Eeeeks, what's going on?

John Carran, Senior Economist at Gareth Morgan Investments

August was the worst month in markets since the credit crisis... we’re now mid way through September. We ask John Carran, Senior Economist at GMI, if things are looking any better—or worse—for global markets.

What has happened in Europe in the last month to stir the debt crisis back up again?

In the past month three key developments have heightened the focus of markets on the Eurozone¹ debt crisis.

First, attention has shifted to the high levels of debt in Italy and Spain and the inadequate efforts authorities in those countries are making to close large fiscal deficit. If these countries get into serious trouble they will be too big for the Eurozone to save.

Second, it is apparent that Greece is not doing enough cost cutting to meet the tough targets set by the Eurozone and the International Monetary Fund (IMF) to continue qualifying for financial aid. There is increasing doubt that Greece will get more help, which raises the chances that it will plunge into a messy default.

Third, concerns are increasing that the European banks, which are large holders of troubled sovereign debt, are running into serious liquidity and capital problems.

Alongside these developments Eurozone politicians have been making conflicting statements about the crisis and appear to have no clear plans for resolving it, exacerbating uncertainty in markets.

Is anything happening that might prevent further problems?

Recently the leaders of Germany and France expressed their commitment to keeping Greece in the Eurozone. This slightly eased the rampant speculation about whether this would be the case.

The most significant action recently was an announcement from the European Central Bank (ECB) that it would coordinate with other large central banks, including the US Federal Reserve, to provide substantial liquidity to the global banking system. This eased bank funding pressure and led to a rally in stock markets.

The extra liquidity provided to the financial system is a stop-gap measure. Markets are nervously awaiting two key pieces of information over coming weeks that could set their direction. First, in early October the ECB and IMF will decide whether to disburse another instalment of bailout funding to Greece. If this does not go ahead there will likely be panic in markets. Second, Eurozone countries will make decisions on whether to expand a central fund and give it additional powers to recapitalise banks and buy Eurozone members’ bonds. Markets are hoping for better clarity in this area so they can see a path toward stabilisation of the crisis.

What do you think is the most likely outcome?

It is very difficult to predict what European politicians will do. The consequences of not doing something to deal effectively with the sovereign debt crisis are so disastrous that I tend to think they will have to announce a major plan sometime soon. I suspect that behind the scenes authorities are preparing a plan for massive recapitalisation of the Eurozone banking system, together with a programme of buying the bonds of troubled Eurozone countries like Portugal, Italy and Spain. Announcement of this plan will probably precede an attempt to engineer an orderly default on Greek debt. This may be announced early next year. However, the politics of the situation are at the moment so acrimonious and fragmented that risks of an disorderly and ineffectual response are high.

What do you think the impact will be on investors?

Markets will react positively if Eurozone politicians get their act together and put together a credible plan for dealing with the debt crisis. However, I wouldn’t expect markets to take off on a searing recovery, because the growth outlooks in Europe and the US will continue to be weak, perhaps for two to three years.

The European banking system could be in dire difficulty if the Eurozone crisis continues to muddle along and no credible plan emerges to deal with it. Under this scenario bank credit would be constricted globally and demand for goods and services in Europe would be severely constrained. This would flow on to many other countries around the world, and market sentiment would undoubtedly turn extremely gloomy.It would not be a good time for investors, and solace will no doubt be sought in safe investments such as cash and gold.

With the debt ceiling being raised in the US will growth return in the foreseeable future?

Resolution of the debt ceiling debacle in the US lifted one needless source of uncertainty from markets. Nevertheless, uncertainty remains about US economic prospects. Recent indications are that the US economy is experiencing very slow recovery. With households and government hunkering down to reduce excessive levels of debt, there is little chance of a quick turnaround in economic prospects.

Hovering over US prospects is the Eurozone crisis, which, if it turns out badly, will dampen activity from the already low levels expected. Our expectation is that growth will return to the US over the next year, but at a very modest pace.

So are things getting better or worse?

There’s no definitive answer to that. The risk of a significant deterioration in the US economy has eased slightly – we do not expect a double-dip recession there. But a fair degree of uncertainty remains and is likely to persist as long as the Euro situation remains unclear.

September 21st 2011