Germany’s Deutsche mark could make a surprise return from currency extinction
The writing is on the wall for the euro and so too is the eight-year bull market for global equities and credit
Doomsday may be creeping up again, but you would never guess so considering the seemingly endless appetite for global risk assets right now. Europe is heading into a perfect summer storm, but global investors remain in party spirits. It is unlikely to last too much longer.
The writing is on the wall for the euro in the next few months and so too is the eight-year bull market for global equities and credit.
Europe is facing up to a horror show of risk in the next few months and European unity and the euro are unlikely to survive intact. Upcoming French elections, the threat of Grexit and the risk of a major credit event in Italy should be putting global investors on high alert right now. There is even the chance that German Chancellor Angela Merkel could be on the way out after September’s national election.
Global investors can hardly be blamed. All they are doing is “making hay while the sun shines” pumped up on a raft of central bank-generated global liquidity. But, you can bet your synthetic-bottom dollar that investors will beat a quick retreat and run for cover as soon as the tide turns. 2008’s financial crash and the 2010-12 European crises left investors with livid scars.
All it takes is for one euro zone country to exit the single currency and chaos will ensue. Whether France leaves the euro, Greece opts for debt default, or the mother of all credit events happens in Italy, the result is still the same. The euro is finished, European political cohesion is over and the European Central Bank faces extinction.
The ECB has already reached its point of no return. Euro interest rates are sub-zero, the bank’s asset sheet is bloated with distressed debt and the ECB’s QE super-stimulus is earmarked for shutdown later this year. There is nothing left in policy reserve once the “house of cards” comes crashing down.
If the euro implodes, the European economy is in deadly danger.
Right now, confidence indicators might be showing some brighter signs of life, but, in truth, the euro zone is a zombie economy pumped up on monetary steroids. Take them away and recovery prospects will be left in tatters. If the euro zone breaks down and the monetary union starts to deconstruct, there will be little left to fall back on.
Without an effective ECB to orchestrate monetary policy across the 19-nation euro zone bloc, Europe’s single-currency will founder, leaving “everyman for himself”. There will be no centrally co-ordinated interest rate management, no open-market support operations for distressed government debt markets and no currency intervention. The euro will fragment and Europe will return to extreme market volatility.
The return to a multi-currency system in Europe would see the Deutsche mark rising from the ashes, a boon for global investors desperately seeking a safe haven hedge, but a nightmare for German trade. Demand for the Deutsche mark would surge on flight-to-quality flows, with German exporters taking a major hit. German government bond yields would dip even further into negative territory, putting Germany’s savings and pensions industry in grave danger.
The return of other currencies like the French franc, Italian lire and the Spanish peseta – probably greatly devalued – could provide vital export-led recovery boosts. But, de-linked from Germany, borrowing costs would rise longer term. Higher domestic interest rates would be needed to stop currency devaluation going too far. And, more heavily indebted countries like Italy would need dramatically higher bond yields to prevent a major investor stampede. European recession would quickly follow.
The collapse of the euro would pave the way for the mother of all financial crises in Europe. The risk of sovereign debt default would return to haunt the markets with a vengeance. Greece would teeter on the brink, while increased risks of Italy being swept into a major credit event would spark major market mayhem. The euro’s break-up would spell a major new pandemic shock for the global economy.
In the ECB’s absence, there would be precious little left as a last line of monetary defence for Europe. Germany’s Bundesbank would have its work cut out shoring up financial stability at home rather than providing a monetary anchor for the rest of Europe.
There is still a slender window of opportunity for investors to play safe in the next few months. But the clock is ticking and, when midnight chimes, the world will be in deep trouble.
David Brown is chief executive of New View Economics