For a week in late 2009 we all became experts on the Middle East as Dubai’s finances imploded (hands up all those who had to look up the other five emirates apart from Abu Dhabi and Dubai). Cue a $5bn ‘gift’ from next door and nobody cared anymore – until the next bond is due, anyway. Now the same story is being re-run with Greece playing the part of Dubai and the EU the part of Abu Dhabi. It is not new news that Greece is a financial basket case – nor, for that matter, that Portugal, Ireland, Spain and Italy are all in the mire. If the UK was in the Euro we would have the headlines all to ourselves, as our deficit is the same as that in Greece, but the absolute amount of the financial black hole is so much greater. Nevertheless, we confidently predict that Greece will not be hogging the financial headlines in a week or two, as they produce a 5 year path to budgetary nirvana predicated on strong economic growth, increased tax compliance and a reduction in nominal spending on public services, which will be enthusiastically greeted by Brussels and banish talk of default and ejection from the Euro. The depressing fact that this budgetary opus is a work of fiction will be quietly ignored, and markets are likely to bounce, as they did after the Dubai crisis faded.
Unfortunately the carpet is beginning to show some unsightly bulges as more and more bad stuff is swept underneath it. The sad reality is that a 10% of GDP reduction in the deficit at a time of rising interest rates and with a large stock of debt to start with is virtually impossible in a democracy. The Greeks have already called a general strike at the prospect of a wage freeze (they need a 15% reduction to make a meaningful difference). The farmers have started blockading the motorways with their shiny new (EU subsidised) tractors as they demand HIGHER subsidies. The western world has got used to living beyond its means on cheap and plentiful credit, and its citizens will not react well to being told to adjust to a lower (material) quality of life. But that is what will happen over the next decade, though the bitterness of the pill is likely to be sugared by a plentiful dose of inflation. Luckily for politicians, most people think nominal rather than real as far as money goes, though rising inflation rates and sovereign yields will exacerbate the funding crisis as well.
Will the Euro fragment? Not in the next few years. It was always an experiment in politics and bad economics from day 1, with Germany accepting a financial burden in exchange for the ultimate goal of a Bismark-esque Federation. The risk to the Euro is when the German electorate finally get hacked-off with subsidising their spendthrift Mediterranean neighbours. Given that they have already paid for rebuilding East Germany and for all of the Greek (and Irish) tractors, they seem to have a pretty high financial pain threshold, and it might take a while yet for the penny (cent?) to drop. At that point the Euro could be in trouble, but we’ve probably got a while yet. In the meantime we must get used to periodic mini-crises as European and American deficits remain stubbornly high and fixed interest investors start to sense Pimco’s bed of nitroglycerine under most bond markets rather than just the UK’s.
So how do we make money? In the near term, take advantage of the recent pull back to make a few trading gains. After all, nothing has changed from a few months ago apart from perception. Market participants missed the best bit of the 2009 rally as it was all over by June. Most got in late, and come December, needed to believe in a new bull market. Greece was merely the bucket of cold water that snapped markets out of their reverie. We are seeing a good number of oversold stocks at attractive, if not bargain-basement valuations, and have upped our net investment position reasonably significantly. This is, however, likely to be a trade of a few weeks duration, and after a bounce we expect Western markets to continue a downward drift.
Secondly, and more importantly, tilt your portfolio further towards Asia. Currencies and domestic assets will outperform those in the West, and bond markets will not suffer from chronic oversupply. Simples!!!
