The outlook for Europe is worsening by the day, it seems, despite a steadying in markets overnight Thursday.
The European Commission has just chopped its forecasts for 2012 eurozone economic growth to 0.5% from the 1.8% it foresaw in the spring.
The Commission said sovereign debt levels in the eurozone would increase next year by more than previously thought, reaching 90.4% of overall gross domestic product, up 88% this year.
And a separate monthly bulletin from the European Central Bank of professional forecasters added to the growth downgrade, predicting eurozone growth next year will halve to 0.8%.
Last week the new head of the European Central Bank warned a mild recession was likely this year and yesterday senior EU officials added to that warning.
The AMP’s Dr Shane Oliver says the risks in Europe "have increased dramatically with Italian bond yield spreads to Germany now blowing beyond levels that ultimately forced Ireland and Portugal to seek a bailout."
"A bailout is looking increasingly likely to be required for Italy.
"The trouble is Italy accounts for 17% of Euro-zone GDP and 23% of its public debt, and European banks have a near $US800bn exposure to it (nearly six times their exposure to Greece).
"The enhanced European bailout fund is unlikely to be big enough to deal with Italy as well as other countries and in any case it’s not up and running yet.
"The ECB should be committing to unlimited purchases of Italian bonds but remains reluctant to do this. So the news out of Europe looks like it will get worse before it gets better."
He says that the value of the Australian dollar is vulnerable to the pressures flowing from the crisis in Europe.
A year ago I thought the $A would head up to around $US1.10. Having done that, it has been messy since mid year with the $A falling just below $US0.94 in September before recovering back above parity in October.
Where to from here? Is the upswing from $US0.48 in 2001 now over?
The $A moves with other growth trades
In recent years short term swings in the Australian dollar have become highly correlated to other growth oriented risky assets like shares.
This is clear in the chart below which shows the Australian dollar against the US share market.
While the longer term trends in each differ (up for the $A, down for US shares) each time shares have taken a decent hit so too has the $A – falling 39% during the GFC, 13% during last year’s double dip worries and 14% recently.
There are three key reasons for this sensitivity.
First, because 70% of Australia’s exports are commodities the $A is seen as a commodity currency.
Whenever there are concerns about global growth and shares take a hit, commodity prices also take a hit and so too does the $A.
Second, in times of economic uncertainty investors unwind so called ‘carry trades’.
These involve borrowing in Yen or $US at near zero interest rates and parking the money in higher yielding currencies like the $A.
When they are reversed during times of uncertainty, it pushes the $A down.
Third, the $US is seen as a safe haven currency (perversely given America’s debt problems).
Since a big chunk of global trade and lending are conducted in US dollars, demand for them goes up in times of uncertainty.
The $US strength in times of stress also pushes commodity prices down as most are priced in US dollars which in turn weakens the $A.
If anything this correlation with shares for the $A may intensify as more investors cotton on to the importance of macro economic issues in driving global investment markets and so see investing in terms of ‘risk on’ (buy shares, commodities and commodity currencies in good times) and ‘risk off’ (do the opposite).
Europe getting worse
It’s likely the $A’s vulnerability will remain high for some time.
Europe looks terrible, with any relief provided by the EU’s -latest policy response now being blown apart by political instability in Greece and Italy.
While the EU’s latest response to its debt problems – if implemented – may help head off a worst case financial blow up it does nothing to break the vicious spiral of fiscal austerity, economic contraction, budget blowouts, market panic, more fiscal austerity, etc.
Current indications are that Europe is on track for recession.
But it’s also driving social and political dislocation on an immense scale, as seen recently in Greece and Italy.
Italy’s slide into the abyss since July is particularly worrying as it accounts for 17% of Euro-zone GDP and 23% of its public debt, and European banks have a near $US800bn exposure to it (as opposed to a $US130bn exposure to Greece).
Italian elections will only lead to more uncertainty and delay. Italian bond yields have now reached levels that if sustained will turn its problems into a solvency crisis just like Greece.
They have now surged past the levels that forced Ireland and Portugal to seek assistance.<
