Posted by:
Andrew Bell

29 May 2012

The Eurovision Song Contest might have been won by a (non-Euro) country with a song called “Euphoria” but the dominant recent emotion in the Euro-currency markets has been acute angst.

Euphoria is a Greek word which appears to have abandoned the place of its birth, a state of intense happiness not being the dominant mood in Athens. Angst, a German word meaning apprehension, anxiety or inner turmoil is one of its less welcome exports. It is perhaps appropriate that a version of Norwegian painter Munch’s The Scream recently set an auction price record for the sale of any art work (making it, so to speak, unafjordable).

Europe is trying to fix a marriage which was entered into unadvisedly and lightly, where the commitment to stand by each other “for richer, for poorer” has become diluted by what some would characterise as infidelity and others as selective memory. The “pre-nup” was signed with differing preconceptions and full of holes.

Rationally, both parties (simplifying it to Greece and Germany as the two extremes of competitiveness) would appear better sticking with the Euro in the near term. The reduction in wages which Greeks are resisting would be imposed by the market through devaluation if they left the Euro. With government spending (excluding interest costs) greater than revenues the Greek government would have to pay part of its bills in IOUs – which would be discounted in the market as being of uncertain ultimate value. The sacrifices being asked of Greece as the price of supportive financing from the rest of the Eurozone do not look as if they will be avoided by defaulting further (though this might help) or devaluing. Whether this realisation is reflected in the second Greek election next month remains to be seen.

For Germany’s part, it faces a combination of direct exposure to Greek borrowers, indirect liabilities via the ECB, the costs of resisting contagion if a “Grexit” led to pressure on Spain and others and the growth costs for its own economy if the inability to contain contagion led to a deep European recession, with or without a break up of the Euro. It is likely that the costs of avoiding a break-up are a bagatelle compared with the impact of a subsequent depression and (for Germany) currency revaluation.

It may be that Germany is playing a deep game, recognising the costs of abandoning the Euro. Chancellor Merkel may be less blind than is believed to the need for growth to temper necessary fiscal retrenchment. Forcing through unpalatable reform measures in weaker economies is easier if the alternative prospect is financial disaster. However, it is hard to diagnose the difference between brinkmanship and misjudgement.

Markets are, understandably, working on the assumption that there is no grand plan but appear willing to assume that a major miscalculation will be avoided. This has resulted in an uneasy tug-of-war between the upside possibilities in fairly lowly rated equity markets if the US recovery continues and the room for further falls if Europe falls into a prolonged slump, with damage extending elsewhere through global bank-sector interdependence.

This is unsettling for investors to live through, with market corrections accompanied by forecasts of disaster in Europe become an annual fixture. Meanwhile, the valuation stretch continues to widen between government bond yields at 300 year lows, yielding less than inflation and equities with dividend yields above inflation and (headline) earnings multiples below long-term averages. The need to find a balance between tactical risk-management and longer-term investment prospects is thrown into sharp relief by these contrasting valuation trends. 

Comments or feedback are always welcome at theblog@witan.co.uk

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