Europe goes retro, markets get cool

As bond yields rise, credit ratings threaten to fall and interest rates bottom out, Europe finds itself in an eerily similar position to that which it was in at the start of the dismal 1970s.

Global sharemarkets succumbed to a morose mood overnight, as fears over the fragile economic backdrop overshadowed hopes that central banks would once again flood markets with liquidity.

In the United States, investors fretted that the labour market appeared to be losing momentum after the number of people filing for unemployment benefits was higher than expected.

European bond markets were also rattled after the Spanish government faced higher borrowing costs at its debt auction overnight. The yield on 10-year Spanish bonds climbed to 5.93 per cent, dangerously close to the 6 per cent level that economists consider to be unsustainable.

Meanwhile, French 10-year bond yields spiked to 3.1 per cent after rumours swept through the market that France’s credit rating could be downgraded ahead of the first round of the French presidential election on the weekend. The rumours were quickly denied by French government sources.

Tensions from rising rates were quickly reflected in the region’s sharemarkets. In Madrid, the sharemarket plunged 2.4 per cent, hitting its lowest level in three years. Spanish banks were hardest hit, with banking giant Santander falling 3.56 per cent, while BBVA fell 4.5 per cent.

In Paris, the CAC 40 dropped 2 per cent and, again, French banks were harshly punished, with Socit Gnrale dropping 5.2 per cent lower, while BNP Paribas lost 4.8 per cent.

In his latest market commentary, John Taylor, chief investment officer of FX Concepts, the world’s largest currency hedge fund, points out that a number of European economies are now facing a re-run of the dismal 1970s, as rising borrowing cut consumption and choked economic growth.

He notes that US and global interest rates peaked around 1980, and since then the world has enjoyed a favourable investment and consumption climate. Economies have grown, stockmarkets have climbed and the politics of the developed world have been benign.

The fall in interest rates – which reflected the decline in inflationary pressures – meant that mortgage rates dropped, while price/earnings ratios climbed. As Taylor points out, this happy confluence "allowed many of us to assume we were geniuses as our personal wealth climbed and every investment decision worked".

It was a far cry from the previous decade, the painful 1970s. Over a period of eight years in that decade, top US companies saw their borrowing costs soared from around 5 per cent to 16 per cent. As Taylor notes, "how could stock prices rise, when each hike in rates made P/Es look more overpriced?”

At the same time, homes looked more expensive as borrowers were faced with higher mortgage rates. Home buyers are limited by what they can afford to pay on their monthly mortgage. But by the end of the 1970s, mortgage payments were three times what they were at the beginning of the decade. This meant that, unless they received salary rises, the average buyer could only afford one-third of the house at the end of the decade than they could have at the beginning of the period. The same calculation applies for automobiles, where buyers are also limited by what they can afford in terms of monthly payments.

"As rates go up, it’s harder for the average Joe to buy a nice car. As a result, climbing rates mean a decline in consumer spending and GDP growth. That was the 1970s, but ever since then we have been on the right side of that slope.”

The trouble is that for the past few years, the slope has stopped declining. Interest rates in the US, Europe and Japan are now "more like a flat valley, a valley so low it is below sea-level – like Death Valley. With interest rates at zero, they have nowhere to go but up, which means that the post-1980 favourable wind is over.”

According to Taylor, with interest rates at zero, "things purchased on time are as cheap as they will ever get and P/E ratios are as high as they ever will be. And that is not good".

At least in the US, Ben Bernanke, the boss of the US central bank, is promising not to raise rates until 2014. But many European countries are now facing the daunting prospect of the 1970s uphill slope.

For instance, Spain enjoyed an incredible decline in interest rates after it joined the euro, which made assets much cheaper to finance than they ever had been. In 1990, ten years before the euro, Spanish mortgage rates were over 16 per cent. By 2005, they had dropped below 4 per cent.

But now the Spanish government faces borrowing costs that are 400 basis points higher than the German government, and Spanish banks and cajas are face a similar blow-on in spreads compared to German banks. As a result, Spanish banks have little choice but to raise their interest rates.

"This means that all the good created by declining rates after joining the euro will be reversed in the coming years, depressing home prices, auto sales and GDP growth," Taylor says.

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