Eurozone woes offer little hope for small investors

Storms are dangerous, and we ever-optimistic small investors must hope that, like little boats, our portfolios bob up and down on the waves of economic turbulence when one arrives. We know we may get a little seasick at times, but we expect to stay on course. However, occasionally a great turbulence hits the markets and the wise seek safe havens.

Today, the immediate menace comes from the eurozone.

The 12-year-old currency was intended to become a strong, stabilising element of the global economy. Yet the eurozone is threatening to split apart, with unpleasant consequences.

The UK has wisely stayed outside the single currency. But its geographical position, perched nearby on the European continental shelf, and its membership of the EU means it is not immune to collateral damage.

Sometimes the ground rules of investment suddenly change. This latest developing crisis has sent us some rather chilling warning messages:

* There are few, if any, 'risk-free' government bonds any more.

* In equities, we cannot rely on continued economic strength and a solid currency in continental Europe. Many of the companies we invest in must look further afield to prosper.

* So far the eurozone has been a flagship for low inflation. Over the past decade, annual growth in the Consumer Prices Index has been just 2.1% for the zone as a whole. This moderation may not continue.

* Once again, we have had to take note that politicians are prone to promising more than they can deliver.

History has taught us many lessons.

The first great financial crisis of the 20th century erupted in the early 1930s, when the stability previously imposed - sometimes brutally - by adherence to the gold standard was torn apart. Banks collapsed around the world. Wall Street experienced its worst ever bear market and a global economic depression persisted until World War II.

After the war, a redesigned global financial regime was set up under the control of the new International Monetary Fund.

Stability lasted for almost 20 years and the global economy expanded strongly, but this solidity was abruptly halted by an oil crisis. Inflation surged, not least in the UK, where it peaked at an annual rate of 27% in 1975, and by the end of the 1970s, many developing countries were in default, especially in Latin America. Governments had eagerly ridden the post-war boom, but could not handle the bust.

Flawed recovery

Gradual recovery followed through the 1980s, but by the 1990s, there was a local crisis in the UK - Black Wednesday. A more general bust followed a few years later in 1998 in the Far East, beginning in Thailand and spreading quickly to many other countries. Banks once again proved fragile. A long regional boom had disguised the cracks in financial structures and the distortions introduced by crony capitalism.

Out of this unsettled picture emerged the euro in 1999, a new currency for the 21st century intended to bolster Europe as a region of order and stability. The global environment was far from helpful after the bursting of the stockmarket's technology bubble.

Still, for a few years, all appeared to be well, at least if not too much attention was paid to the property bubbles developing in countries such as Spain and Ireland, and the recklessness of Europe's politicians in allowing a weak and unreliable country such as Greece into the eurozone in 2001 - followed by assorted others such as Slovenia, Slovakia and (in January this year) Estonia.

In previous developing economic crises, we can detect a recurrent pattern of optimism combined with a denial of underlying problems followed by eventual submission. The final breakdown usually comes over a panicky weekend as the financial markets cut through the political make-believe with ruthless judgements. Vain politicians, surrounded by the pomp of office, tend to hope that sheer willpower will see them through. But they also have to find practical solutions to a crisis. The Greek government, for example, must find ways to persuade Greeks to pay their taxes, while Spain must reform its malfunctioning labour market.

The simplified analysis is that we are seeing the inevitable showdown between disciplined Germany and the 'Club Med' of easygoing and overspending southern EU member states.

But underlying this confrontation since 1999 has been Europe's intensifying problem of its lack of competitiveness.

The growth in the economies of China, India and other developing countries has left Europe struggling to justify its much higher personal income levels. We see this reflected in rising unemployment (to more than 20% in Spain) and widening income differentials. When governments fill the income gaps with benefits, there is a danger that public sector deficits will spiral out of control - we are not far from that point here in the UK.

The remedies for the euro problem are all deeply unpleasant. But they will all have to be brought to bear.

First, there are the squeezes: tax rises and public spending cuts. These are already being implemented. The trouble is economic growth will be badly damaged. In the worst cases, battered national economies will spiral downwards.

Inflation has its attractions, although this will never be officially admitted. Inside the eurozone, inflation is low, but outside the picture is different. Public sector debts can be inflated away, and the same applies to personal mortgage borrowings to make housing affordable again. In the UK, at any rate, the Bank of England has now admitted that its 2% inflation target is out of reach. In any case, it argues that inflation is the fault of global markets and commodity speculators.

Finally, there is the default option, or debt repudiation. Greece is close to this already.

