The Euro in a Shrinking Zone

Robert Skidelsky


LONDON – The recent European Union summit was a disaster. Both Britain and Germany played the wrong game: British Prime Minister David Cameron isolated Britain from Europe, while German Chancellor Angela Merkel isolated the eurozone from reality.

Had Cameron brought an economic-growth agenda to the summit, he would have been fighting for something real, and would not have lacked allies. As it was, he fully accepted Merkel’s austerity agenda – which his own government is implementing independently – and chose to veto proposals for a new European treaty to protect the City of London. This cheered up the Euroskeptics in Cameron’s Conservative Party, but it offered nothing to counter the lethal medicine prescribed by Germany’s Iron Lady.

The agreement reached in Brussels forecloses any possibility of Keynesian demand management to fight recession. Structuralbudget deficits would be limited to 0.5% of GDP, with (as yet undisclosed) penalties for violators.

This is the wrong cure for the eurozone crisis. The Merkel doctrine holds that the crisis is the result of government profligacy, so only a “hardbalanced-budget rule can prevent such crises from recurring.

But Merkel’s analysis is utterly wrong. It was not deficit spending by governments that fueled the economic collapse of 2007-2008, but excessive lending by banks. Government’s mounting debts have been a response to the economic downturn, not its cause. What ought to have been hard-wired into the EU’s institutional structure was not permanent fiscal austerity, but tough financial regulation. Of this there is little sign.

More immediately important is the failure of the proposedfiscal union” to do anything for European recovery. The figures are grim: before the summit, the European Central Bank slashed its eurozone GDP growth forecast for 2012 from 1.3% to 0.3%. That is almost certainly optimistic. In fact, the eurozone will contract in the first half of next year – and probably in the second half, because of the deficit-cutting policies now being pursuedplacing further pressure on banks and sovereigns.

The reason why recovery from the crash of 2007-2008 has been so anemic is straightforward. When an economy shrinks, government debt grows automatically, because its revenues decline and its expenses rise. When it cuts spending, its debt grows even more, because its cuts cause the economy to shrink further. This makes the government more, not less, likely to default.

In the eurozone, most government debt is held by private banks. As this debt increases, the value of banks’ assets falls. So the crisis of the sovereigns engulfs the banks. To put weakened governments on iron rations, as Merkel did, was to make a financial crisis inevitable. To continue to preach salvation through austerity as the economy declines and banks collapse is to repeat the classic mistake of German Chancellor Heinrich Brüning in 1930-1932.

To be sure, the eurozone needs more than a bailout. The periphery needs to recover competitiveness, and some have taken heart from the Mediterranean countries’ shrinking trade deficits – the structural trade imbalances within the eurozone are correcting themselves, they say. Unfortunately, these corrections are not based on increased exports, but on declining imports, owing to depressed levels of economic activity.

The idea that a country can achieve a trade surplus by importing nothing is as fanciful as the idea that a government can repay its debt by starving itself of revenue. One person’s spending is another person’s income. In insisting that its main trade partners cut their spending, Merkel is cutting Germany off from the main sources of its own growth.

So, will the single currency survive? Two policies that might, in combination, save it are off the agenda. The first is quantitative easing (printing money) on a heroic scale.

The ECB should be empowered to buy any amount of Greek, Italian, Spanish, and Portuguese government bonds needed to drive down their yield to near the German rate. This might stimulate real growth through several channels: by reducing lending rates, by raising the nominal value of public and private assets, and by weakening the euro against the dollar and other currencies. But the effects of quantitative easing on economic activity are uncertain, and such an inflationary policy might well invite retaliation from Europe’s trading partners.

That is why quantitative easing should be run in conjunction with a eurozone-wide investment program designed to modernize the creaking infrastructure of eastern and southern Europe. Capital spending by governments, unlike current spending, can be self-financing through user charges. But, even if it is not, well-chosen public investment produces high returns: new roads reduce transportation costs, and new hospitals produce a healthier workforce.

An institution, the European Investment Bank (EIB), already exists to carry out such a program. It should be recapitalized on a sufficient scale to offset the contractionary effects of Europe’s national deficit-reduction programs.

Quantitative easing, combined with public investment, would impart the growth impetus that the eurozone sorely needs to bring about a gradual reduction in its aggregate debt burden. But it is almost certain that neither policy, much less both, will be implemented.

The ECB is stealthily buying government bonds on the secondary market, but its new governor, Mario Draghi, insists that such intervention is temporary, limited, and intended solely to “restore the functioning of monetary transmission channels.” No one at the recent EU summit suggested making the EIB an engine of growth. So the bleeding will go on.

This means that the eurozone is beyond saving; the euro will survive, but the zone will shrink. The only question is the scale, timing, and manner of its breakup. Greece, and probably other Mediterranean countries, will default and regain the freedom to print money and devalue their exchange rates.

