A European Drama with Many Twists

The eurozone crisis is proving to be a wonderful political drama, with the most essential of all ingredients, as with all good drama, that the potential consequences of different outcomes are so serious. There is almost nobody in Europe, and increasingly beyond, who has not by now worked out that they stand to be adversely affected in some way or another, especially if the worst of all conceivable outcomes materialises. The fallout has reached capitals and markets all round the globe, from Washington to Beijing.

A few days in Amsterdam last week provided plenty of anecdotal evidence of how widespread the fear of imminent disaster has become, even in one of the most sensible and securely financed of all European countries. Some advisers at Dutch banks have, according to one first-hand account I heard, been advising their clients to sell all their stocks in the search for safety – one reason no doubt why German one-year bunds at one point last week were priced, for the first time ever, to give a negative yield.

The rumours which spooked the markets about a leading European bank being in danger of failing were also widespread. There may, or so I heard from one apparently reliable source, be another major rogue trader scandal in the offing. The view that Europe is already in recession has spread far beyond the orbit of professional investors. Few seem to have any faith in the ability of Europe’s political leaders to stop the rot in the eurozone.

But what is the worst outcome and how likely is it? A widespread sense of foreboding is a classic contrarian indicator. During the summer I wrote that the most likely outcome was that the equity markets would finish the year relatively strongly. On November 24 I suggested in my blog that the arguments for an end of year rally, possibly extending into the early part of next year, remained good and that still seems to me to be the most likely outcome. The market recovery since then, from an oversold condition, is certainly a step in that direction.

Such a prospect does not come from any inside track or insight into what, if anything, the political leaders of the eurozone will be able to agree before their summit meeting this week. It is more a question of faith in the logic of events, which when allied to pressure from the financial markets is finally driving European governments towards a patched up solution that may just succeed for now in avoiding what many regard as the worst case scenario, namely a disorderly break-up of the eurozone instigating a new global credit crisis.

The essential prerequisite of any such stay of execution has always been that the eurozone’s leaders start to address the fundamental problems with which they are faced, something that is at odds with the natural default position of politicians – which is to avoid taking tough decisions for as long as they can, or at least until they are confident of securing popular support for doing so. The real significance of the Cannes summit, in my view, was that both Mr Sarkozy and Ms Merkel did finally acknowledge in public a possibility that has been obvious to all but the most blinkered europhile for some time – that the eurozone cannot continue in its current form, and that a desperately uncompetitive country such as Greece will never resolve its problems as long as it is harnessed to an absurdly inappropriate exchange rate.

Far from being a faux pas, as some still seem to believe, the fact that a break-up of the eurozone had ceased to be an unmentionable is a necessary – though sadly not sufficient – first step on the road towards the realisation of a workable solution to the eurozone’s problems. No serious analyst can avoid the conclusion that either a realignment of currencies within the eurozone, or (more likely) its partial fragmentation, is necessary if the eurozone is to survive. The odds of it doing so in its current form may still not be good, but it is far better that governments should be planning for such an event than allowing the markets to dictate such an outcome. (Like all vigilantes, the bond markets are short-sighted, unelected and thuggish – only one step removed from lawlessness, in fact).

Even if the next European summit does come up with a deal that holds the line (and it may of course fail to do so), it does not mean that the longer term outlook for investors has improved significantly. It will only mean that the severity of the damage has been somewhat contained. Although sentiment is very weak, these are not yet the conditions in which a roaring bull market is likely to be spawned. One seemingly immutable market law however does look like being confirmed again this year, namely that consensus views at the outset of the year will once again be confounded.

Few pundits, as I recall, suggested that emerging markets would badly underperform the US market this year, or that bonds would hold up as well as they have done. Yet in the first 11 months of the year, the US market has comfortably outperformed Europe, all the emerging markets and Japan. And who would have thought that the best performing market in Europe this year would be Ireland? Next year: Greece, anyone? It is not impossible.