This week, following my earlier article
on the European elections, I look at the ratification of the new fiscal compact. The European Union (EU) is being crushed by austerity, focused on the weaker countries suffering from excess housing like Spain, which has 23.3% unemployment. As an illustration, Carrefour's recent like-for-like sales fell 19% in Greece, 7% in Spain and 5% in Italy—clear evidence of real people cutting back on real essentials. Many politicians appear too relaxed about economic prospects for 2012-13—perhaps because they seek re-election.
François Hollande is gaining in the polls ahead of Sunday's voting in the first of two rounds in the French elections. (Let's not forget his call for renegotiating the fiscal treaty and the addition of stimulus measures.) The shift to the left with François Hollande and Jean-Luc Mélenchon (the candidate for the Left Front, who is also advancing in the polls) is quite worrying while most other EU states move to the right. Hollande is calling for less fiscal austerity and Nicolas Sarkozy is saying the European Central Bank (ECB) should not limit its mandate to controlling inflation, but should instead add economic growth. This increases the scope for more internecine political rivalry and policy confusion. With George Papandreou's, Silvio Berlusconi's and José Luis Rodríguez Zapatero's political heads rolling because they were incumbents during the Great Recession, U.S. President Barack Obama may need to watch out.
After some months of post-LTRO (long-term refinancing operation) calm, Spain's revised 2012 budget deficit forecast of 5.3% of gross domestic product (GDP)—a 3.2% cut to satisfy EU demands but, importantly, up from an agreed 4.4%—spooked markets last week. Investors questioned whether fiscal austerity can result in growth and debt sustainability during Spain's second recession since 2008. Yields on 10-year government bonds rebounded above 6% and Spanish equities dropped to a three-year low.
The fiscal compact (Maastricht 2) must be enacted through all parliaments. The Irish referendum, while redundant in terms of relevance, may give Ireland the potential to stymie progress. Following Greece’s default, Ireland may request relief from more onerous terms than Greece. Depending on when the referendum occurs, Ireland's economic renaissance may become challenged as the euro zone slows or enters recession.
Potential for increased volatility.
Across the EU, there should not be too many difficulties with the fiscal compact but, in terms of adding volatility to markets, it can have headline-grabbing potential—as we've seen recently with Spain. Austerity and the fiscal compact have the ability to generate sizeable swings in market sentiment.
Europe's long-term challenges remain.
While the huge ECB LTROs have kept banks afloat, they have not helped real economies much. Thus deleveraging, forced limiting of consumption, investment and low confidence have not created conditions for escape velocity. Europe's problems have not been solved and recent economic data show even Germany and France could be headed for recession. Europe's longer-term challenges are far from being solved.
Why buy despised EU equities where attractive yields abound? The sums add up.
The prescription from all central bankers is:
Zero interest rates
+ Zero intention to raise them
+ 100% commitment to this for 3 years
The only conclusion is:
- Either this works (the jury is still out) and growth returns, in which case my recommendation is to buy equities and sell fixed income;
- Or inflation surges and debases the Organisation for Economic Co-Operation and Development (OECD) debts so countries' real debt burdens collapse, in which case my recommendation is to buy equities to protect the real purchasing power of savings.
Volatility will probably be high and unpleasant, but the writing is on the wall.