The upturn in global economic activity that began more than two years ago faces a stern test of its resilience – in view of the ongoing trauma in the euro-zone – and, could well be short-circuited should the elevated stress in credit markets refuse to subside in the near future. The financial markets have already priced in a mild European recession over the next two quarters, which the global economy should be able to withstand without too much dislocation but, such optimism could well be misplaced.
Indeed, it is not difficult to construct a scenario in which a probable downturn in euro-zone activity is more severe and, of longer duration than most commentators currently believe. Should such an outcome unfold, strong global interdependence amongst economies virtually ensures that the negative impact on economic activity across the globe would be far more pronounced than the consensus currently anticipates.
The current cheery consensus among market practitioners is difficult to fathom given recent developments in the euro-zone and, more than likely, reflects the all-too-human tendency to overweigh the positive potential outcomes and, to place too little emphasis on uncomfortable negative scenarios. The fact of the matter however, is that the probability of a severe recession can no longer be considered non-trivial for a number of reasons and, as a result, asset allocations should be adjusted appropriately to reflect expected outcomes rather than wishful thinking.
Euro-zone business surveys have already slipped to levels that are consistent with a contraction in economic activity but, the optimists are confident that Europe’s leadership will do whatever is necessary to contain the decline. Such optimism appears to be based on hope rather than reality however, as both Brussels and Frankfurt appear to believe that the only road to lower market interest rates and a return to healthy economic growth is fiscal austerity – a policy prescription that is almost certain to lead to heightened rather than reduced market stress.
Fiscal austerity across the euro-zone is unlikely to appease the financial markets for one simply reason – domestic private demand is not sufficiently strong to absorb the deflationary impact. Indeed, the elevated stress in the credit markets has already taken a heavy toll on business confidence while, surveys of lending conditions show that the banking system has become less willing to supply credit and, standards are virtually certain to tighten further, once the recapitalisation of ailing balance sheets – as prescribed by policymakers – gets underway.
A deep recession is virtually certain given current policy prescriptions and, as a result, financial market stress is unlikely to ease. The contraction in economic output will cause tax revenues to fall short of plan and, government expenditures to exceed original estimates due to the rise in unemployment benefits. The wider-than-expected budget deficits mean that public debt-to-GDP ratios across the euro-zone are likely to edge higher and, ensure that yields on sovereign debt remain uncomfortably high.
The optimists argue that such a scenario is unlikely to unfold, which seems to be predicated on the belief that the ECB will reduce policy rates aggressively and, ultimately purchase sovereign debt in sufficient size to ease the strain on governments. Once again, such premises are built on hope rather than hard fact.
First, market funding costs have already disconnected from policy rates, while lending standards are beginning to show a similar dynamic. As such, it is reasonable to argue that the stimulus to economic activity, arising from a reduction in interest rates from their current low levels, is likely to be negligible.
Second, the ECB is extremely reluctant to expand its balance sheet and purchase large quantities of stressed sovereign debt given the credit risk that it would assume. Any sovereign that issues debt in a currency that it does not control, is simply not free of default risk. Indeed, the Greek case clearly demonstrates to private investors that holding distressed euro-zone sovereign debt is not that far removed from owning high-yield bonds.
The truth of the matter is that the ECB is unlikely to purchase troubled sovereign debt without an ironclad guarantee that it will be compensated in the event of losses. Such a guarantee would not appear to be on the table in Berlin and, is unlikely to be, in the absence of further fiscal integration. This process will take time and as a result, aggressive ECB action could happen later rather than sooner.
The odds of a severe euro-zone recession are growing by the day and, it would be foolish to believe that the rest of the world would emerge unscathed given the increase in financial interconnections and trade linkages. Indeed, one important lesson to glean from the ‘Great Recession’ is that greater global integration ensures that an economic crisis in one region is quickly transmitted to another.
Global decoupling is nothing but an old wives’ tale and, investors should note that the escalating euro crisis puts the entire world economy at risk.
Originally posted on www.charliefell.com
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