There's no easy solution to Europe's woes - so plan for disaster

published 27 September 2011

Markets are rebounding this morning. Everything from gold to stocks is on the up.

Why? The truth is, it's probably just market physics. There's only so far that prices can fall before they need to take a breather.

The pundits, of course, need to find reasons for the rise. Most are putting it down to 'hopes' of a deal on Europe being reached.

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But we've been here before. For all the encouraging noises being made by politicians, we suspect Europe has some more nasty disappointments to spring on the market.

Europe scrabbles for a bigger safety net

The main fear bothering investors right now is that Europe will end up giving us the 2011 equivalent of the Lehman Brothers collapse.

Yes, last week's sell-off was sparked by disappointment with the Federal Reserve's 'Operation Twist'. But that's because the markets were hoping that Ben Bernanke would somehow put a crash mat in place that would stop anyone from getting hurt when Greece goes bust.

So all eyes are on the next big 'solution' to the European problem. The new cunning plan is to create a bigger bail-out fund. Peter Spiegel sums it all up in this morning's FT.

The existing bail-out fund, the European Financial Stability Facility (EFSF), doesn't have enough firepower. The way it's currently structured, it has a capacity of about €250bn (the headline figure is €440bn, but it can't actually lend that much).

So the idea is to do two things: give the EFSF more powers, and give it more money. The idea is that a chunkier EFSF would be able to pump money into the more fragile eurozone banks. It would also be able to buy dodgy sovereign bonds, buying time (yet again) for countries to reform themselves.

With this safety net in place, Greece's debt could be restructured, and everyone could stop fretting about the other eurozone countries. Sounds simple, eh?

It might be simple if only one country were making the decisions. But of course, that's not the case.

Germany votes on whether to give the EFSF expanded powers this Thursday. If they block it which seems unlikely that would be 'game over' for that particular grand scheme.

But this is just the beginning. When and if the restructured EFSF is approved, Europe needs to figure out how to make it bigger. There are various ideas about how to do this. The trouble is that the most effective ones basically rely on turning the EFSF into a backdoor route for the European Central Bank to print money, and the Germans won't like that idea.

As I already mentioned, the Europeans have run out of 'sneaky' solutions to the problem. They're still trying to find them, but unless the Germans turn around and agree to shouldering the debt burdens of most of the rest of Europe, then it's not going to happen.

So a lot more arguing and making and breaking of plans lies ahead for the eurozone. And the longer it takes them to hammer out a deal, the more likely it becomes that events will overtake them.

In short, if markets are rising today because of 'hopes' for the eurozone, you can almost certainly expect them to start falling again in the near future. Because those hopes are going to be raised, then dashed, then raised and dashed again several times between now and a Greek default.

Stay defensive and hang on to gold

What does this mean when it comes to your investments? Again, it's another reason to keep your portfolio positioned defensively. There are some attractive opportunities in European stocks indeed, my colleague David Stevenson recently pointed one out, and Paul Hill also suggested two in the current issue of MoneyWeek magazine but there's also likely to be plenty of upheaval ahead, so valuations could go even lower.

Julian Pendock of Senhouse Capital says their European Focus fund remains invested mainly in "high quality global franchises and stable dividend-paying stocks". He's also avoiding European financials. The problem, he says, is that "it is still unknown whether losses on sovereign debt will be absorbed by taxpayers or by the holders".

As for gold, Dominic Frisby will be giving his latest views in Money Morning later this week. And my colleague Merryn Somerset Webb explains why she's happy to hang onto it in her blog.

All I'd say is this: did gold fall because the global economy suddenly became a lot more stable? Did it fall because governments have finally decided to start defending their currencies and raising interest rates? No. If anything, the way is being paved for even more debasement the Bank of England is on the verge of re-starting quantitative easing, and if Europe does make it out of this in one piece, it'll be at the expense of the euro. So I don't see any reason to sell your gold yet.

Our recommended article for today

Where is safe for investors now?

As it beomes clear that the US and Europe are heading for a double-dip recession, stockmarkets are hurtling downwards and even gold has joined in the slide, Merryn Somerset Webb looks for safe places to hide.

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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.