The millstone around our necks

Ronald Doeswijk, Senior Strategist with Robeco's Economics and Financial Analysis team, weighs up the investment implications of the eurozone's ongoing debt crisis.

The financial markets are still being completely overshadowed by the debt crisis. The spreads on bonds issued by peripheral eurozone countries such as Greece, Portugal and Spain have widened on an almost daily basis for two months now.

That's despite the EUR 750 billion EU/IMF aid program, the acquisition of bonds by the ECB and supplementary austerity measures by a number of governments across the region. The value of the euro also continues to fall.

Markets are relaxed about some debt
We should, however, beware of lumping all this debt together. The news that ratings agency Fitch is urging the UK to take extra cost-saving measures to secure its rating as an excellent creditor is having no impact on markets. The yield on the ten-year Gilt has even dropped a little, while the UK stock market has performed in line with other markets.

It is common knowledge that the UK’s budget deficit will amount to an unsustainable rate of almost 10% of GDP in 2010 and 2011. Yet the same applies to the US and—to a lesser extent—to Japan. There, though, government debt was already at very high levels prior to the crisis.

Eurozone remains the focus of concern
Markets are taking a much less sanguine approach to the eurozone, where monetary union is only as strong as its weakest link. The absence of a central entity to deal with the debt problems painfully exposes the prevalent discord between the various countries and the lack of decisiveness in taking action.

That said, the ECB is already buying up debt issued by the problem countries, even as it becomes increasingly clear that there is growing German resistance to plugging the gaps in other countries’ budgets.

Europe's debt-holding banks are a worry
Another problem for the eurozone is that the government debt is largely in the hands of commercial banks. That means that if a country is no longer able to meet its liabilities, the European banking system will be dealt a fresh blow.
Furthermore, the mounting pile of debt has resulted in the likelihood of inflation and deflation increasing. The heightened risk of inflation is due to new money being printed, while deflation could be a result of one or more countries defaulting.

Likeliest scenario: global debt declines thanks to growth & austerity steps
What is the likeliest outcome? My basic scenario is that the size of the global debt mountain will decrease, as a result of economic growth and savings measures. And because printing new money is less painful than bankruptcy, I consider an inflation scenario to be more likely than deflation.

If I were to attach probabilities to the three scenarios, I would give our baseline scenario a likelihood of 60%, 30% to the inflation scenario and 10% to deflation. But the risk of deflation is mainly a factor in the eurozone. I do not expect deflation to occur in the UK or the US. Moreover, Japan is currently extending the life of its government debt, as the authorities there appear to have realized that in a few years year domestic savings will no longer be sufficient to cover the country’s financing needs.

Economic growth will be held back by debt-reduction efforts
Another impact from the debt mountain will be reduced economic growth for a year or two, thanks to governments' austerity measures. A recession is usually followed by a period of above-average growth. And indeed the macroeconomic figures have improved consistently this year. Consumers and businesses are rallying. But governments' public-spending cuts and other steps will put the brake on that recovery. I estimate that these measures will have a negative effect of approximately 1% on growth. I therefore consider it probable that economic growth will, in general, be no more than moderate.

Lackluster outlook for equities
How does all this translate into market performance? Investors in bonds have benefited from falling yields in the bonds of "safe" countries. Meanwhile, stocks have staged a recovery after their substantial falls (at least in local terms) from their highs in April.

Even so, I do not have high hopes for equities. That's because there is little chance of fresh positive surprises either for the economy or for earnings growth in the coming months. The recent divergence between the bond markets, with the rising spreads of peripheral countries, and recovering stock markets is remarkable. Combined with the high levels of volatility, it points to ongoing risky market conditions.

An earlier version of this article appeared on FD.nl.