This will send shock waves throughout the world. But sometimes shock waves are needed to break the ice and start the water flowing again.

Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.

Barron's Cover


Buckle Up!


Wall Street strategists see U.S. stocks rising 12% next year, but most of the gains will come in the second half. Europe's response to its problems will call the tune. The case for big dividend payers.

For investors frightened by the stock market's volatility in the past six months and tired of worrying about places in Europe once given little thought, 2012 promises scant comfort -- at least in the first half.
The outlook for the year ahead comes packaged with "if, then" caveats -- as in, if the European Union implodes, then stocks will fall, possibly by a lot.

The mean prediction of the 10 stock-market strategists and investment managers surveyed by Barron's is that the Standard & Poor's 500 Index will end 2012 at about 1360, some 11.5% higher than Friday's close of 1220. That sounds like a big gain, but a lot of things have to go right for the market to make such impressive headway. Even the most bullish of these Street seers fears stocks could be more wobbly in the next six months than in the six months past.

Ironically, 1360 is very nearly the same S&P 500 target offered up a year ago in these pages -- for 2011. But what a difference a year makes. Last December, the strategists and investors we rounded up were looking ahead with modest but sturdy optimism. Investors can only look back with envy now to what seems a more hopeful, less dangerous time, when the main topic of debate was the sustainability of the U.S. economic recovery. By May the market had risen 8%, and seemed poised to motor to 1370 with ease.

BUT THEN S&P STRIPPED the U.S. of its prized triple-A debt rating. Congress barely reached an agreement to raise the nation's debt-ceiling limit and keep the government running. And Europe pitched headlong into a sovereign-debt crisis that shows no sign of ending. Given today's plethora of concerns, investors should derive some comfort from the fact that the S&P 500 is down only 3% for the year.

"One year ago we were in a much more positive spot," says Barry Knapp, head of U.S. equity portfolio strategy at Barclays Capital. Knapp expects the S&P to end 2012 at 1330 but says the forecast is back-end loaded, and assumes "some degree" of stabilization in Europe and diminishing political uncertainty in the U.S. after the November 2012 elections.

Timeline: 2011 - A Year to Remember

Although many European banks have loaded up on the sovereign debt of nations that can't repay it, even our most bearish prognosticators don't expect the Continent's financial problems to explode into a full-blown banking crisis on the order of 2008. Yet, the "nightmare scenario" must be considered.

David Kostin, chief U.S. equity strategist at Goldman Sachs, says the S&P could fall to 900 -- about a 25% drop from his 2012 target of 1250 -- if multiple euro-zone nations defaulted on their debt. Conversely, an unexpectedly successful move to ameliorate the crisis could send the U.S. stock market sharply higher, to 1400.

INVESTORS WHO GET EUROPE RIGHT likely will do best in 2012. But other, domestic issues also will shape the market's course. Chief among them are next November's presidential and congressional elections, and all the commentary -- about tax policy, entitlement spending, job growth and such -- leading up to Election Day.

Then there are questions about the growth of U.S. corporate profits. The top-down call, or that of Wall Street's market strategists, is that earnings per share will rise about 7% in 2012, to $105, for companies in the S&P 500, from this year's estimated $98. The typically more optimistic bottom-up crowd of industry analysts calls for a 10% increase, to $108, although that forecast is down from an estimate of $113 in July. Analysts' earnings estimates have been falling around the world, and both top-down and bottom-up projections for next year are lower than the 15% growth rate likely in 2011.

THE S&P 500 CURRENTLY TRADES at a price/earnings multiple of 12.5 times this year's expected earnings. Given the uncertain political and economic backdrop, none of our bullish experts sees any meaningful P/E expansion until the clouds start to part toward the end of next year. In other words, the S&P's advance to 1360, which is about 13 times the strategists' 2012 profit forecast, will be supported by 5% to 7% earnings growth, and modest P/E expansion, at best.

Adam Parker, Morgan Stanley's U.S. equity strategist, thinks the market's P/E multiple could even drop in the next few years to as little as 10. He sees downside risk to Wall Street's earnings estimates, and says "you pay a lower multiple for that."

Still, U.S. stocks look cheap on a historical basis -- especially when compared to U.S. Treasuries, says Tobias Levkovich, Citibank's chief U.S. equity strategist. The spread between an 8% S&P 500 earnings yield -- that's the inverse of the P/E -- and the 2% Treasury yield is near levels that in the past preceded big rallies for equities.

Bears say it is more likely the spread will be narrowed by a drop in Treasury prices than higher stock prices. But that is hard to imagine when the U.S. Federal Reserve has said it is committed to keeping interest rates low for a while.