A curious secret debate is going on in official eurozone circles about how 'restructuring' or 'reprofiling' could be presented as somehow different from simply reneging on debts. Perhaps a 'restructuring' by Greece on its own is too small to matter much, but for investors there is a real risk that such financial trickery - now you see your AAA bond, now you don't - will spread to become a more or less standard solution for hard-pressed governments.

Until a year or two ago, most European government bonds were regarded as risk-free, and financial regulators pushed pension funds and insurance companies to buy them, even on very low yields. After all, they were completely safe, weren't they? Banks lapped them up too, encouraged by the Basel II banking rules. Now government bonds may become riskier than corporate bonds - and even equities. As a result, financial sector balance sheets are in a mess.

We can still think of the core countries in the eurozone, such as Germany and France, as safe havens. Their sovereign bonds will not be subject to 'haircuts'. However, the bonds of the 15 other eurozone countries carry risk.

For professional investors, this environment may present opportunities. They may eagerly trade the twin risks of default and ejection from the eurozone. Before the eurozone was established, the big game was the 'convergence' trade, when Italian and Spanish bonds benefited handsomely from the adoption of the euro. But now the emphasis has to be on divergence or disintegration strategies. This is far too dangerous a game, however, for private investors.

Investing in bonds

In the past, the credit rating agencies have often been quite happy to hand out AAA ratings for government bonds. One important reason for this has been the fact that governments can always print money to pay interest. Although this will lead to internal inflation and external currency depreciation, and thus serious losses for international investors, this will be classed as a soft default and not the hard default that takes the form of reductions in redemption values - the famous haircuts.

In the eurozone, though, this reasoning cannot apply. A country such as Greece cannot print euros. So sovereign risk has, in practice, been greatly increased in the eurozone. Indeed, several fringe eurozone states have had their bonds downgraded to junk bond status.

Core eurozone countries such as Germany and France are in a much stronger position, but uncertainty or panic is likely to cause problems for the whole eurozone. After a breakup, the costs of bailing out European banks - and even the European Central Bank itself - would be very high, even for Germany.

Too many countries, not least the UK, have allowed their borrowing to escalate to dangerous levels. How can the debts be brought down again? Of course, things have been even worse in the past, usually because of wars. Here in the UK, the national debt was only about 30% of gross domestic product in 1914, but it rocketed to 170% by the early 1920s.

World War II pushed the ratio up to a dangerous 250%. But this time the post-war trend was very different. By the early 1950s, the ratio fell below 200% and continued to consistently fall, reaching a low point of about 40% by 1990. Was the debt being repaid? No, but it was being rapidly eroded by inflation. Moreover, the economic growth rate was reasonably good, and the enlargement of an economy makes old debts appear smaller.

With the UK's national debt officially forecast to climb back to 70% of GDP by 2015 (a figure that ignores huge liabilities for pensions and other benefits), the temptation to inflate must become greater.

However, inflation isn't wholly negative. Investors can hope to get back something they have been missing over the past few years : worthwhile interest rates. Since 2008, governments around the world have desperately sought to boost economic growth through near-zero short-term interest rates.

The transition back to 'normal' interest rates will be hazardous, however. Governments have been propping up the markets in their bonds using buybacks, dubbed quantitative easing (QE). Moreover, they have been bolstering the banks by keeping money market rates at low levels so they can buy government bonds and make big profits from the yield differentials. In other words, tottering governments are propping up dodgy banks. It is hard to see how there can be any orderly way out of this mess.

We are heading for tricky and unusual (but not unprecedented) times. Will Europe suffer from the kind of financial instability seen in Latin America in the 1970s?

Avoid the eurozone

One consideration that should guide us is that private sector assets are probably safer than public sector assets. Another is that 'real' assets - equities, property and perhaps commodities - may in the longer run have advantages over monetary assets (such as bank deposits and fixed-interest bonds).

Equities have been trading sideways for some months. But they are vulnerable to the ending of QE.

One of the objectives of QE (especially in the US) has been to boost asset prices of all kinds, including share prices. Loose monetary policies put easy money into the hands of investors. But suppose there was to be a monetary squeeze in order to suppress inflation and support exchange rates. This is not likely to happen soon, but one day we will have to enter the post-QE world.

Gold bullion and German government bonds offer the best available protection against market distress. They are not quite safe havens, but they are storm resistant. On the other hand, emerging market equities provide the best growth prospects, but these are not plentiful.

Over the next few years, wealth preservation will be the best we can realistically hope for, not the building of fortunes. As personal portfolio managers, we must remember our seasickness pills. But opportunities will come our way, as long as we remain flexible.

The full feature appears in the July issue of our sister publication Money Observer.