There was one piece of great news last week. A new Mayan calendar find in Guatemala made no reference to the world ending this year. That’s nice, so I can now go back to worrying about Greece in peace.
Or maybe not.
In fact, it’s starting to feel a bit like Ground Hog Day for investors. Here we are with another year that started fine with share markets up on optimism about an improved global outlook to now be in May and see the same old worries back with a vengeance.
Europe seems to be falling apart again, worries about a Chinese hard landing are back and US economic data has become mixed, with worries it will fall off a “fiscal cliff” next year. So far since their highs this year global shares have fallen 8% and Australian shares by 5.5%.
Quite clearly Europe remains at the head of the worry list with increasing signs of a backlash against fiscal austerity, fears Greece is about to exit the euro and increasing concerns about Spanish banks.
The Socialist victory in France and the fall of the Dutch Government are probably of less concern as even Chancellor Merkel is likely to agree to some easing of the pace of fiscal austerity following her own coalitions’ electoral losses and the EU seems to be moving towards a more relaxed enforcement anyway, having realised that austerity is just making things worse. (That’s the downside to Austrian economics!)
Greece is far more problematic.
It is now headed for a new election; with Greeks seemingly schizophrenic in wanting to stay in the euro but thinking they can substantially renegotiate the terms of their bailout. It seems that each successive crisis in Greece is taking it closer to exiting the euro, whether it’s via a new government rejecting the bailout deal or if several months down the track it fails to meet its agreed deficit reduction targets.
An exit from the euro would mean complete chaos for Greece – a 50 to 70% collapse in its new currency, the inability to fund its budget deficit and hence even worse fiscal austerity, a banking system collapse, etc.
For the rest of Europe a Greek exit would be far less problematic than might have been the case a year ago as private sector financial exposure to Greece has been substantially reduced and firewalls have been strengthened. But uncertainty would still be intense in the process of Greece exiting and this may result in more market turmoil, as investors will look around for who will be next to leave – Portugal? Spain?
Spain being much, much bigger is more of a worry, with a recession and falling property prices making the situation of its banks more difficult risking the need for a public sector bailout.
Some estimates put the requirement at 100 billion euros which would add 10 percentage points to Spain’s public debt to GDP ratio, which would take it to around 80% of GDP. This would still be below the euro zone average of 87% and normally wouldn’t be a problem – but these are not normal times: And if Spain gets into deeper trouble; investors will likely focus on Italy again.
This has all resulted in a renewed blowout in bond yield spreads between Spain and Italy on the one hand and Germany on the other. Despite Europe stagnating in the March quarter rather than confirming recession as expected, we continue to expect a 1% contraction in euro zone GDP this year. Whichever way you cut it, Europe is a mess and it is still hard to see the way out.
However, several things are worth noting.
First, while the sovereign crisis in Europe has returned anew, interbank lending spreads remain under control, suggesting the risk of banks not being able to fund themselves and hence a systemic banking crisis, threatening a re-run of the
GFC and a huge blow to global growth, is currently low. This is thanks to the provision of cheap ECB funding for banks.
Source: Bloomberg, AMP Capital
Second, the experience of the last two years where fears that European blow-ups would trigger a return to global recession and financial meltdown highlight that policy makers have the power to calm things down. Right now, Europe needs a slowing in austerity and much easier monetary policy. The odds are that European authorities will move in this direction. But as always it may take more bad news before they get there.