Sometimes there is so much going on in Europe, with its never-ending eurozone crisis; it can be difficult to gain an overall understanding of what is happening. There are so many moving parts.
This article provides an overview of the current state of play and the likely next steps in the eurozone crisis.
- German election - Angela Merkel is up for re-election in September. This is dominating the whole political calendar in Europe. A comprehensive solution to the eurozone crisis (e.g. Debt Mutualisation, European Banking Authority) will not be put in place until after the election. Merkel cannot be seen by her electorate to be taking a soft line against wayward countries.
- Italy - Italy has finally elected a new Prime Minister (Enrico Lette) after 3 months of political uncertainty. He is definitely breaking with the old guard. Lette is young (46) and does not support the policy of continued economic austerity. This will quickly put him on a collision course with Germany. Expect bond yields on Italian debt to widen and renewed uncertainty in the markets until they reach a compromise.
- Austerity a dirty word - There is a late realization within parts of Europe that focusing on austerity (as opposed to growth) has been self-defeating and has made the economic climate worse. Even the EU president has said that austerity had reached its limits. The continent is still in recession and even German business confidence has started to decline markedly. This could herald a re-think in European economic policy.
- Euro rate cut - In order to try and address the continued weak economic situation in Europe the European Central Bank will shortly reduce its main euro interest rate (probably from 0.75% to 0.50%). It is hard to imagine that this will achieve much. The rate cut is already priced into the EUR USD exchange rate.
- Ireland and Portugal - Ireland and Portugal have received an extension on some of their EU bailout loans by 7 years. This is a positive development especially as both countries are due to leave their bailout programs over the next year. Ireland is in a stronger financial position in that it has already returned to the markets and secured financing for most of next year. Portugal however has just had some of its major economic reforms deemed unconstitutional by its highest court (including the outrageous right of employees to be paid 13th and 14th month salaries). This puts it in an awkward position within Europe. Germany is not happy.
- Cyprus - The cost of the Cypriot bailout has recent increased from $17 to $23 billion. Capital controls remain in place and citizens can still only withdraw €300 ($400) per day. One euro in Cyprus is no longer the same as one euro in Germany. Once these controls are removed any remaining money will flee the island and a second bank bailout will be required.
- Investors are also taking a long hard look at Malta - another small Mediterranean island with an oversized (and arguably undercapitalised) banking sector.
- Greece - The country is still as bankrupt as ever. Greece remains hopelessly in debt and will require further massive debt forgiveness if it is too emerge from its economic depression anytime soon. The mood in Greece is so anti-German that its government has just launched a war reparations claim against Germany for the damage it suffered in World War 2. Germany occupied the country from 1941-44 and the Greeks have very long memories.
- Slovenia - This tiny country next to Italy has lost access to the bond markets and will be the next country requiring a banking and government bailout. Its main banks are all in public hands but it has not stopped them running up ruinous financial debts. These debts now threaten to bring down the whole economy. The smart money is already leaving Slovenia, lest it is forced to endure Cyprus-like capital controls and the banks are closed (a distinct possibility).
- France - And where is France in all this? The country was once a powerhouse and one of the two main motors of Europe. Not anymore. France continues its national economic decline and as a result is influencing European policy less and less. The twin German/France engine that has guided the European project for over 60 years is being replaced by a German dominated economic federation. At the most recent EU meeting on the Cypriot bailout the France Finance Minister fell asleep. He had to be woken by the head of the IMF. Is that a portent sign for a country that has not balanced its budget since 1976?
From an investment perspective the Euro (FXE) will obviously remain soft against the U.S. Dollar (UUP) for the rest of the summer. It will probably be relatively stable against the Pound, as the U.K. is still stagnating economically, with its main export partners in the Eurozone in recession. The euro may gain slightly against the Australian dollar (FXA) if the AUD continues its slow decline and also against the Japanese yen (FXY) as the markets digest Japan's new policy of massive monetary expansion. I would also expect European stock markets (VGK) to remain soft. They will follow the U.S. lead (SPY).
The European Union was established after second world war with the specific aim of restricting German power - in case it was ever tempted to go for the hat-trick. This hasn't worked. Instead it has reinforced German economic strength and the rest of the continent now bows to its will. As George Soros noted recently no economic policy can be proposed in Europe without its approval.
Angela Merkel has done an excellent job of disguising from her German electorate the true size of the check they will need to write to hold the eurozone together. This day will come but not until well after the German election in September.
In conclusion, the crisis is Europe is still very much alive and kicking. The next phase of the crisis will be the collision course between Germany and Italy on austerity and the forthcoming Slovenian bank bailout.