The European Financial Crisis

Tuesday 20th December 2011

Europe will hold the key as to whether we have a good 2012 or another year of extreme volatility, hope and despair.

With the Greeks having woken up to the old adage that if you owe the bank enough money then it becomes their problem not yours, it remains to be seen whether the other struggling southern European countries, such as Italy, Spain and Portugal take the same view. The early signs are that the new Governments in place are at least trying to put their houses in order.  The European crisis has already claimed the scalps of the Irish, Italian, Spanish, Greek, Portuguese, Belgian, Finish, Dutch and Slovakian Prime Ministers and the challenge for Europe’s politicians will be to avoid the short-term voter pleasing bias in favour of the longer term difficult decisions which need to be made and may ultimately cost them their jobs.

In the meantime, the European rescue packages continue, which have now moved towards no fewer than 16 summits since the Greek crisis blew up in 2010 yet little has been achieved as the outcome the markets are looking for is either a huge European financial stability facility (EFSF) or a Euro Bond issuance that will remove specific country loans in favour of a loan from the European Central Bank.  However, the solution is still elusive as Germany will be the main contributor towards this and is being negotiated at a time when most countries are looking over their shoulder at the rating agencies hoping that their debt will not be downgraded, as has happened with America and is no doubt likely to happen to France in the near future potentially putting their own Bonds under pressure.  

The concern remains that European politicians are not really addressing the central problem. The real issue is whether the politicians can look up from their own agendas for long enough. It has also not gone unnoticed that over-indebted Europeans are still trying to guarantee their own debt – so they can borrow even more, with Italy, for example, due to contribute €139bn to the EFSF yet being one of the major recipients of the cash back for its Bond markets.  However, on a brighter note, the ECB has joined forces with a number of Central Banks to provide virtually unlimited liquidity to the European banks and this resulted in a sharp rally on the equity markets, reflecting the importance of money market liquidity to equities; if liquidity dries up, equities are often the only source of ready cash and this has been overhanging the markets for some time.  So, European politicians continue to deal with the symptoms, rather than the cause and the crisis will continue to manifest itself through the European Bond markets as there are obviously no individual currencies to take the strain, and, as we have seen recently, Italy is now in the firing line after Greece.

We had hoped to have some clarity by the year end but that now looks increasingly unlikely and what seemed slow to the financial markets is actually break-neck speed for politicians.

Looking forward to 2012, I think the themes of 2011 will continue to be the main drivers of returns in 2012 and the investment environment is likely to remain highly challenging in the early part of this year.  2012 is likely to be the year where the Euro will be resolved for better or worse.  A favourable resolution will set markets up for a very decent rally on the basis of today’s depressed valuations, whereas an adverse outcome has the potential to push the developed world back into a severe recession.  In our opinion, so long as the cost of the break-up scenarios are prohibitively expensive and outweigh the cost of keeping the single currency together, the probability is that the Euro will survive with a small window of opportunity for many structural issues to be addressed.  

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