Euroland: reasons to be worried

Arguably the recent release of the latest full Euroland money and credit data should be seen as a significant warning for markets and market participants, and there’s a dangerous gap between the enthusiasm based on company expectations as evidenced by the IFO index and other surveys, and the latest hard economic data from Spain and Italy that have been dire.

Digging into the details of the country data, we may suspect that Spain may now be accelerating into a full blown depression and Italy’s data from its real sectors does not seem much better.  Optimists counter with the observation that these countries are producing small current account surpluses but it was not these surpluses that caused the greater part of the improvement in their overall balance of payments positions. The problem is that the surpluses were apparently only created at immense and ultimately unsustainable cost to the domestic economies. Thus, they are a reflection of a collapse in domestic demand.

As to the primary reason for the improvement in the Spanish and Italian balance of payments positions and by implication in their debt markets, we can identify a return of foreign portfolio investors to their bond markets and a return of private wholesale funding flows to their banking systems.

However, if the peripheral economies really are as weak as they seem, then we can shortly expect both more bad news on the fiscal outlook, with a material reduction in tax receipts, and greater potential for political instability, particularly but not exclusively in Italy.

Such events must be key concerns in charting the way forward for Euroland, but the more immediate concerned flagged up within the latest money and credit data for Europe was not just the weakening trend in the overall credit data, although that is bad enough, but it was also the news that the commercial banks seem to be selling out of the peripheral bond markets once again.

This is very important because it was the commercial banks’ massive monetisation of peripheral bonds late last year that was instrumental in the improvement in the debt markets that occurred at that time, this in turn supported the improvement in overall investor sentiment and capital inflows to the region. But if the banks that caused the improvement are now once again taking fright and realising their investment, then we may worry that they may be a sort of leading indicator if not direct cause for the next phase of the crisis in Euroland.

Stepping back to provide more context for the most recent data, it is clear that recently there have been record inflows into the periphery, but there is a risk that these now reverse leading to financial stress conditions once more.

Of course it’s wrong to read too much into one month’s data but this cuts both ways – optimists have very little hard evidence on which to base the current enthusiasm exhibited in equity pricing, and conversely the size of the shift in bank behaviour seems significant. And here the real nagging concern is that traditionally, Europe’s banks have been ‘ahead of the curve’ when it comes to their actions in the debt markets and the banks’ decision to become net sellers in of peripheral debt in December may therefore be of more significance than the pro-equity fund flows driven off asset re-allocations.

The conclusion that we’d draw is that with equities it’s wise to stick to reliability and quality, accepting that such assets will lag a sustained bull charge, but that in a pull back, underlying value will be important in limiting avoidable losses.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla