What if?

Weekend press coverage of the economy in the UK was decidedly mediocre. One journalist said it was time to consider stocking up with foodstuffs and buying a gun ahead of the breakdown of law and order. In the same paper another writer was saying that small caps would provide superior returns in 2009.

It seems to me that the City has failed to raise its commentary game to address the severity and speed of the proto-recession - there is still far too much standard thinking. I would like to see some fresh thinking about the possible structural market impact of political banana skins that are being thrown out by the current economic downturn and the series of uncoordinated government and half baked responses to it. What would happen to currencies , equities and fixed income markets if one of the following was to play out ?:

What if Israel decides that the US administration is fixated on the economy and ignoring the threat posed by Iran? Will a new government in Jerusalem take the view that Iran is close to developing a workable nuclear warhead and attack Teheran's nuclear facilities? The recent election results seem to have boosted the hawks. Where would oil trade? Would the economic and psychological benefits of the stimulus be choked off leading to a second major leg of the downturn?

The lack of policy response at the weekend G7 meeting in Rome shows that the market state is dead. What will replace the political consensus of the last 60 years in the UK? Socialist safety net, Thatcherite austerity or something new? What does this mean for equities - will higher tax rates of say 60% on income slow corporate growth or will new high margin and strengthened corporate entities emerge to drive market valuations?

What if Ireland defaults (see previous posts)? Will the ECB bail them out or will German voters surprise us all and say no to their government and no to bail outs for the other PIIGS - what would the ECB do then? Would the Euro survive the withdrawal of its key economy? 49% of Germans want a return of the Deutsche Mark according to the latest polls.

Clearly government austerity is on the cards for the UK. Will the UK be forced into a major reduction of defence spending? If Trident is cancelled will the UK have any justification for retaining a seat on the UN security council?

What if Russian foreign policy continues to trend towards nationalist goals? Will Moscow use the economic crisis to destabilize Ukraine in the belief that gas hungry Germany and Italy will prevent any concerted action against it?

Why would the ECB want the UK to join the Euro?

Sentiment on the trading and research desks of the big City firms is as dire as I've ever known it. The creeping realisation that the salary component of the remuneration package is likely to be larger than the bonus element isn't helping.Prop desks in many houses have had their hands tied and are ticking over at 10% of summer levels.

Lot's of talk about nationalisation of the banks, sterling at parity with the greenback, and a reduction in national installed capacity of 10%-15%. Some pundits are beginning to say the unthinkable that the UK will need to join the Euro. Question is why would the Europeans let us ? Entry would probably be at around £= 70/75 euro cents to make sense and that would only serve to boost UK competitiveness, and attract FDI into the UK from the rest of Europe. Whatever the outcome the UK government is at some stage going to have to address government spending with particular focus onpublic sector pensions. President Sarkozy remains convinced that the UK will have to come cap in hand to their European neighbours by the fall at the latest - the alternative being an IMF bailout. There's going to be plenty of fun ahead in the currency markets!

Leaving the Euro

Currency markets have got it into their mindset that one of the PIIGS will leave the Euro. A question that should be asked, but isn't, is what would happen if the ECB were to expel a country for willful non-compliance?

The political impetus to retain the Euro is strong in countries like Spain and Italy where expulsion from the common currency would be seen as an emasculation of their European credentials. They would fall into that strange second tier of peripheral states like the UK , in the EU but not of it. The leverage that can be applied by the ECB on countries and their governing political elites that fail to make the structural adjustments required is enormous. It would seem most unlikely that any of the major states could face the domestic and international political and economic consequences of going it alone.

Much more at risk of expulsion are economies like Ireland. There are those in the EU who might take a less supportive view of helping Dublin's economy if the Lisbon Treaty is rejected out of hand by their voters a second time. Some ECB sabre rattling pour encourager les autres can be expected - it would also do wonders for the strength of the Euro and inflation targeting.