How to profit from Angela Merkel’s game-playing

Despite Angela Merkel's recent hard-line stance, the news from the latest eurozone summit is looking positive. John Stepek looks at some possible outcomes, and explains how you can profit.

It might be my imagination, but I think Angela Merkel might be starting to learn something about markets.

She's spent the whole run-up to this European summit knocking back every proposal going. She even went so far as to suggest that shared liability wouldn't be introduced "in her lifetime" (no doubt fully realising that the Anglo-Saxon media would then turn the line into the punchier, "over my dead body").

Smart woman. She's getting the feel for this game.

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The good news is, you can profit from that

The end of the world has been postponed - again

Resolving the eurozone crisis will be a long, painful process. Imagine you're the German chancellor: you're going to have to cope with other countries' intransigence, not to mention your own voters' mood swings.

The last thing you need is markets having a fit of the vapours every time some southern European blows the credit card again.

So don't get investors' hopes up. Make them imagine the worst. And then, whatever progress you come up with, however tiny, looks like a real achievement.

Markets go up, the bears get burned, investors once again get scared to bet against the collective might of policymakers, and you've got a bit of breathing space until the next crisis.

And that looks like the game plan here. Because while I may be speaking prematurely, so far the news out of the latest eurozone summit is pretty positive. The most important aspect in the short term is that the European bail-out fund will eventually be allowed to bail-out banks directly, rather than going via a sovereign state.

This is very important. The problem just now is that Europe lends money to the sovereign let's use Spain as the pertinent example - which then uses it to recapitalise its banks. But that leaves Spain on the hook to the bail-out fund. That in turn, pushes all other lenders down the chain for payback.

As a result, every private lender gets scared of another Greece happening where they lose all their money, while European institutions stay whole. Now, European leaders have also said they'll sacrifice seniority. But talk is cheap, and politicians' promises even cheaper.

That's why the decision on the bail-out funds is so critical. If European money does go direct to the banks, effectively you have the whole of Europe standing behind the Spanish (or French or German) banking systems, rather than just Spain.

In turn, if Spain doesn't have to stand behind the banks alone, it means that the country doesn't look as though it's completely bankrupt anymore (because like Ireland, it's the banks that are the problem, not public spending). And that means that private lenders might be willing to lend it some money at less than 7%.

None of this solves the crisis. None of this means the euro is going to have a long and happy future. And as Jeremy Batstone-Carr at Charles Stanley points out, this is basically yet another jam tomorrow' promise. The bail-out fund everyone depends on still doesn't actually have any cash in it, and probably isn't big enough.

But I reckon that this, plus whatever comes out of the summit later today, will be enough to tide us over until the next bout of one week to save the euro' hysterics.

Markets are rallying with relief but what gains will stick?

So what happens now? You'll get markets rallying with relief. A rising tide lifts all boats, so most of the risk-on' stuff will jump. Indeed, it already is.

But which rallies are worth taking part in? It comes down to valuation. Clearly, this looks like good news for beaten-down European markets. We've already noted on a number of occasions recently that judged by the cyclically-adjusted p/e ratio, markets like Italy and Spain were looking cheap.

Specifically, we suggested that Italy looked worth buying in a recent MoneyWeek magazine cover story. Our Roundtable experts also looked at their favourite European stocks in the latest issue, out today.

I'd say there's still a case for cautious buying of the cheap markets in Europe. You can take what you want from the summit the appetite for holding the euro together is clearly still powerful but ultimately, it's the cheapness of the stocks that matters. Of course, this is on top of, not instead of, your selection of nice, income-paying blue chips.

Elsewhere, the story is more mixed. Commodities have rallied too, basically because they're risk-on' assets as well. But I'm not so keen on them. Europe might have pulled back from the brink again. But it's not going to suddenly see a rampant economic recovery. And that's bad news for China in particular. So I can see the commodity rally being short-lived.

The other vulnerable-looking area is US stocks. As James Mackintosh points out in his FT column this morning, if investors stop fretting quite so much about Europe, they'll have more time to worry about America.

The big problem there is the fiscal cliff'. America like everywhere else has spent too much and needs to raise taxes and cut spending. All else being equal, that means slower economic growth. So normally, you'd expect them to dodge doing anything about it.

But this is an election year. A smart politician would get into power, take the painful hit early on, then start spending again towards the end of their term. So there's no guarantee they won't cut back.

Also, US stocks aren't immune to a European slowdown. And more importantly, they are much more highly valued than their European peers. Says Mackintosh: "The total US equity market has outperformed the eurozone by 30 percentage points over the past year, the biggest gap since 1991".

That gap looks like closing. If the eurozone crisis gets worse, then "the US will not be immune to the world recession or worse which will follow. If by some miracle it is solved, depressed eurozone shares have more to gain."

Regular contributor Tim Price looks at a risky way to profit from a fall in US marketsin the latest issue of MoneyWeek, out today (you can read it now by signing up for a subscribe to MoneyWeek magazine).

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

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.

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.