Europe's outlook turns gloomy once again
March 21, 2013
The optimism that reigned in Europe at the beginning of 2013 fueled international investors' hopes that financial markets might finally be returning to "normal." But recent developments ranging from the inconclusive election in Italy to a controversial bailout package for Cyprus remind us that Europe isn't out of the woods yet.
We asked Peter Westaway, Vanguard's chief European economist, to comment on the recent events in Cyprus, the United Kingdom, Italy, and Spain.
There has been an uproar over efforts to shore up the Cypriot banking system, both within Cyprus and in other countries. Cyprus is one of the smallest countries in Europe. Why is it making headlines?
Peter Westaway: The approach agreed between the European Union and the Cypriot authorities to address Cyprus's economic difficulties was unprecedented, and it raised concerns around the world.
A €10 billion (about $13 billion) loan had been proposed to keep the Cypriot government afloat, along with a €5.8 billion (about $7.7 billion) "bail-in" that would have expropriated funds directly from all local bank deposits—including small accounts held by ordinary Cypriots. Understandably, this plan proved very controversial, as it contravened the spirit of the E.U.'s previous assurances that deposits up to €100,000 (about $130,000) would be protected. It ran the risk of causing an immediate run on banks in Cyprus and other countries with weak banking systems. Not surprisingly, the plan was promptly rejected by the Cypriot parliament.
What will happen next?
Peter Westaway: It is likely that we will see a more progressive bail-in that exempts smaller accounts and charges larger deposits more heavily. But unfortunately, the damage to the credibility of the €100,000 deposit guarantee may linger.
"The U.K. remains, relatively speaking, a safe haven for investors ... [but] Moody's believes that the U.K. is unable to gain any growth momentum in the foreseeable future."
It's important to understand that Cypriot banks are popular among non-Cypriots, and European leaders suspect that a large part of Cypriot bank deposits have arisen from money-laundering activities, particularly by Russians. This makes Cypriot banks an obvious source to fund the E.U.'s rescue plan. However, shifting the burden of the bailout towards bigger depositors is not without risk because of the delicate diplomatic relationship between Cyprus and Russia.
Whatever happens in the next few weeks, European leaders have insisted that Cyprus is a one-off due to the country's unique circumstances and, so far, there is little sign of contagion, partly because the European Central Bank's commitment to preserving the euro is still deemed credible.
Turning to Britain, the British government recently lost its triple-A credit rating, with Moody's becoming the first rating agency to downgrade Britain's debt, while S&P and Fitch maintained their negative outlook. Should investors be worried?
Peter Westaway: Markets have expected the downgrade for a long time and effectively "priced it in" already. That's why we saw little movement on bond yields following the downgrade. The U.K. remains, relatively speaking, a safe haven for investors. The underlying cause of the downgrade is actually more worrying. Moody's believes that the U.K. is unable to gain any growth momentum in the foreseeable future and many economists seem to share that view.
What does that mean for monetary policy in the U.K.?
Peter Westaway: It seems like the market is expecting that the Bank of England's Monetary Policy Committee (MPC) will loosen its policy markedly, even before the new governor of the bank, Mark Carney, steps up. And the recent announcement by Chancellor of the Exchequer George Osborne of an expanded mandate for the bank has reinforced this view. This could mean a new round of quantitative easing as we have seen in the U.S. Some have even suggested having negative interest rates. The latest inflation report has made it clear that the MPC will likely tolerate high inflation for longer. Even so, I think a major loosening of policy is unlikely, and the risk of an upsurge in inflation is exaggerated.
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How is the result of the Italian election going to affect the reform process in Italy?
Peter Westaway: The Italian election has produced the worst possible outcome for markets, and we have seen an immediate spike in bond yields as a result.
The center-left party of Pier Luigi Bersani has no working majority, even in alliance with Prime Minister Mario Monti's centrist coalition. Beppe Grillo, the leader of the populist Five Star Party, is explicitly against the euro, so we will possibly see attempts to build a grand coalition involving Bersani and former prime minister Silvio Berlusconi. Any such coalition would likely be weak and short-lived and would almost certainly fail to deliver on the much-needed structural reforms.
Does this put the survival of the euro into question again?
Peter Westaway: It is too early to say exactly what exactly the knock-on effect of the Italian election on the euro will be. But when you look at the results, especially the meager 10% of votes of Monti's center coalition, it is clear that Italy has voted against reforms.
Reassurance that the European Central Bank (ECB) will be able to provide support to Italy if yields spike may also be misplaced. Such support would be conditional on a stable government and a credible program of economic policy, something that the new government may find hard to deliver. So the ECB's "whatever it takes" approach may be tested to the limit.
Spain has been out of the news for a while, but it seems the country's economic crisis is now back in full swing. What's the situation there?
Peter Westaway: We've had some bad news from Spain over the past few weeks. Reyal Urbis, one of the largest listed property developers, filed for bankruptcy, and Bankia, one of the largest Spanish banks, reported a record loss of €19 billion (about $24.5 billion), reminding us that the country is still in the middle of a deep recession.
Spain's latest GDP is expected to confirm a further decline in the fourth quarter of 2012, making 2012 a year of continuously falling activity. The economy will likely continue to shrink, followed by a weak rebound in 2014. Unemployment will probably remain high, threatening the social cohesion needed to push through reforms, and the fiscal situation is unlikely to improve.
On top of all this, the Spanish government under Prime Minister Mariano Rajoy faces accusations of corruption, undermining its legitimacy. At the moment, Spain insists it doesn't need any financing assistance from the ECB. Ironically, whether this will change may also depend on the market's confidence in Italy going forward.
What do you think investors should do in view of these rather bleak developments?
Peter Westaway: The news in recent weeks has been rather bad, but we believe the market has for the most part already priced in these events.
As always, we think investors should assess their portfolios carefully and avoid making impulsive moves. Suddenly becoming too aggressive—or too conservative—in response to market or economic news can shift a portfolio's long-term asset allocation out of balance. It can also result in significant investment costs and unwanted tax consequences. Recent events have reminded us of the benefits of a balanced approach to asset allocation.
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