that the Laffer Curve and tax minimization will imply that the revenue will fall as taxes rise or at the very least it will not rise in 1-to-1 relationship to tax rates increases. We have evidence of this. VAT receipts have fallen at more than 4 times the rate of fall in national income and in line with retail sales. Income tax receipts are down at ca 1.5 times of income contraction (and this is before self-assessment returns come in).

And as far as tax minimization goes - many of those on both high and low incomes are sole traders or business proprietors. These categories of workers do not pay income tax on a regular basis, bunching much of their payments into October. They do pay more regular VAT and this smooths quarterly VAT returns. Comes October, they will do everything legally possible to make sure Biffo-the-Gruffalo, Bromidic-Brian and Mary-the-Lottery-Winner don't get their paws on hard earned cash. In addition, the sole-traders on lower earnings will never be brought into the tax net, no matter how much the Government widens it, because they will 'adjust' their income to just below any feasible new threshold.

I did some crude maths on the two effects and here are my estimates.

First the assumptions. I assume that both Laffer Curve and Tax Minimization effects will reduce 1% increase in the rate of:

• Income tax to a 0.68% increase in underlying revenue (with Laffer effect reducing tax rate increase contribution by 20% and a Tax Minimization effect reducing it by further 15%),
  

• Corporate tax to a 0.6% increase in underlying revenue and
• Excise taxes to a 0.4% increase in underlying revenue.

Now, note I am not assuming that the Laffer effect will result in a fall off in revenue, but that it will only undermine the rate of revenue expansion. I then computed two scenarios:

Scenario 1: 'Biffo gets upset' - increasing excise tax rates by 20%, income tax rates by 25% and corporate tax rate by 10% across all possible bands. Under this scenario, gross annual revenue rises to €33.5bn assuming January-February slaughter of the Exchequer continues. To assure that budgetary deficit does not exceed DofF estimate of 9.5% of GDP, promised by Biffo to Brussels in January, and allowing for a 5% decline in GDP, Brian-Brian-and-Mary must come up with €6bn in fresh public sector cuts on top of the above tax increases and the pensions levy!

Scenario 2: 'Biffo goes Gruffalo' - increasing excise tax rates by 25%, income tax rates by 50% and corporate tax rate by 25% across all possible bands. The Gruffalo-Biffolo must come up with €3.1bn in fresh public sector cuts!

And that's before any second order effects of tax increases (dynamic Laffer Curve) and no spillover from higher taxes into weaker economy.

Pat McArdle estimates the required additional cuts to be around €4bn this year. Ok, close enough... An impossible task for Mr Cowen's gang of public sector appeaseniks.

A sight of carnage: US

DJIA has fallen past the psychologically important 7,000 marker to trade at 6,763.29 at the time of writing this - well below its previous 52-week intraday low of 6,952.06. As it stands, the Dow is now at the levels last seen in April 1997. The chart below illustrates.The drivers for the latest slide are clearly the renewed pressure on financials and the fact that the Obama Honeymoon is over - the markets are now turning sceptical about the new administration's ability to push the economy out of a depression spiral. Concerns are mounting as to the inflationary effects of the current policies amidst a general conviction that there will be no upside to economic growth. The traditional partisan Democrat policies are now being seen as setting the stage for a return to the dark ages of Jimmy Carter in the near future.

The graph below (courtesy of Calculated Risk) illustrates:Notice that although the downgrades are much steeper today than in the 1970s, the trajectory of the most current downgrades (slope) is virtually identical to the 1973-1974 crisis. A fellow in the US investment community (thanks for the question HM) just asked me how this can happen, given oil is scrapping the bottom of the barrel in price terms while inflation is yet to rear its ugly face - the opposite of the stagflationary 1970s scenario. Here is an explanation.

The fiscal stimulus package unveiled by Obama is designed to increase inflation-inducing public spending by unprecedented amounts. At the same time, personal income is rising again, while propensity to consume is improving. These are the driving forces of the renewed inflation that can appear just as suddenly as deflation set in late last year.

On the other hand, today's energy in he economy is no longer oil. Instead it is credit and cash. Both are in short supply and near peak level of prices. The oil price is largely irrelevant lagging indicator of global demand, not of the productive capacity of economy. The flow of credit is the latter and not the former.

So the Obama-styled Carterism is going to manifest itself in higher inflation down the road and falling or stagnant real output, as price of the modern 'energy' - credit and money - is going to remain high.
Then again, the US has had it easy so far, compared to Ireland... Chart above illustrates.

May be Mr Cowen can bring some Irish bonds as a gift to the White House for the Paddy's Day? Cheaper than shamrocks and equally symbolically useless.

P.S. There is an excellent summary of the US Economic Conditions for February 2009 at Calculated Risk site (here).