Europe is heading for recession - that's bad news for Britain

The markets aren't going to let this eurozone problem lie.

Having toppled the Italian government, investors turned their gaze back to Spain. The gap between what Germany pays to borrow money and what Spain pays, hit a euro-era high yesterday, and it's continuing to rise today.

And once they get bored with Spain, they'll turn to France. Or maybe Belgium.

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In short, this story is going to run and run. As we've noted several times already, this either ends with Germany paying for everyone else, or with the eurozone breaking up.

So rather than talk about Europe today, let's turn to a topic much closer to home how is all this going to affect the UK?

How Britain has benefited from Europe's crisis

Britain has benefited from the crisis in the eurozone in at least one very obvious way. By comparison with Europe, we look a safe bet.

Britain's cost of borrowing has slid. The yield on a ten-year gilt is now sitting at 2.2%. Given that inflation (judging by the more forgiving consumer price index measure) is still sitting at 5% a year, that's pretty impressive. Lenders to Britain are in effect, accepting the prospect of a near-3% loss in real terms (ie after you adjust for inflation).

The government would like you to believe that this is all down to their austerity plans, and take every opportunity to remind us that this is the case. But it's not.

Yes, it makes sense to try to tackle our debts, but that's not the reason that we're seen as a better credit risk than much of Europe. If you just looked at the numbers, we are in many ways worse. For example, Britain has a worse deficit (annual overspend) than Italy or Spain. It also has a higher national debt than Spain.

So why aren't we being threatened with national bankruptcy?

As Robert Peston noted the other day on his BBC blog, one reason is that the average maturity of Britain's debt is nearly 14 years. In other words, we don't need to remortgage as often as many other countries. Spain and Italy have to roll over big chunks of debt next year, which is far from ideal timing for them.

However, the most important reason for Britain's apparent immunity to market fear, is that the Bank of England is happy to print money to buy gilts. The rules of supply and demand have been thrown out of the window. Investors are assured of a willing buyer with technically limitless funds. At a time when people are more concerned about the return of their capital, than the return on their capital, that's about as good as it gets.

And now for the bad news

So the good news for Britain is that for now we are among the best of a bad bunch. The bad news is that the eurozone is likely to drop back into recession in the very near future.

Sure, Germany and France reported solid enough growth for the third quarter this morning. But that's in the past. As Capital Economics points out, "more timely data, like yesterday's industrial production figures for September, suggest that the eurozone economy is likely to drop back into recession in the fourth quarter and beyond". That would hit Britain hard.

First, there's the question of exports. The idea that our exporters would lead the way to a grand recovery always seemed a bit optimistic. Our manufacturing sector isn't big enough, and it always depended on the rest of the world recovering enough to buy our goods in huge quantities.

And given that Europe is our biggest trading partner, the chaos there makes the hope of exporting our way to health even more forlorn. Sales of British-made goods to the eurozone fell by nearly 3% in September. Sales to Italy were down by 16.5%.

However, as Capital Economics points out, "the bigger threat to the UK is that Italy's problems trigger a serious credit crunch and even the collapse of the entire eurozone". Fears over the state of the eurozone are already pushing up funding costs for the banks, which are then naturally passed on to consumers. For example, mortgage rates "nudged up in October".

This is all coming at a time when the economy is hardly in peak condition. Quantitative easing may help keep gilt yields low, but it has the unfortunate side effect of squashing the consumer at the same time. By driving down the pound and pushing up inflation, it makes it harder for the British consumer to make ends meet.

Even although the inflation rate came in a tiny bit lower than expected this morning, at 5%, it remains high. And the chances of it dipping to the Bank of England's 2% target rate seem very slim. With no real sign of wage growth to match inflation ahead, that means British consumers will continue to feel the squeeze. And given that consumers are still the main driver of the UK economy, that's bad news.

So what can you do? Our main focus is on finding sustainable, decent yields. And with stock markets virtually static, you can still find a good number of them out there. My colleague David Stevenson has recently updated our views on several FTSE 100 stocks which have reported their figures recently: ones that remain attractive include Vodafone and SSE, while if you feel like dipping a toe in the retail sector, M&S might also be worth a look.

But if you're looking for something a bit spicier, check out the current issue of MoneyWeek magazine where we highlight some riskier, but higher-yielding opportunities for the more adventurous investor: Three risky but lucrative ways to spice up your portfolio.

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