Inside investment: The European wrong contest
Investment strategists seem convinced that the euro crisis is over and European equities will outperform in 2014 as growth returns. There are clear and present dangers to this cosy consensus view and the banks are still at the heart of the problem.
So you do not have to suffer, each year your faithful correspondent ploughs through the screeds of year-ahead outlooks generated by the finest minds in sell-side investment analysis. It is time-consuming and no one should have to do it. But like so many things that are entirely discretionary, it is possible to derive a sort of perverse pleasure. In this case it is the homogeneity of the views and the futility of the process that are mildly rib-tickling.
Several thousand pages on, the sages think as follows: global equity markets will rise between 10% and 20%, with Europe a clear outperformer and emerging markets underperforming; it will be a sticky year for developed market sovereign bonds, but Bunds will best US treasuries; the search for yield will continue in credit markets, so high yield will trump investment grade; and the US dollar will strengthen against the G10 currencies.
The fact that all forecasting in inherently complex systems such as finance is entirely futile is a topic that has been tackled here before. For now though, the sanguine outlook for Europe is a concern and possibly seriously wrongheaded. If a back-to-the-future repeat of the summer of 2011 is played out in 2014, it will have a serious impact on the global economy and markets. It is not difficult to see how it could happen.
The clear and present danger is deflation. China, and now Japan, are exporting deflation around the world by keeping their currencies artificially weak, while the euro grows stronger. In normal circumstances the European economy could cope. But Europe’s banks are insolvent and being forced by regulation to delever. The credit multiplier is broken.
The European Central Bank still has some policy ammunition. It could cut its refinancing rate into negative territory, forcing banks to do something else with the funds they park at the ECB. It could offer Long-term Refinancing Operation funding for an open-ended period. It could even engage in quantitative easing by outright asset purchases, the "whatever it takes" approach ECB president Mario Draghi hinted at in July 2012.
There is a problem, though. In Germany there is already a fear that one-size-fits-all monetary policy is inflating property bubbles in cities such as Hamburg and Berlin. The Bundesbank also loathes the sort of policy apostasy so eagerly embraced by Draghi.
If deflation did take hold, the debt-to-GDP ratios of the periphery would balloon. But if Draghi is fast and loose with monetary policy, the chorus of disapproval from the core, most particularly the Bundesbank, will increase.
The ECB is walking a tightrope. The chances of a misstep should not be ignored. If Draghi gets it wrong, there will be more questions about the durability of the eurozone. At the same time, the ECB is also trying to sort out the banking system ahead of the inauguration of a single supervisory mechanism under its auspices in November.
Deflation and the travails of European banks are related. As Japan showed during its lost two decades after the bursting of its asset price bubble in 1990, zombie banks unwilling or unable to lend act like Agent Orange on any green shoots of economic recovery. The ECB is seeking to speak truth unto zombies through the Asset Quality Review and Balance Sheet Assessment, which will happen ahead of November.
This is good policy, but there is yet another problem. The last time the ECB checked on the health of the banking system, the results were rightly regarded as risible. This time, for the sake of its own credibility ahead of becoming a regulator, it has to be seen to be tougher. Forcing banks to recapitalize and deleverage now might avoid a replay of Japan in the long term. In the short and medium term it is a further headwind to growth.
There is another festering European sore that might disrupt markets. In Spain, Catalan nationalists are proposing a self-determination referendum in November. If this gains credibility, and opinion polls point to a ‘yes’ vote, Spain’s progress toward debt sustainability will be stopped in its tracks. The nightmare would be if the Basques were to take a cue from the Catalans and put a referendum to the electors of Vizcaya, Navarra and Gipuzkoa.
The two richest and most industrialized regions of Spain might repudiate the debts of the sovereign. A European Union that has failed to issue joint and severally liable common euro bonds could do little about it. Financial reform, including banking supervision and a single European bond market, has been too slow. Politics marches on. Europe remains the biggest risk to the bullish consensus in 2014.