The Good, the Bad and the Eurozone

Have our elected representatives across the developed economies dealt with the credit crisis? Recent market activity would suggest that they have not and have simply delayed the further action that will be required in order to bring some stability to financial markets.

In response to this, the impatience of stock markets has shown through recently with corrections in the major indices across the globe. This is largely due to the continued problems of high government borrowing and rising debt levels. As you will no doubt be aware, this has resulted in the likes of the USA losing their coveted AAA credit rating. This pushes up the cost of repaying the same borrowing.

This has also impacted upon the sustainability of the eurozone and raises question marks as to how long the lack of growth in developed economies will persist.

Why we need Banks!

Much to the annoyance of some, bank balance sheets across the globe are still being repaired. There are estimates that US banks are two thirds of the way through this process and UK banks are around half way through, although European banks have hardly started!

Unfortunately, if we adopt a capitalist system, we need banks, or something that performs their normal role, that is the supply and control of money within the economy. Banks have not been able to perform their normal role due to the extreme conditions of the credit crisis.

Eurozone-o-phobia

The challenge in the Eurozone is that every country that is a member of the single currency has their currency pegged at the same level – the Euro. This means that Germany, for all her strength has the same currency exchange rate as Greece.

The only way that these economies and all the economies that make up the Eurozone can be distinguished is in the interest that they pay on their debts. Concerns continue to focus on Greece, which has seen the largest widening of the cost of borrowing when compared to Germany. Unfortunately, Greece has had to borrow more money simply to pay the interest on its mounting debts.

Back in Old Blighty

Back at home, the debate about George Osborne’s plans to cut the government deficit continues. Some argue that these cuts are too quick and will push up unemployment and slow economic growth. They also argue that the recovery in the private sector will be impeded by tax increases and will not be able to counterbalance the contracting public sector.

As a contrarian view, some argue that these cuts are needed due to pressure from the bond (UK borrowing) and foreign exchange markets and that without such cuts; the UK may even face the same problems as Greece. In addition they state that public sector finances are still unstable and the cuts made so far may not eliminate the deficit and the level of outstanding debt will consequently continue to rise for several more years.

The Cuts in Context

Let’s look at the public finances in the UK. The figures go something like this:

If we deduct 7 noughts and use the figures to represent a modern UK household, they would look something like this:

Clearly under these circumstances, debts are going to continue to rise.

Debt Exit Strategy

So how do we extract ourselves from these difficult economic conditions? Some possible
options are:

1. Have a credible plan for reducing the debt levels over time.
2. The gap between the growth of the economy and the interest payments made to service debt needs to widen.
3. The longer the term of the loans (debt) that the government owes, puts less pressure on government finances, because less debt needs to be refinanced each year.

So how are we doing against these possible routes in the UK? The UK government debt level is for now considered sustainable by financial markets. The government has a credible plan for debt reduction and although growth is slow the interest payments on the debt is also low.

The UK also has longer term loans than most other developed economies.

Conclusion

The road to recovery is not quick and the options mentioned above are tough and we all have experience of this across the developed economies, i.e. the UK, US and Eurozone.

Many investors have looked for a risk-free investment, however, this may prove elusive as Government bonds (debt), usually considered to be risk free, and are unlikely to provide a return that exceeds inflation, over a reasonable time horizon.

After a sharp increase, Gold has recently fallen in value, however, in these circumstances there are selected opportunities in the bond markets and in global equities providing dividends. However, investors will need to accept capital and income volatility and these markets have the potential to provide a source of real returns.

Please note that the above commentary does not constitute financial advice. For advice on your own personal circumstances please contact us on 01626 833225 to make an appointment.