IN ANY OTHER YEAR, these issues would provide more than enough for investors to cogitate on. But there are also concerns that Europe's economy will slip into a recession, even if the Continent's debt pressures ease, and that China's economic engine will slow. The good news is, even the bears we polled don't expect a recession in the U.S.

While American companies with substantial European business could be hurt, "the U.S. probably will prove reasonably resistant to a European recession if Germany doesn't [contract] and the rest of the world is OK," says Barclays' Knapp. Barclays is projecting 2.5% growth in U.S. gross domestic product next year, up from an expected 1.8% this year. With regard to sectors, most strategists favor tech shares and recommend avoiding financials and raw-material stocks.

Few concern themselves with monetary policy, as it is unlikely to play a big role in shaping markets next year at home or abroad. There is a strong consensus that U.S. interest rates will stay where they are, and that rates will fall some in Europe and emerging markets, which would be a plus for stocks.

GIVEN THE CHALLENGES and the competition, the U.S. stock market just might be the best house on a bad block next year. It has been so this year, as the S&P 500, though relatively flat, has outperformed every other market index in dollar terms.

Money managers need equities to do significantly better in 2012, as most of the pros have underperformed for too long. Goldman's Kostin notes that 84% of large-cap growth-fund managers were trailing their respective benchmarks this year, through Nov. 18. Most mutual-fund managers have underperformed year to date, following a similarly disappointing 2010, he adds. If 2012 turns out to be a third poor year of performance for portfolio managers, redemptions and pink slips might follow.

RETURNING TO THE INVESTMENT topic du jour, no 2012 market forecast can ignore Europe's debt woes, even if it's tempting to shut out the 'round-the-clock news of proposals put forth by EU leaders to keep the banks solvent, along with several small countries. At the least, says Robert Doll, chief equity strategist at BlackRock, "European leadership has begun to move to something that will be successful over time [in] combating the [debt] problem. The world isn't going to end…we'll muddle through."

Haves and Have-Nots

Financials led the S&P 500 lower this year, with a big assist from raw-materials stocks. Dividend-paying utilities put in the best performance.

Price Returns











Consumer Staples





Health Care





Consumer Disc





Info Technology










Telecom Services




















S&P 500





* Through 12/15.

Sources: Standard & Poor's; Bloomberg

The strategists see a cumbersome and slow process of recovery, a two-steps-forward-one-step-back improvement in Europe's outlook. While some expect some form of mutualization of debt across the euro zone, others think the European Central Bank eventually will buy the troubled bonds, despite its protestations to the contrary.

Federated Investors' chief investment officer, Stephen Auth, calls the sovereign-debt negotiations "a slow-motion car accident, not a high-speed train wreck." As such, he says, "politicians have time to work through the problem." Moreover, the ECB has shown "it is focused on the banking system." Bank-stock prices are one conduit of fear in the market.

Auth turned more bullish early this month, increasing the equities overweight in the firm's model portfolio after a concerted intervention Nov. 30 to improve dollar liquidity at European banks.

INDEED, THE BERNANKE PUT, a reference to the Fed's habit of pumping money into the financial system whenever crises occur, has morphed into the global central-bank put, says John Praveen, chief investment strategist at Prudential International Investments Advisors.

As in 2011, "stocks will struggle in 2012 mainly because Europe will continue to be a dark cloud," Praveen says. "But U.S. markets should have modest gains." Praveen is among the most bullish of Barron's forecasters, with a 2012 year-end target of 1430. That is predicated, however, on the S&P 500 rallying to 1300 by the end of this year, which seems unlikely though not impossible.

To Praveen, the market's currently low P/E multiple is pricing in extremely negative scenarios, such as a disorderly euro-zone default and the bankruptcy of some European banks. He expects debt-crisis fears to remain in early 2012, as a wave of sovereign-debt refinancings comes to market, testing the ability and resolve of euro-zone governments and the ECB to prevent defaults and defend the euro. As these fears subside, the market's P/E is likely to move higher.

WHERE IN THE WORLD TO INVEST? That's always a relevant question, but especially so with the U.S. stock market in the red this year and down 15% in the past five years. Parker, the Morgan Stanley strategist, recommends shares of companies with strong balance sheets; recurring revenue and relatively high dividend yields. A basket of such would include Philip Morris International (ticker: PM), which yields 4.1%, as well McDonald's (MCD), Microsoft (MSFT) and Costco (COST), among others.

