Europe Is Not Off the Hook

08/23/2010 12:01 am EST


Chris Gilchrist

Editor, The IRS Report

Europe Is Not Off the Hook      

The continent’s undercapitalized banks will struggle to roll over their debt, writes Chris Gilchrist in The IRS Report.

China's growth slows, and its banks demand huge slugs of fresh capital. Its trade surplus widens again as its stockpiling of materials runs out of steam. US economic data is weak, housing in the doldrums, the savings ratio at its highest for years and nobody quite believes booming corporate earnings.

Meanwhile, the eurozone fails to face up to the fact that its banks require another big round of recapitalization. The stress tests didn't force the issue, so the banks will sit back and recapitalize from profits while rationing credit. Sluggish growth in Europe for several years is now probable.

Overall, the issue for the world economy is still insufficient demand rather than insufficient supply, except at the commodity fringes. So, the risk is of deflation rather than inflation, a conclusion supported by declining real yields on government bonds.

The “lost decade” of Japan is cited by more and more analysts as a likely scenario for Europe and the UK. This reinforces my belief that quality large caps, with strong franchises and balance sheets, are the best equities to own. As in Japan, they may just gently outperform the market for a decade—a scenario any investor should be happy with. And gold remains a good hedge against political turmoil, sterling devaluation, and inflation.

The transfer of private sector debt to sovereign balance sheets has led the politicians to focus on cutting deficits. But this is not where the real action is. It is, once again, the debt markets, with European banks most heavily exposed to “olive belt” bad debts in the firing line. Nervous talk about some banks having problems with wholesale funding tells us that this crisis remains what it was when it started: a banking crisis.

Unlike the UK and the US, the European recapitalization of banks was smaller in scale and left out some of the neediest—the state-owned banks in Spain and Germany, which some commentators have described as toxic financial waste dumps. European politicians have no stomach for a bigger recapitalization. Their preferred solution—keep official interest rates at zero and let banks borrow from central banks and invest in government bonds yielding 3%-4%—will recapitalize the banks, but not in a hurry.

So, the heavy lifting is left to monetary policy. The Bank of England is taking a break from quantitative easing, but my bet is that it will have to do more next year as wholesale debt rolls over and banks cannot refinance it. So the next crisis is likely to be another version of the bank crisis. Expect more stormy weather.

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