The debt crisis has inflicted a heavy toll on the region’s economy with recession looking an inevitable side effect of sovereign woes as we move into 2012.
Of course peripheral bond markets have been devastated but contagion into other asset classes has been more limited thus far.
Indeed, although equities fell over the summer it was driven by concerns of a broader global slowdown rather than Eurozone worries specifically, underlined by October’s impressive equity bounce which was underpinned by an improvement in US data among other things.
Similarly the euro has traded much better than many anticipated in recent months.
To an extent this has been driven by (now reversing) rate differentials and a far more accommodative approach from the Fed, including the rates pledge and ‘twist’, but longer-term ECB inaction looks more of a threat than an asset to the currency, endangering growth and exacerbating existing tensions in the block.
EU efforts to recapitalise the banking sector should be a further headwind, the simplest way for banks to increase tier one ratios (EUR106bn demanded) being to reign in lending and further jeopardising growth.
It is also worth stressing that the only efficient adjustment mechanism available to the Eurozone is a weaker FX rate. Club Med are crying out for just this and it also appears to be the support mechanism that makes the most sense politically, minimising the scale of fiscal transfers north to south and/or a lengthy period of deflation in the afflicted countries to restore competitiveness.
Germany may be the regional heavyweight but the euro is more than simply a Deutsche mark proxy. We’ve heard a few explanations as to why we’ve seen a firmer euro that we’d otherwise expect, including regional banks selling non-euro assets and repatriating cash to cover bond losses.
But fundamentally the case for a weaker euro is compelling in our eyes.
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