The UK Election and the European Crisis

Well, I am sure that nobody can have missed the fact that the UK has a hung parliament. I read several articles before the result that suggested that a hung parliament has been 'factored in' to the price of gilts and sterling, but it seems that this was not the case with severe market jitters following the election results. The jitters seem to have revolved around whether the Conservatives would be able to form the government, and the concerns are about the early versus later cuts to spending. I also wonder whether the markets have been counting on the notion that the Conservatives have been lying about the degree of the proposed cuts, and have expected the cuts to be deeper than those outlined in the Conservative manifesto.

The news that the Conservative and Liberal leaders are urgently trying to find a mutual position before Monday is being reported as being driven by a desire to have an agreed framework in place before the markets open on Monday. Such is the fragility of confidence in the UK economy. However, a recent report suggests that the Conservatives and Liberal Democrats are struggling to meet the deadline (update - there will be no deal before Monday).

The problem of the UK's hung parliament could not have come at a worse time. I have, over recent months, been noting the gradual loss of confidence in the UK economy, and the risks to the European economy, all of which are resultant from massive deficit spending. The result of the increasing concerns in the markets are now taking the whole world economy to the edge of crisis. Any review of the finance pages of any serious media outlet report the same nervousness and fragility of confidence. The violent plunge of stock markets is just one symptom:

U.S. stocks fell the most in 14 months, erasing the Standard & Poor’s 500 Index’s 2010 advance, as concern Greece’s debt crisis is spreading and the most volatile trading in 23 years sent the gauge down 6.3 percent.

Waves of electronic selling helped push the Dow Jones Industrial Average down as much as 9.2 percent on May 6, the biggest drop since the Crash of 1987, before paring losses. Industrial and materials companies in the S&P 500 fell at least 7.9 percent as all 10 industry groups declined.

There is increasing talk of further problems of contagion in Europe, though this should be re-described in the more accurate phrase of improved diagnosis of problem economies. The following is just one example of the concerns being expressed:

‘Nuclear Implosion’

The “unwinding became a nuclear ‘implosion’ of sorts as the carry trade became a true burden on the shoulders of the global equity market,” Dennis Gartman, a Suffolk, Virginia- based economist and hedge-fund manager, said in his daily Gartman Letter on May 7. “It was indeed a ‘perfect storm’ of unwinding of risk and the strange creation of fully fledged panic.”

The Dow Jones Industrial Average plunged by almost 1,000 points in intraday trading on May 6 as waves of computerized trading exacerbated declines. For the week the gauge declined 5.7 percent, while the Standard & Poor’s 500 fell 6.4 percent.

The euro yesterday traded as low as $1.2586 in New York before jumping to $1.2747, near its $1.2798 high for the day. Speculation that the ECB would offer “a large credit facility” to European banks sparked the gains, said Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York.

The risks to the European banking system of an ongoing sovereign debt crisis can not be understated. As several analysts have noted, the risk of sovereign default by EU countries is heavily concentrated within the European banking system. The risks of defaults extend far and wide but, yet again, the risks are potentially going to be absorbed by European sovereign states. In particular, we have the extraordinary situation in which a European stabilisation fund is being proposed, which will see already indebted (and some already dangerously so) countries having to borrow yet more money to lend to countries that are apparently in worse condition than themselves:

The proposal, tabled by Nicolas Sarkozy in an emergency meeting late on Friday night, will involve the creation of a €60bn "European stabilisation mechanism" designed to provide bail-out support for countries which may face similar strain to Greece in the coming months.

It is thought to be focused particularly on Spain and Portugal, both of whose leaders fear an assault by "bond vigilantes" in the market who have scented weakness within the eurozone. The plan will have fiscal implication for all European Union countries, including the UK. The key element is an extension of an existing bail-out package, already used to support Hungary and Latvia.

