Simon Denham on the harsh realities of Europe’s growth crisis

In this blog, Simon Denham, Founder of London Capital Group Holdings, wonders why recent bond worries seem curiously subdued and whether electorates will finally tire of ‘pseudo austerity’.

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Since Mr Bernanke announced that the Fed was looking at ceasing fiscal stimulus – QE and all its other aliases – bond yields across the globe have risen in sympathy.

The markets can hardly say that there was not some suspicion already in the wind as ten year US Treasury yields rose more in the five weeks prior to the Chairman of the US Federal Reserve’s speech than they did post the event, moving from 1.6 per cent on the 2nd May to 2.1 per cent at the moment that Mr Bernanke stood up and now sit at over 2.5 per cent. Obviously, in times past, a move of 80bps would hardly have merited much of a mention but in the current low-yield world in which we live, we can put it another way and say US yields have risen 50 per cent in just a few weeks.

The reaction in Europe has been encouragingly subdued. Sure, yields rallied in line but are still miles below the stress levels of 2011/12. Spain has pushed some 70bps higher in the same period to 4.7 per cent but nowhere near to the 7.25 per cent reached this time last year. Many commentators will be finding this to be curious as the problems of the last five years have hardly just gone away; in fact, just the opposite could be the case. Employment and growth in all Eurozone countries remain on the wrong side of the line and deficits continue to grow – albeit more slowly – which leaves all governments treading a very thin line.

With growth from the BRICS also suddenly looking less certain, markets seem to be rather more optimistic than one might have thought. There is always the double-edged sword on bond yields. Low growth generally means low inflation and so higher bond prices (lower yields), but this always pre-supposes that principal repayment is not an issue.

In the corporate world, yields generally have to also take into account the fact that a company might actually go bust and bond holders be forced to take a loss. Greece recently imposed a pretty substantial haircut on holders of its debt – an event which seems to have been forgotten rather more quickly that one would imagine. Greece might have been a special case but the fact is that its GDP/Debt ratio when it started to get into trouble was not much different to the current levels of Italy, Ireland and Portugal and a short step from Belgium, France, Spain and the UK. With most of these countries stuck with an uncompetitive currency valuation (from their point of view), the age old ‘devalue or inflate your way out of trouble’ solution is just not available.

Sense and security

The fear of further defaults have been mitigated to some extent by the actions of the European Central Bank and EC Ministers but in reality these have merely pushed the problems a little further down the line and still rely to a massive extent on agreement from the electorates of the Northern Bloc of nations.

The last crisis was averted by huge liquidity injections and further ‘promises to pay’ but will these agreements survive another call on the wallets of the less profligate?

Nearly all of Europe, plus the US and Japan, is currently sitting above 90 per cent GDP/Debt ratio and the ambition of these governments is merely to bring their annual deficits down to under 3 per cent of GDP. Unfortunately, with totally anaemic growth and moribund inflation, even this limited target would still result in a steady increase in the GDP/ Debt burden.

If yields begin to move towards more normal levels of around 4 to 5 per cent, then an increasing slice of tax revenue will be required just to pay the interest on the existing debt, let alone any further debt increases or – high fantasy this – attempting to pay back the principal. Effectively, Europe is almost certainly doomed to low growth, low interest and high unemployment for many years to come.

Getting on top of these problems will take a great deal of time but the press, and by extension ‘the people’, all seem to want instant solutions. An expectation that creates its own issues: it means that democratic governments find it almost impossible to initiate harsh policies simply because the solutions required will take too long to show returns, and they would lose the next election. So far the only incumbent political body that seems to have been brave enough to actually implement many of the requirements has been Ireland. No-one else seems keen to follow suit.

How long will electorates tolerate the pseudo austerity without obvious success?

Actually enduring real tough times when you can see light at the end of the tunnel is one thing. Being told that you are enduring austerity without anything seeming to get better is quite another.

Do you agree or disagree with Simon?

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