How will the problems of the Euro zone be resolved?
The answer is very slowly. To be honest over the last few months things have become clearer. The Euro zone needs quantitative easing whereby the European Central Bank would buy the bonds of many of the troubled Euro zone governments. Germany stands in the way.
Germany is (rightly) insisting that the ECB should only be given bond-buying powers if the countries being bailed out emphatically commit to policies that substantially reduce their deficits. When Germany talks about the need for cohesive fiscal policies across Europe they are saying that all countries should abide by the rules.
Will the new technocratic governments in Greece and Italy work?
The problem for the Technocratic governments is that they have been put in place to take the hard decisions and hopefully implement them. In both Greece and Italy the country needs smaller government, which in turn will lead to further job losses on top of the already high unemployment levels. As an example of the scale of adjustment needed, Greece and Italy have lost about 60% of their competitiveness against the United States over the last twenty years.
Technocratic governments are however unelected bodies and still need the general support of the politicians. If sufficient politicians see it as politically expedient that they withdraw their support for the unity governments then the initiative for change will be lost. The press reports that Mr. Berlusconi is already eyeing a return to government within the next six months. We can hope that the technocratic governments will work and introduce the needed reforms.
How big a credit crunch is underway?
There are various estimates of the scale of the credit crunch. According to BCA Research Euro area banks have outstanding loans amounting to $25 trillion of which $5 trillion are direct loans to foreign entities. The Euro area banks seem most likely to reduce their foreign loans by a little over $1 trillion in 2012. It is estimated this could take 2% off global demand. Two percent may sound small but in the global economy it would amount to a massive retrenchment of growth
Which areas are most at risk from a credit crunch?
Already we have seen some pain in Eastern Europe after Commerzbank announced it was no longer providing additional loans to countries outside of Germany and Poland. The cost of long term borrowing in a number of emerging countries has risen in recent months in fear that European banks would withdraw their capital. Any company or country that has to refinance its debts over the coming year will be at risk. The real estate sector in Europe is at risk as Banks reduce their exposure to a sector that previously was well supported by the financial sector.
In Dubai there is a significant amount of debt that will need to be rolled over however at this stage there appears to be sufficient liquidity in the region to make the situation manageable. The ongoing strength of the oil price also helps sentiment. Dubai had about $30 billion of debt to roll over this year and next as at the end of September.
What is the worst thing that could happen?
The worst thing that could happen would be a default of Italian debt. The Euro zone financial sector would go into a tail-spin with many of the banks forced to go under government ownership.
Other Euro zone government bond yields would rise sharply forcing governments to squeeze their economies to reduce debt and regain their credibility. The Euro zone would slump into a deep recession. The rest of the world would suffer a sharp fall in activity due to a collapse in demand from Europe. Equity markets would fall further, gold would rise sharply and the very safest bonds would see a significant rise in prices and a consequent fall in yields.
It can’t be all bad news.
It isn’t. The US economy has surprised everyone with its strength through the third quarter. The most recent retail sales figures show that consumers were willing to run down their savings to spend in October. In China the economy with all its challenges seems to have contrived a soft landing that should in due course allow for interest rates to be cut. The Japanese economy, post the disruption of the earthquake, has achieved growth of 6% quarter-on-quarter annualized in the third quarter, a quite outstanding achievement.
What do I watch for next?
It is crucial that the new technocratic governments in Italy and Greece achieve something remarkable to encourage the Germans to allow the ECB to print money. Italian and Spanish 10 year bond yields need to be kept below 7% in order that they have a realistic chance of turning around their economies.
The current negotiation on the US budget is important for determining whether the US economy will maintain its impressive improvement seen over the last six months. The politicians will need to impress on the markets that they are serious about reducing the deficit but they also need to provide sufficient policy looseness to allow the economy to grow its way out of problems. Some emerging countries have already embarked on a path of cutting interest rates.
However others such as Hungary have been forced to increase interest rates. Also look out for the current negotiations in the US on the shape and size of the proposed budget for 2012. It was only a few months ago that the US government almost ground to a halt due to a fall out between political parties. A repeat of last times horse trading could lead to added volatility in the markets and downside on the dollar. The next round of negotiations is due on November 23rd.
How do I invest in current market conditions?
Investors with cash will have some remarkable opportunities over the course of the next few years to make some significant income and capital gains. However it is important to be patient. We continue ot recommend investing in a combination of high quality bonds, sukuks, cash and gold and only very selectively in equities.
For more sophisticated investors we are noticing a number of distress funds being launched that are replacing banks in lending to some sectors such as property. The funds look able to provide returns of 8%-20%depending on how long the investor is prepared to lock their money away for. Private Equity firms that previously only went hunting for ideas in the United States are nor poring over the Euro zone.