The next black swan could be fast approaching from a region that few are talking about
Complacency has replaced the sense of crisis that engulfed the Eurozone four years ago, although little has been done to fix its core problems
With the outcome of next Tuesday’s US presidential election hanging in the balance following a new probe by the Federal Bureau of Investigation into Hillary Clinton’s emails, global financial markets are focused on one thing and one thing alone: US political risk.
In a sign of mounting concern that the brazenly populist Donald Trump will win the election, the Mexican peso - the most accurate gauge of “Trump risk” because of the Republican candidate’s pledge to build a wall along America’s southern border - resumed its decline against the dollar this week as Clinton’s lead in the polls evaporates, with a Washington Post-ABC News poll even showing Trump slightly ahead for the first time since May.
Yet beneath the surface of market nervousness about the US election lurks a bigger vulnerability; one which investors have been able to more or less ignore for the past four years but which threatens to flare up again in the coming months.
A Trump victory is still less likely than another financial crisis in Europe’s ill-managed single currency area.
Make no mistake, Europe is a bigger concern than the US.
While investors are being forced to come to terms with the risk of a Trump presidency - the recent tightening in the polls has caused the Vix index, Wall Street’s so-called “fear gauge”, to approach levels reached just after Britain’s shock decision in late June to vote to leave the European Union (EU) - complacency reigns over Europe’s financial markets.
The yields on benchmark 10-year Spanish and Italian bonds, which surged to more than 7 per cent during the acute phase of the eurozone crisis at the end of 2011 and in the first-half of 2012, have fallen dramatically and have remained under 2 per cent since mid-2015.
Even senior policymakers in Europe have become complacent.
On Tuesday, Klaus Regling, the head of the eurozone’s bail-out fund, went so far as to say that the EU does not require further political and economic integration in order to strengthen Europe’s shaky monetary union. “The truth is, on the whole, Europe is doing reasonably well. It has made tremendous progress since the crisis. The euro area works well and there is no need for a full political union nor a full fiscal union.”
These are worrying words, and ones which are sowing the seeds of the next crisis.
To be sure, the eurozone has made considerable progress since the dark days of November 2011 when investors feared the bloc was on the brink of imploding.
The eurozone even grew 0.3 per cent (or 1.6 per cent on an annualised basis) in the third quarter of this year in a sign that the bloc’s fragile recovery, which began in mid-2013, has not been derailed by the Brexit vote. What is more, the risk of a prolonged Japanese-style bout of deflation has been averted, with inflation in Europe’s single currency area rising to its highest level in more than two years last month to 0.5 per cent, with the prospect of a further rise in consumer prices in the coming months as the drag from lower oil prices fades.
The eurozone’s banks are also in better shape, with the results of the latest stress tests, published in late July, showing that the region’s lenders, which have raised 180 billion euro of capital since 2013, are better positioned to withstand another financial crisis.
Yet the good news stops there.
Unemployment in the eurozone remains stubbornly above 10 per cent - and close to 20 per cent in Spain, supposedly the bloc’s star performer along with Ireland - while inflation is still woefully below the 2 per cent target of the European Central Bank. Italy, the eurozone’s third-largest economy, is still struggling to emerge from recession while its banks are burdened with a large stock of non-performing loans.
More importantly, the EU has just lost its second-largest economy which is fuelling anti-EU and anti-establishment sentiment in other member states, notably France which holds a crucial presidential election next spring.
This is why European policymakers are fearful of pushing for further political and economic integration. Yet without some sort of fiscal backstop in which Germany, Europe’s largest economy, effectively underwrites the debts of southern Europe in exchange for much stronger control over Italy’s and Spain’s budgets, monetary union is doomed.
It is the ECB’s ultra-loose monetary policies that have kept the eurozone’s financial crisis at bay for the last four years. Yet it is these very policies -which are proving less and less effective with each passing day - that have bred complacency.
Trump risk may dominate the headlines but investors ignore Europe’s problems at their peril.