Evercore Pan Asset

Critics of the Euro have long thought it  thought it could make people poorer, destroying jobs and output and creating banking stresses.             
1. They allowed countries to join which were nowhere near ready to join on their own sensible criteria. The high borrowing, inflation and devaluation prone countries were not compatible with Germany and have found it difficult to compete within the zone.
2. The Euro area authorities had insufficient political control over spending, tax and borrowing when they needed to stop countries free riding by borrowing too much.  In the early years the weak countries were able to borrow at relatively low rates thanks to the credit worthiness of the stronger countries rubbing off, even though there was no cross guarantee.
3. Belonging to a single currency means the stronger countries are likely to be pulled into lending more to the weaker countries and to paying more tax and sending more transfer payments to the weaker parts of the union.

So it is proving. Yesterday Mr Barroso helped trigger a world market crisis by saying the contagion from Greece, Portugal, Ireland and Cyprus was now spreading to Italy and Spain. Markets had been warning this could happen.  It was altogether more serious when Mr Barroso himself said it is happening. Mr Trichet at the European Central Bank followed up by saying the Bank is in the business of buying bonds from stressed countries. That led people to ask why were the bonds still so weak, and how much buying could the Bank plausibly do?

Why did two such senior Euro figures make such unhelpful statements?  In the case of Mr Barroso it may be that he was so concentrating on the audience of the member states that he forgot the impact his words could have on everyone else. Or it is possible that he wanted such an impact, because he is trying to get the member states to do something when they would rather forget the problems between meetings. Mr Barroso wants the EU states to complete the ratification of new rules for the bail out funds, and wants the Euro area to intervene more rapidly and with convincing sums of money behind it.  Mrs Merkel’s people expressed their displeasure at Mr Barroso re-opening this issue.

Mr Trichet may simply have run out of any answers which could reassure investors. He would be damned if he said he was not going to intervene, and damned if he said he would. If he ruled out intervention it was a further sign that Euroland was not yet grown up, that it did not yet  recognise the need to restore some balance to its troubled debt markets. If he said he would intervene it highlighted the lack of financial firepower of the zone to sort out Italy and Spain on top of the four countries already recognised as debtors of the system.

So what are the options from here? Each time we review them there is a predictably bigger mess to sort out.

An orderly break up of the Euro area is the least bad option. If they had pushed Greece and Portugal out a year ago they might have been able to contain the pressures. Now it is more difficult to keep Spain and Italy in.

They of course will not want to do that. They are more likely to move more rapidly towards a stronger European economic government. That is probably why Mr Barroso said and wrote what he did this week.

It is getting a bit late for that. Such a Euro sovereign will need to impose credible limits on how much member states can spend and borrow in the common currency immediately. It will need to work with an active European Central Bank, buying in debt of the weak states, issuing its own Euro debts, and printing more Euros to meet obligations and inflate away some of the liabilities. It will have to follow something more like the US policy.

This US policy itself is not proving to be a huge success, but it is the current Establishment orthodoxy.

How likely is all this? Euroland is likely to do too little too late again. The main politicians and Parliaments are all on holiday. Mr Barroso will find it difficult to get them assembled and to persuade them to take action. As the full costs of keeping this system afloat are revealed Germany will find it more difficult to sell it to the German people. The weak countries have to be made more credit worthy. That means the strong countries have to subsidise them one way or another. That in turn means the strong countries have to become less credit worthy. There may be limits to how far public opinion in the stronger countries will allow that to happen.
 
Meanwhile, there were more bad numbers from the US. This worries Wall Street and the rest of the world, as growing demand in the west is an important part of the bullish investment case. Few are currently forecasting a world recession, but too many bad days and too much gloomy talk can reinforce poor handling of the banks and the Euro crisis to bring on what people fear. Our investment view remains clear. Avoid Euro government bonds – including Germany – because they are collectively borrowing too much and are locked into a system which is not able to work well. Avoid Euro area shares, because the struggles of the Eurozone mean slower growth and weak banks. They have created a vicious circle, with weak banks lending to weak governments who in turn prop up weak banks. At best this means a long period of restrained credit and cuts in spending. At worst it could create a continuing series of solvency and liquidity crises.
 
We also think this is bad news for the UK recovery. The UK deficit control programme relies heavily on increased tax revenues from a growing UK and world economy. As growth is likely to disappoint, the UK deficit reduction programme is more difficult to deliver. We recommend avoiding all UK government debt and see no great prospects for UK shares. We are concerned about the latest figures from the US, which imply slower growth in line with our general view. There is no great case for US bond or share investment either in these continuing post Credit Crunch conditions.
 
We have maintained holdings in emerging markets, which are also suffering in this general market sell off. We think China is now cheap, and closer to changing policy to a more expansionary one. As the west struggles more, so the Chinese will have to speed their latest five year plan ,which assumes a transfer of effort from exporting more to the west to making more for domestic consumption. The Stock market sell off is part of the long adjustment to the Credit Crunch, and to the huge remaining imbalances in the world economy. We are closer to wanting to add to emerging market exposures, as at some point the slowdown in the west will be discounted. At some point emerging markets will reckon they have done enough to curb inflation, helped as they will be by the impact of lower western growth on commodity prices. The latest sell off is all part of the big adjustment of shares of energy, wealth and income towards the east from the west.