18 April 2012

FT: Eurozone is starting to look Japanese

This article states that the fear of emulating Japan's experience over the past quarter of a century has been a constant worry ever since the financial crisis broke in 2007. The reason is simple – it will have massive implications for asset allocation.

The signs are already there, and not just in short-term German rates. Benchmark 10-year Bund yields on Wednesday fell to 1.63 per cent, an all-time low. John Paulson, the famed hedge fund manager, may have logic on his side in his bet against Bunds, as nearly everyone expects Germany to foot the bill to the sovereign debt crisis one way or another.

The outlook for equities under a Japan-style scenario is gloomy, even after their long period of suffering in Europe. The continent’s bourses have significantly underperformed their US rivals in local currency terms. The Euro Stoxx 50 is up 30 per cent since its post-crisis low from March 2009, against a 105 per cent gain for the S&P 500. A true Japanisation of the eurozone would lead to a further hollowing out of European equity markets. Assets under management in European equity funds slumped by nearly a half from their 2007 level by the end of last year.

The cheap loans, known as  LTROs, come with the big danger of creating a swath of zombie banks, not just in the periphery, but in parts of the core as well. The fact that 450 German banks tapped the second LTRO demonstrates the degree of over-banking in the eurozone’s largest economy.

Elsewhere, Spanish and Italian banks’ stocking up on their own domestic government debt using LTRO cash links their fates ever more inextricably to that of their own states, scarcely a good thing.

The extent of the eurozone’s  problems– stretching from Spain’s deficit to Italy’s debt stock and France’s banks – could signify, as Matt King at Citi argues, that a dramatic policy response such as in the US in 2008 and Sweden in the 1990s would not work. Muddling along then becomes the least worst option to avoid triggering a chain reaction of defaults across the continent. But it also suggests that a Japan-style slump in stocks and rise in bond prices could well be a best-case scenario.

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