Sunday, February 7, 2010

I love Felix Salmon's blog, especially his take on the unburst property bubble, but I have to take issue with his post on the recent wave of eurozone worries and their link to market declines.

The link between newsflows and market perception is a lot more complex than simple cause and effect, and has been for a long time. The best way I've found to think about this is that markets accurately reflect the conventional wisdom in asset pricing. As Keynes put it over 70 years ago

"It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence."

If that's the case, then the best way to understand the market declines in the last few days, is that conventional wisdom has adjusted its view on what the stock markets in general are worth. What could have driven this adjustment? Felix is quite right in saying that the fiscal status of the Eurozone countries has not changed. But information about it has become much more readily available, both in Greece where the new government in October revealed that the fiscal deficit was twice as wide as forecast, and in Spain where the government recently revealed that the fiscal deficit for 2009 was two percentage points higher than forecast. And while the MSCI exUK index is down 6.9 percent for the year, the Spanish Ibex is down over 20%, and Athens is down 16%.

Both Greece and Spain have much further to go. Greece has a gaping 13% hole in its budget, with debt pushing 110% of GDP. Spain is in a better position on the debt side, but international investors are right to worry about a country with unemployment at 20%, rigid labour markets, declining productivity, and a government that has little control of its regions and has stuck its head in the sand until recently. Belt-tightening by the Spanish government in 2010 will be at the worst possible time, a it coincides with the withdrawal of ECB monetary stimulus and the economy remain the last G-20 country still stuck in recession.

“For the past 10 years we have had an abstract, theoretical debate about whether a monetary union can work without a fiscal union,” says Marco Annunziata, chief economist at Unicredit, based in Milan. “Now we have had it tested – and have found out that that it does not.”

Once you start going down that road, there are a lot of larger European countries that start becoming suspect - Italy, the UK, even France at some level. All three have much higher levels of debt than Spain, weak economic prospects in 2010, and the UK has a fiscal deficit even wider than Spain's as well as a national election in 2010. After the "98 Asian crisis" are we going to end up seeing a "2010 European crisis" ?