This involves extending an already-existing Lisbon Treaty clause originally designed to provide cash for economies hit by natural disasters. Under this, the European Commission will borrow directly from markets, with its own finances guaranteed by EU nations – something which would leave the UK public finances exposed if a country fails to repay the loan. It could also impact the UK's credit rating.

Whilst I have avoided and rejected the use of the word contagion, within such proposals we do finally have a mechanism of contagion; just as the bank crisis was shifted into sovereign risk (contagion), here we have the potential to spread the problems of one sovereign to another. Whilst any new borrowing that these solutions generate may not be the cause of a sovereign crisis, they may end up as a significant contributory factor. Unsurprisingly, the Liberal Democrats and Conservatives appear to be keen to avoid any connection with this deal, and can later leave the blame with the Labour government:

Representatives from either party were unwilling to comment last night. The plan, which was only expected to be entirely finalised by lunchtime today, in time for the ministers’ arrival in the Belgian capital, must be completed in time for markets opening on Monday morning, according to Mr Sarkozy.

It is no wonder that they are unwilling to comment, when they are in the process of discussing how to address the UK's own fiscal black hole. However, were they in a position to negotiate, they would be just as likely to agree to participation in the fund - after all, they may need the same support in the future, and to not contribute now may put future support at risk.

Alongside the brewing crisis, there is the usual talk of 'speculators', and 'bond vigilantes'. Whilst some will profit from the turmoil, the underlying driver of the turmoil is not speculation but the fear of investors for the security of their investments. Those investors will include pension funds and other investments that are aggregations of individual savings. The idea that this crisis might be the fault of 'the markets' is laughable and allows the politicians and policymakers a way of absolving them from responsibility. The cause of the crisis is clearly in the hands of the policymakers and politicians of sovereign states who have borrowed recklessly. Without such reckless borrowing, the markets would have no reason to shun the bonds of the at risk countries.

Alongside the European crisis, there has been the retreat to the illusory safety of the US, with treasuries as the big winners:

Treasuries surged, with 10-year note yields registering the biggest two-week drop since December 2008, as concern that Europe’s debt crisis will spread beyond Greece sent investors to the safety of U.S. government debt. Thirty-year year bonds gained for a fifth straight week, the longest winning streak since the collapse of global credit markets at the end of 2008 drove yields to record lows. The jump in demand comes as the Treasury is scheduled to sell $78 billion in notes and bonds next week.

Regular readers will know that I have suggested that, as crisis escalates, there would be a market swing towards the US as a safe haven. I will repeat the analogy I made a long time ago; as the investors flee the bear in the woods, they will flee into a cave for safety, not realising that the bear actually lives in the cave. If looking at the drivers of the crisis in Europe, it is possible to see similar problems afflicting the US. The flight to the supposed safety of the US will allow the US to plod forward for a little longer, seeming to confirm the wisdom of investor decisions, but the underlying poor position of the US economy will eventually lead to a US crisis. The reserve currency status of the $US will only allow the US a breathing space, but will not allow the US to continue down the current path.

Overall, what we are starting to see is the potential for the crisis to escalate. The UK is in limbo, with markets ever more nervous about the state of the UK economy. Alongside the UK, the crisis in Europe looks to be accelerating, and is even threatening the destruction of the Euro. The risks of a major crisis are increasing with each day that goes by. Confidence is hanging on a thread, and there is no way to guess the way in which markets will jump. When markets are so jittery, it is quite possible that any single news event might trigger a panic, and with that panic, if it takes hold, the world economy could plunge.

This kind of situation always brings to mind the cartoons of Wile Coyote and Roadrunner. As Wile runs of the cliff, his legs keep on pumping and he appears to defy gravity. Then, as he looks down, and he realises there is no support, he plunges downwards. Whilst it was possible to defy gravity for a while, in the end gravity pulls him down. The big question that we face in the coming weeks is whether the markets will look down, and see that they have actually run off the cliff. I have no idea whether this might happen, but the chances seem to be increasing day-by-day.

We are living through interesting, and very worrying times.