What Europe's new credit crunch means for you

Europe's banks are in desperate need of money. That means tighter credit and a struggling economy. John Stepek explains what's going on, and picks the best ways to invest now.

Well, that didn't last long.

An upbeat start to the year has rapidly given way to fear, as Europe hogs the headlines again. The euro slid against the dollar yesterday.

There's plenty to worry about, as usual. France is in danger of losing its AAA credit rating. Hungary (though not in the eurozone) is fraying nerves as it flirts with full-blown debt default. But the biggest concern as ever is the banks.

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Investors are finally waking up to the fact that Europe's banks need a lot more money than any sane investor is prepared to give them. That means they won't be keen (or indeed, able) to write more loans. In turn, that means tighter credit and a shrinking economy a new credit crunch.

That's all very scary sounding. So what should you be doing about it?

Why banks are having such a hard time raising money

The main thing rattling markets yesterday was the Italian banking sector. Italian bank UniCredit is trying to raise more money with a €7.5bn issue of new shares. But its share price has dived by about a third since details of the offer came out, raising fears that the issue will fail.

The risk warnings in the prospectus accompanying the rights issue probably didn't help. Investors should be aware that these include the danger that the eurozone will break up, or that the euro will collapse. Or that the European Central Bank (ECB) will stop being so lenient when it comes to lending money to troubled banks.

It's nothing investors didn't know already. But perhaps having the situation spelled out in black and white like that has brought home its seriousness. As one analyst told the Financial Times: "Frankly, you'd be insane to put any money into this. That's nothing against UniCredit. It's a country problem."

It's not as if this capital raising should come as a huge surprise. The European Banking Authority (EBA) has already warned European banks that they need to raise €115bn as a group to strengthen their balance sheets.

The basic problem is simple. Banks don't have enough capital to comfortably back the loans that they've written. If those loans go bad (say, oh I don't know, a small European country goes bust), then they won't have enough capital to absorb the losses. So the EBA wants them to raise more.

But as the reaction to the UniCredit deal suggests, no one really wants to pump more money into banks that are already dependent on the begrudging support of the ECB to stay afloat.

That's a bit of a problem for all the other banks who need to raise money. So what's the alternative?

Backdoor money-printing is no longer a solution

Well, if there's not enough capital to back your lending, and you can't raise more capital, the answer is simple: you shrink your lending. You have to cut back on writing new business, and you also have to call in some of your outstanding loans.

The problem is, it's not just banks that need more money. Countries are desperate for it too. Where are they meant to get it from? The latest cunning plan from eurozone politicians is that the ECB will lend banks money on very easy terms, and then they'll use it to buy up all this sovereign debt. It's a lot like Britain's quantitative easing (QE), but more sneakily done.

In normal times, that'd be a great deal and a winning plan get cheap money from the ECB, buy Italian bonds at 7%, and rake in the difference. But these aren't normal times. Banks want to make fewer loans, not more. And who wants to give more capital to a bank with lots of exposure to Italian bonds?

So while the ECB is attempting QE by the back door, it may not be bold enough in its current form to reassure investors. And that means eurozone bond yields will stay high, and banks will keep reining in their lending.

As James Ferguson notesin the latest issue of MoneyWeek magazine (out today if you're not already a subscriber, you can claim your first three issues free here), this is all bad news for asset prices, and for the real' economy in general, which will be starved of funds. British and American banks have made at least some progress on raising money since the crisis in 2008/09. European banks are only now starting that process. In other words, we're facing a new credit crunch.

And it's not as if the UK and the US will be immune to this. A deep recession in Europe would of course be bad news for global demand in any case. But as data from the Bank of England showed yesterday, lenders over here are worried too. Banks in the UK are already warning that their funding costs are rising (which would have a knock-on impact to the cost of lending for everyone else). They only expect this to get worse in the next three months.

The silver lining to the European cloud

Sounds like bad news. And it is. However, there could be a silver lining for investors. As politicians realise that they have little alternative but to print money or face a severe recession, political opposition will diminish. The ECB is already showing a far less Germanic attitude than it did under Jean-Claude Trichet. It won't need much encouragement to embrace full-blown QE.

When that happens, it's likely to be good news for stocks. We'll be looking at the European companies that could benefit most in an upcoming issue of MoneyWeek.

Meanwhile, you should be hanging on to defensive stocks, gold, and getting some exposure to the US even if you don't want to buy US stocks directly, many of the big defensive FTSE 100 stocks offer good exposure to dollar earnings. In the States, unemployment data seems to be continuing to improve, with the dole queues shrinking again. As my colleague David Stevenson points out, the S&P 500 tends to rise as the number of jobless people in the US falls.

The US economy can still hardly be said to be going great guns. And perhaps the recent spurt in employment has as much to do with the time of year as anything else. But increasingly the country looks the best of a bad bunch.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.