Eurozone mess – time for inflation protection

Travelling through Switzerland I can’t help but think that politicians both here and in the UK have a lot to thank their predecessors/electorates for.  The relative safe-haven status enjoyed by both economies reflects, at least in part, the arm’s length relationship with the euro. (Swiss readers may not take kindly to being compared with us Brits, but you take my point.)

The eurozone policy makers who are currently trying to thrash out some sort of ‘deal’ have an almost impossible task on their hands. Despite a belated recognition that some leadership is much required, the reality is that a comprehensive solution won’t be reached. We’ve talked before (see here) about the inherent dangers in any monetary union absent fiscal union. Are the French, Italians, the Spanish, even the Greeks ready to be governed by Berlin? Or indeed, if Greece et al are willing to give up all sovereignty, are the Germans willing to take responsibility for the deficit countries of Southern Europe?  Fiscal union requires both the debtors and creditors to be compliant.  The foundations of the building are unsafe; replacing the roof may help keep the rain out but it won’t ultimately stop the house collapsing.

Absent fiscal union and two outcomes spring to my mind; euro breakup (of some form) or the monetisation of deficits.  The former would likely see a return to 1930s depression economics, the latter some would argue risks a rerun of the 1920s Weimar experience.  While we’re certainly not predicting a rerun of 1920s hyperinflation, it will be the temptation to inflate that will win out. The structural adjustments required of  many European economies will likely prove too big a pill to swallow.  German led protests will fall on deaf ears, and German resignations from the ECB will make little difference. Inflating away liabilities will prove an easier sell for economies that have binged on debt and leverage for decades.

Time to visit some inflation protection? Given there is so little inflation priced into bond markets right now, I think so!

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. Justin Pugsley says:

    I totally agree with the 2 probable conclusions outlined above that are in the long run the most likely. 

    With so much political and increasingly real capital invested in the Eurozone project, I believe the ECB will eventually try and print its way out of trouble rather than let the Euro break-up and after various bailouts have been tried and found not really to work or simply can’t be agreed.   

    I think a massive QE programme by the ECB would probably create a huge rally in most asset classes, but of course it won’t address the problems of economic divergence and differing levels of competitiveness and will probably be a doomed rally given what would follow next.

    I still believe that eventually the Euro will break-up anyway in an acrimonious and messy fashion and all this could play out a lot quicker than most of us expect.

    I cannot see peripheral Eurozone countries tolerating a decade+ of austerity and in some cases depression like conditions for so long. It goes against human nature, even the prospect of this is enough to cause massive social turmoil! 

    Posted on: 26/10/11 | 9:46 am
  2. WellRed says:

    Like the house metaphor there. Well put.

    A few years of Merv-style 5% inflation should do the trick for Italy and Spain in the meantime though, shouldn’t it? The combination of inflation and austerity is working wonders for you chaps..

    Posted on: 26/10/11 | 7:55 pm
  3. LouisRD says:

    The current environment of ultra-low base rates and high inflation has created a lot of demand for RPI linked retail bonds – witness the recent success of the National Grid IR 2011 1.25%.
    Methinks this will be of interest to organisations looking to raise capital with a very low initial interest outlay.  I’d be interested to know how folks see this market playing out.

    Posted on: 03/11/11 | 11:16 pm

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