Saturday, December 31, 2011


Recession, unemployment and austerity . It's unlikely to be a great year but also unlikely to be the Armageddon that many commentators are forecasting.

The key question :
Dominating the performance of all markets and all asset classes is the question of whether the Euro can survive .My view ? The effect of a breakup would be so devastating that the common currency will probably hold together for the coming year. Some of the big investment banks are talking about a 25% drop in Euroland GDP if there were to be a disorderly divorce. This seems improbable. More likely would be a steep - 3-5%- fall in output, followed by a decade of zero growth and growing social unrest as unemployment levels rise to the mid teen.

To avoid this governments will engineer a fall in the €'s value relative to most other major currencies by lowering interest rates. This will help maintain jobs, boost Euroland
competitiveness , and ease the agony of disinflation as austerity measures take hold in Spain and Italy. A mishmash of ECB bank funding and IMF loans will help dull some of the economic pain in Portugal, Ireland and Greece. This combination of factors paves the way for higher, imported, inflation in France and Germany from 2013 onwards. Imperfect but at least a workable solution. Greece, which is now effectively dysfunctional at the economic level, may see a structured default and a temporary suspension from full Euroland obligations in order to keep a lid on social discontent. A full exit by Athens remains unlikely.

The major threat to this difficult scenario will come from France. The possibility that Francois Hollande, the Socialist candidate and possible victor in the May 2012 Presidential elections, will seek to water down the austerity measures could lead to a crisis in Franco-German relations . Markets would not respond well to this perceived back-tracking . The French triple A rating would certainly go and French bank shares might need government help in recapitalizing . On the downside , there's a 1 in 5 chance that things could move out of the politicians control with French ratings seriously weakened an Italian and Spanish debt refinancings becoming untenable.

The real pressure on Euro cohesion comes in 2013 when the Italian and Spanish electorates feel the full brunt of austerity with no end in sight and before the ECB printing presses are rolling at full tilt.

Bottom line . Expect the Euro to survive in 2012 but with extreme turbulence across all asset classes as the French Presidential election and its unguarded rhetoric unfold. Market volatility , particularly in the continental banking sector, may start as soon as the new trading year .

To follow later this week. The succession issues in Russia, the US, and Saudi Arabia. Why gold is weak. Oil as an insurance policy .

1 comment:

  1. “…governments will engineer a fall in the €’s value relative to most other major currencies by lowering interest rates…”

    But which interest rates and which “other..currencies”?

    The € will fall if the money markets sell €’s and buy other currencies. Buying other currencies, (the £/$ are the only viable alternatives), would cause those currencies to rise. Which neither the UK nor the USA would welcome, since both countries are hoping to export their way out of recession. They could/would simply print more money to keep rates low. There is no other country against whose currency the € can effectively devalue. The Swiss have already tied their currency to the €. The reminbi is not convertible and unlikely to be so for the foreseeable future, the Nordic currencies are too small to absorb any significant inflow.

    Besides which, surely the interest rates which matter are the Eurobond rates in the relevant countries. The money markets have already passed their verdicts on the PIIGS. The rates these spendthrifts have to pay are already stratospheric – are they likely to improve? Not in the short term because the economic fundamentals in these countries are shot to ribbons.

    Can the ECB print enough money to buy all the ‘sub prime’ bonds out there? I don’t see how they can without causing massive inflation – at which point Fritz throws a wobbly! In fact Germany is going to pull the plug on the ECB long before it gets to that stage. And I think they are likely to get support from elsewhere in Europe. The Finns are not happy, the Dutch and Austrian economies are linked pretty tightly to Germany’s. I wouldn’t be surprised to see the Czech Republic siding with the Germans and what of Poland? The largest European country currently not in the Euro Zone but whose most important market is Germany? Speaking as one of Polish descent, I can tell you their attitude towards work, a sound economy and fiscal probity is a lot closer to Germany’s than Italy’s, let alone Greece’s. A half century of communist misrule inculcated some unfortunate habits –“We pretend to work, they pretend to pay us” etc. but that is changing fast.

    So I hope you are right in your analysis that the € will muddle through 2012 – but I’m doubtful.

    My scenario foresees one of two possibilities. Either Greece and Italy are kicked out of the Euro in which case there is chaos but France, Spain and Portugal agree to get their act together, balance their budgets, accept the austerity option, stop overpaying themselves, in which case I guess Germany will step in and help them OR Germany quits the Euro. In the ensuing chaos the DM appreciates against the € and ClubMed cowboys live to spend themselves stupid again. Germany suffers pain but knuckles down, accepts (temporary) lower living standards (but still higher than ClubMed’s) and within 3/5 years exports its way out of trouble.

    Personally I think the second option appeals greatly to the German psyche. They are fed up to the back teeth with the limpet like French attachment to the German tit and they have nothing but contempt for the ClubMed mafia. It’s only their politicians who (believe?)/act otherwise. Let’s see what happens when the mood turns nasty in Germany.

    There are some very, very unfortunate precedents in Germany which the German political establishment absolutely will not ignore. They just need to be pushed up hard enough against the wall to the point where they feel they have no alternative but to bow to the will of the people. After all, that’s how democracies work, isn’t it?

    Happy New Year