When one looks at the Target2 and the imbalances in Target2, it is very clear that the eurozone banking system is dysfunctional. This article discusses the investments options considering the crisis in the eurozone banking system.
The chart below gives the latest net balances in the Target2 euro clearing system in billions of euros.
Clearly, Germany is the largest creditor in Target2 and German Target2 claims have skyrocketed to EUR698 billion as of May 2012 from EUR309 billion as of April 2011. Therefore, a break-up in the eurozone would expose Germany to massive losses. However, I don't foresee that scenario panning out in the near-term. At most, we can see a Greece exit from the eurozone.
From an investment perspective (considering a dysfunctional eurozone Banking System), I would look to do the following in the near to medium-term:
1) Avoid the banking sector in the eurozone. The bailouts can prop up the dysfunctional sector in the near-term. However, outlook remains highly risky and uncertain and it does not suit the risk appetite of a retail investor. At the same time, I would avoid the U.S. banking sector because of the derivatives linkages of the U.S. and European Banking system. I had presented an interesting chart on the derivatives linkages in my site recently
2) I would also look to gradually accumulate physical gold or gold ETF shares. The policymakers would certainly look to flood the banking and financial system with more liquidity in order to prevent the collapse of the banking system. Further, some signs of weak economic growth in the U.S. coupled with several countries already in recession in the eurozone would prompt policymakers to go for further quantitative easing. This will be positive for gold in the medium-term. Also, since I am far from convinced about a gold bubble, I would certainly keep accumulating the precious metal as an investment and as a currency, which is a store of value
3) I would also not be keen on going long on the euro in the medium-term. I don't deny that United States has problems. However, the problems in the eurozone are much bigger and the solution entails more money printing. Therefore, relative to the dollar, the euro is very likely to get weaker in the medium-term. In other words, a stronger dollar in the medium-term means tightening global liquidity. From that perspective, industrial commodities and crude oil also need to be avoided in the medium-term. One can connect this to China and the slowdown in China (which will impact commodity prices).
A broad conclusion would be that risky asset classes might have bounced back in June, but the rally is not sustainable and the second half of 2012 can be very undesirable for risky asset classes (primarily due to continued problems in the eurozone).
Therefore, investors considering fresh exposure to equities need to remain in the sidelines and investors with exposure to equities can consider switching to more defensive plays than aggressive bets.