“Keep Calm and Carry On.” Five words, six syllables, printed 2.5 million times as Britain prepared for World War II—precisely 72 years ago this month. The now iconic red and white posters were designed by the British Ministry of Information. Their purpose: to harden citizens’ resolve during unprecedented conflict in Europe. They were sage words in September, 1939. And they remain wise today, even as the European debt crisis threatens a conflagration of global financial markets.
In August, the world finally awoke to Europe’s intractable structural issues. Investors sold off risk assets across the globe and fled to safety in U.S. Treasuries. Political dithering has temporarily crushed investor confidence and put markets on edge.
When it comes to the fundamentals of sound investing, it’s important to see beyond short-term volatility and focus on long-term value. The fundamentals, at least in the U.S., remain healthier than the market’s recent slump implies. Most likely, the future will be brighter than fearful investors anticipate. The arbitrage between fear and fundamentals is a rare opportunity for far-sighted investors.
The not-so-secret safety net in this equation: the world’s central bankers are yet again turning on their trusty printing presses. The world is awash in liquidity; vastly more dollars, yen, and now even euros are sloshing around. U.S. markets, the world’s largest and most liquid, are the primary destination. This bodes well for U.S. stocks and select categories of bonds that have been unduly punished. Over a two- to three-year horizon, I am extremely bullish on a number of investments. But in the near term, I expect volatility will persist until global economic data provide greater clarity.
Europe in Crisis
In Europe, the moment of truth is near. To save the euro from extinction, Germany must work with other European Union states to create what will most likely be a Eurobond program to bail out Portugal, Italy, Ireland, Greece, and Spain (PIIGS). A breakup of the euro would deal a crippling blow to the banking system, triggering a systemic financial crisis—one that could make the U.S. subprime crisis in 2008 look like a dress rehearsal. The cost of cleaning up such a disaster would be exponentially greater than the cost of restructuring the debt of certain European nations. Indeed, Christine Lagarde, who became managing director of the International Monetary Fund in July, bluntly called out the Germans in her speech at the Fed’s Jackson Hole conference in late August: “We need urgent and decisive action to remove the cloud of uncertainty hanging over banks and sovereigns. We must act now. Decisive action will bolster the confidence that is required to restore and rebalance global growth.” I believe German and other European policymakers will figure this out. The question is whether they will do so before the crisis takes a dramatic turn for the worse. Averting calamity will take more political will than has been shown so far; but, I believe officials are beginning to devise a bailout plan behind the scenes that can be sold to the political electorate, especially in Germany.
Realistically, it will likely be recession that forces Europe to act. Growth in the region slowed to 0.2 percent in the second quarter, the slowest rate since it emerged from recession in 2009. Importantly, pain has spread to Germany, whose influence weighs heavily on the European Central Bank (ECB), which happens to be located in Frankfurt. In the second quarter, German economic growth fell below the euro-area average. This is the first time in eight quarters that the Rhineland’s economic engine hasn’t led the monetary union.
France, Europe’s second-largest economy, didn’t grow at all in the second quarter. I expect that the euro area will be in recession by the end of 2011, prompting comprehensive political action. Ultimately, the solution will most likely require issuing Eurobonds to purchase the debt of troubled periphery nations. As a quid pro quo for restructuring those debts, euro-zone states will have to agree to harmonize their fiscal policies—especially with regard to labor and social entitlements such as retirement programs and health care benefits. Until these goals are met, I expect that the crisis in Europe will only worsen.
Uncertainty in Asia
Asia’s major economies face headwinds, too. As Japan comes back on line, there is talk of austerity and a reduction in government spending. Measures such as these would create additional drag that would offset at least partly Japan’s economic recovery.
At the end of August, the Democratic Party chose a deficit hawk, Yoshihiko Noda, as prime minister. In his previous post atop the Finance Ministry, Noda pushed for temporary tax hikes to finance reconstruction of the Tohoku region, which was devastated by the earthquake, tsunami, and nuclear power plant meltdown. But with Japan in recession since the start of the year, it is far from certain that such austerity measures will pass. Another funding idea, issuing special reconstruction bonds, could also run aground following Standard & Poor’s downgrade of Japanese government bonds earlier this year. What’s left? Additional monetary accommodation. I believe the Bank of Japan will once again rise to the occasion.
The longer Japanese and German economic growth remains in the doldrums, the more Chinese exports will suffer. Overcapacity will grow worse, saddling banks with more non-performing loans and driving down prices for select manufactured goods. The upside, for the rest of the world, at least, would be a reduction in a major source of global inflationary pressures. How China manages these risks will be an issue of growing concern over the next 12 to 24 months.