I’m getting a definite sense of déjà vu about these markets.
I can’t be the only one. When the Greek crisis first kicked off last year, everyone panicked. There was talk of dominoes toppling. But then investors decided it was ‘containable’.
Europe’s leaders would do ‘what it takes’, went the argument. Greece isn’t that big after all. If it had never been part of the eurozone, it could be having an economic meltdown and no one much beyond its shores would particularly care.
However, conditions in Greece haven’t improved. The eurozone has had to sign up to a fresh €120bn bail-out. Austerity measures still have to be pushed through. And the global economy seems to be slowing at the same time.
Greece might be ‘containable’ if Europe could get its act together. But the longer it takes, the more likely a completely uncontrolled collapse becomes. And small or not, that kind of chaos would send spasms of fear across the global economy.
Already, the talk is turning once more to which domino will topple next.
The bad news for the euro is that the country everyone’s worried about now really is ‘too big to fail’.
It’s Italy.
Italy’s woes – low productivity and high debt
As if the eurozone crisis wasn’t bad enough, credit rating agency Moody’s has been adding some fresh turmoil to the mix.
Earlier this month, the group said it was putting Italy on review, with the possibility of downgrading its Aa2 credit rating. What’s worrying Moody’s about Italy? Well, it’s the same problem as everywhere else. Debt is too high and growth is too slow.
Italy’s average quarterly growth rate since 2000 has been just 1%, says Reuters. Productivity is low and labour laws are very strict. With an ageing population, that’s only likely to get worse.
Meanwhile, its debt-to-GDP ratio is 120%. That’s bearable as long as it can borrow money from investors at low rates. But if markets get panicked by the problems elsewhere in the eurozone, then borrowing costs for Italy might rise. Suddenly servicing all that debt would be a lot tougher.
Already the gap between the yield on Italian government bonds and German government bonds is at a euro-era record. (In other words, investors are lending to Italy at much higher rates than to Germany: you can keep an eye on this and other borrowing costs at our bonds page).
The good news is that Italy doesn’t have much exposure to the problems in the periphery. French and German banks are far more vulnerable to a collapse in Greece than Italy’s are. Private debt is also low. And while the overall national debt is high, government spending is fairly well controlled – the budget deficit for this year is expected to come in below 4%.
But Italy’s banks still have their problems
But that might not be enough. Moody’s threw another hand grenade into the market last week, as it warned that it might downgrade 13 of Italy’s biggest banks.
As a result, on Friday, Italian banks saw the biggest drop in their share prices in two years. The share price of UniCredit, the biggest lender, fell by 5.5%. Intesa Sanpaolo, the second-biggest, saw a 4.3% drop. Trading in both stocks was briefly suspended.
Why the downgrade threat? Ironically, it’s because Italian banks hold so much Italian government debt. If Moody’s downgrades Italy’s credit rating, then the value of Italian government bonds is likely to fall. That would hurt Italian banks’ balance sheets.
In other words, Moody’s is warning it might have to downgrade Italian banks, because of the danger that Moody’s will downgrade Italy itself.
That may seem circular and a little bit whacky (largely because it is). But in fact, Moody’s is actually doing its job (for once). It’s pointing out something that investors should already know: that the emperor has no clothes.
Can anything stop the panic spreading?
The truth is, there’s nothing new in this. Anyone with eyes can see that Italy is a potentially vulnerable economy. So are Spain and Belgium. Beyond that, plenty of other developed countries look wobbly too.
So what matters here is not so much the state of the individual countries, but confidence that they’ll stay out of trouble. As the Bank for International Settlements pointed out at the weekend, for confidence to return, the eurozone debt crisis needs to be fixed ‘once and for all’.
The trouble is, without a solution that involves acknowledging that Greece is bust and some of its debt won’t be repaid, that won’t happen. And even if there is a resolution where some of Greece’s debt is written off, the danger then is that we need a similar process for Portugal, and also for Ireland’s banks.
That’s why no one wants to grasp this nettle yet. As soon as you admit there’s a problem, you have to be ready to present a workable plan to the markets, or else investors’ imaginations will run wild and you’ll get a crisis anyway.
But the longer this rumbles on, the more likely a nasty messy default becomes. As George Soros put it, “Let’s face it: we are on the verge of an economic collapse which starts, let’s say, in Greece but could easily spread. The financial system remains extremely vulnerable”.
We’ve noted before that holding gold, cash and defensive stocks seems to us like the best bet right now. If you’d like to actively play the weakness in the eurozone, our spread betting expert John C Burford has been looking at the dollar / euro exchange rate regularly in recent weeks. Spread betting is of course very risky, but it’s one of the easiest ways to play the currency market for the small investor. To find out more, sign up for his free MoneyWeek Trader email here.
Our recommended article for today
The biggest contrarian trade in the market today
These are dark days for the owners of the world’s oil shipping fleet. Tanker rates have slumped and costs have soared as the oil price has risen. So it’s no wonder that the share prices of supertanker operators have been collapsing recently. But all that means it’s a perfect time for contrarian investors to make some money. David Stevenson explains how.