Zurich’s Matt Drennan sees encouraging signs emerging in Europe but wishes the euro zone would stop hogging the headlines and let the positive news from the US and China get some air time.
Unfortunately the new year has not brought peace and goodwill to all, but the same intractable issues that the world faced in 2012. Or has it?
Sure, the euro zone still has a mountain to climb, but the US and China have definitely turned the corner. Let’s be honest, from Australia’s perspective I would much rather have those two economies on the mend than some twist on Greek mythology delivering a miraculous recovery in euro-land.
Eurogeddon?
Even in Europe however encouraging signs are emerging. One of which was the recent decidedly blunt comments from the head of the IMF who warned that without a trillion dollars in new funding the world faced a 1930’s moment.
While additional significant funding will obviously be required (in excess of €200 billion in the first quarter alone), I suspect Christine Lagarde from the IMF was taking the opportunity to shock political leaders from the euro zone into action.
This is crucial given the looming spectre of refinancing for many national governments in the first quarter. You know what they say, never waste a good crisis.
The other interesting piece of obvious (but apparently necessary) advice to emerge was that layering further austerity requirements upon countries already suffering recessions was counterproductive. (Apparently a large number of European bureaucrats missed the whole semester on Keynesian economics).
Austerity measures will be a necessary part of long-term reform (admittedly tough to get commitment on once the crisis recedes), but to engage in such foolishness now only pushes countries closer to the brink.
What about the role of the European Central Bank (ECB)?
The ECB has a limited ability to directly support national governments, but can and is doing a lot to ease the threat of another major banking crisis in the region. The ECB is not central to the nationhood of any one nation – the US stands behind the Fed, Australia stands behind the RBA, but only the ECB’s capital (a paltry 10.8bn euros) technically stands between it and insolvency. In addition it is banned from investing in sovereign debt of bankrupt countries, a touchy subject in the euro zone at present.
What the ECB can and has been doing with alacrity is engage in the time honoured practice of socialising the private debt of the commercial banking system. By accepting dodgy collateral from the commercial banks at face value and lending to them at virtually zero interest rates, the banks are then able to reinvest this into higher yielding bonds and turn a significant profit.
In fact, 523 banks borrowed a staggering €489 billion in the first ECB borrowing window. These dollars have been reinvested into Italian and Spanish bonds, reducing the interest cost these governments face when rolling over their debt. As this process progresses, the banks are able to recapitalise their balance sheets and rebuild the necessary firewalls. This process is well underway.
To Infinity and Beyond!
Well not quite, but things are sure looking a lot better in the US and China.
Recent improvements in the US economy suggest a silver lining for asset markets following so much anxiety about Europe. The US economy continues to expand at a modest pace, surprising many commentators including yours truly.
Recent data suggests consumer spending is improving gradually as unemployment edges lower (down from a peak of over 10 per cent to around 8.5 per cent) and house prices stabilise in many areas. This is crucial since consumer spending accounts for 70 per cent of US economic activity.
On balance business earnings continue to surprise on the upside, while increasing demand for credit from businesses is also a positive indicator of expanding economic activity. US exports are far more competitive as a result of the weak US dollar, while the continued expansion of the US energy industry through booming shale oil and gas exploration is acting to spur some local manufacturing, gradually lowering its dependence on imported energy.
In China, authorities have clearly got inflation under control, which leaves room to move to a more stimulatory policy setting. As I have argued many times before, China is in the unique position of not only having plenty of ammunition in the locker to fire up the economy, it also has a much more varied and direct means of doing so compared to the West.
Although Europe remains an important export market for China, it can offset this impact to some extent by boosting local consumption. This is something that needs to occur in any case as its economy matures and the timing is about right.
Market Mania
None of this is to suggest that the world doesn’t face a long workout phase to put the problems of the global financial crisis behind us and regain a more sustainable footing, but the balance is tilting to a more favourable outlook.
Interest rates are at record lows, liquidity is at record highs, Europe just needs to stop making headlines and let the positive news from the US and China get some air time. Once this happens, raw fear will begin to transform into the fear of missing out.
Matt Drennan is executive general manager of investments at Zurich
