The eurozone crisis won't go away - that's bad news for stocks

published 11 August 2011

Well, that didn't take long.

Markets rebounded on Tuesday night after the Federal Reserve promised to keep interest rates low for two years.

Yesterday they lost practically all the rebound gains, as panic in the eurozone switched to France, and banks in general.

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Even although all three major credit ratings agencies said they had no plans to downgrade France's AAA rating, worried investors just kept selling, with the Dow Jones ending the session losing another 500-odd points.

So what's the problem?

We've swapped a private sector debt crisis for a public sector one

Why the sudden panic in the markets? The simple answer is that the short-term solutions the authorities jumped on to resolve the 2008/09 credit crunch are now coming unravelled.

Financial author Satyajit Das, writing in the FT, has a good phrase for it: "Botox economics". Like botox, money from central banks and governments can make an economy look more attractive, but "its effects are temporary and [it] can have toxic side-effects".

The problem is that this has gone from being a private sector crisis to being a sovereign crisis. In 2008, governments were there to "backstop the private sector, especially financial institutions". But now, "the ability of sovereigns to finance themselves is in question, and there is no one to backstop the governments".

This matters for all sorts of reasons. But a key one is that government bonds are an important form of collateral used in the financial system. People trust government bonds. They'll accept them as backing for secured loans. If investors and banks no longer have as much faith in government bonds being repaid, then they'll not be worth as much as collateral. As Das says, this would "lead initially to a global margin call, as the value of the collateral is marked down, setting off a dash for cash".

It's one thing for the likes of Greek debt to lose its value. The financial system can deal with that. But if everything from the US downward starts to look dodgy, then at the very least, the danger is there will be a global squeeze on borrowing costs.

Already the cost of short-term funding is rising in Europe. We aren't at Lehman Brothers levels yet, but the further the fear spreads beyond the likes of Italy and Spain to France, the worse things will get.

Why panic now?

But, I hear you ask, the ratings agencies have kept France at AAA. So why the panic?

Because at some point, someone is going to have to present a permanent solution to the eurozone crisis. Right now, the European Central Bank (ECB) is "half-heartedly buying Italian and Spanish government debt", as the BBC's Robert Peston puts it.

But that's not a long-term fix. The ECB doesn't want to do it. It's hoping that eurozone governments will soon step in and take over. Bank of England governor Mervyn King put it well yesterday. "You cannot expect a central bank to be a substitute for the inability to deal with the fiscal problems facing the euro area. That is a problem for governments."

However, the worry is that "the scale of the fundraising that would be required to shore up Spain, Italy, Greece, Portugal and Ireland and their respective banks would foist excessive liabilities on countries like France". That could result in France losing its AAA rating, which would also see its banks downgraded, which would drive up their cost of funding.

What does it mean for investors?

As it stands, there are more lines of defence in place now than there were after Lehman Brothers. Central banks are primed for another crisis, and although funding costs might have risen, there's nowhere near the same amount of stress in the market as there was around the Lehman crash.

But the markets will remain very jittery for as long as this eurozone indecision is hanging over them. So it's unlikely that despite this morning's rally this bout of panic is over.

So what should you do? Continuing to avoid bank stocks strikes us as a good idea. But is there anything you should buy? Well, as David Fuller points out on Fullermoney, even the best stocks could still fall further. "This is a bear market and therefore even the most successful companies are subject to indiscriminate selling."

However, "this is a very good time to be thinking analytically about one's next share purchases. Remember, wealth is created in down markets and realised in up markets". In other words, get a list of good stocks together so that you're ready to buy low and sell high.

In the latest issue of MoneyWeek magazine, out tomorrow, my colleague David Stevenson looks at some very attractive stocks to add to your watchlist. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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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.