Even though cash-rich American companies have been raising their dividends, the S&P 500 dividend-payout ratio is at an all-time low, notes Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch. Subramanian favors stocks with sustainable and growing dividends, as well.
Thomas Lee, chief U.S. equity strategist at JPMorgan, is one of Wall Street's biggest bulls. He expects corporate earnings to surprise on the upside "because expectations are so low." Lee, who maintains a 2012 price target of 1430 for the index, notes that profits are healthy and companies are stepping up their share buybacks, which helps to lift stock prices. He predicts corporate profit margins will expand to 9.5% in 2012 from 9% this year, and to 10% or so in 2013. Europe, which accounts for only 8.5% of S&P 500 sales, concerns him less. Lee also expects the U.S. housing market to gain some traction next year, after four years in the dumps.

Lee's main concession to bears is that European issues will make the first half volatile. But by the end of 2012 the Continent will be exiting from a recession, and there will be more clarity on the legislative front in the U.S., he says.

Goldman's Kostin notes that since the spring, the market has favored stocks of companies that are domestically focused over those with sizable international sales. That's quite a turnabout compared with recent years. Kostin expects the S&P to head to 1250 next year, and says stocks like Walgreen (WAG) offer the kind of high-quality earnings and dividend growth, plus domestic sales orientation, that will make for outperformance.

MERRILL'S SUBRAMANIAN THINKS the market's recent preference for domestically oriented stocks is temporary, although it could continue for a while longer. Her domestic picks include Union Pacific (UNP), the railroad company; CenturyLink (CTL), a telecom-services provider; and Xcel Energy (XEL), the Minneapolis utility. CenturyLink yields a whopping 8.2%, and Xcel, 4%.

Subramanian favors technology stocks, even though many tech companies depend on government spending. But tech is the only cyclical sector in which earnings volatility has lessened, owing in part to lower leverage. Some 83% of tech stocks in the S&P 500 index are trading below their five-year average P/Es. Among her 10 stocks for 2012 is Apple (AAPL). She looks for the S&P 500 to rally to 1350 next year.

IT'S TOO SOON TO HANDICAP November's elections, although the market might prefer a Republican in the White House. History suggests, however, that there is no relationship between investment returns and the party of the president in the four years of a presidential term. In fact, stocks have done better under Democratic presidents, Subramanian notes, while bonds have done better when the Grand Old Party is running the show. "It's a trading call," she says.

In recent years past, investors' interest in the U.S. and Europe sometimes took a back seat to their enthusiasm for emerging markets. Next year could be one of slower growth in developing markets, and some experts are concerned about China's ability to sustain its current growth rate approaching 10%. Interest-rate cuts in China and Brazil are positive moves, however, and could continue to support local economies and stock prices.

NEXT YEAR COULD BE the year when investors rediscover the appetite for risk, says Jeffrey Knight, head of global asset allocation for Putnam Investments. Knight, who calls himself "fairly optimistic," says, "We won't outrun the secular issues that won't be fixed anytime soon. But there could be a recognition that a modicum of profit growth is possible as we work through these issues, and if governments prudently address them."

As all market forecasters know, surprises can overturn even the most elegant assumptions. And there is no lack of things that could surprise next year. Tensions could flare in the Middle East, which would affect oil prices, for instance. Perhaps the worst risk, says Putnam's Knight, is that European leaders "lose control and get a cascading banking crisis that hits the rest of the world."

Good surprises can happen, too. If Europe gets on firmer footing, a "catch up" trade could ensue as investors acknowledge this year's earnings growth and the possibility of a stronger economy next year. And if the U.S. housing market finally finds a bottom and becomes a net contributor to GDP, that would also be an enormous plus.

Finally, any rearrangement of the power players in Washington that "facilitates improved deficit and debt policy," as Barclays' Knapp puts it, would be encouraging for investors. But that, like so much else next year, would be a second-half event.

Only one thing seems certain about 2012: It won't be dull.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

DECEMBER 16, 2011, 5:22 P.M. ET

Moody's Cuts Belgium's Rating; Fitch Warns on France's


Moody's Investors Service downgraded Belgium two notches Friday, following a move earlier by Fitch Ratings to lower its outlook on France's triple-A rating.

Citing risks to and uncertainties about funding, economic growth and the nation's balance sheet, Moody's cut its rating on Belgium to Aa3, which is three steps below the highest possible rating of credit quality. The downgrade concludes the review for possible downgrade Moody's initiated in October.

Moody's and other ratings firms have been downgrading and lowering their outlooks on many European sovereigns lately because of the credit crisis there. Standard & Poor's Ratings Services put France and most other countries in the euro zone on review for a downgrade on Dec 5, pending the results of the European Union summit at the end of last week.

Fitch Ratings on Friday lowered its outlook on France to "negative" from "stable," indicating there is a one-in-two chance the nation could lose its top investment-grade rating over the next two years.

The credit-ratings company said the negative outlook reflects its view that the likelihood of liabilities arising from the worsening economic and financial situation in the euro zone has materially increased.

Fitch also said that France is the most exposed to a deepening of the crisis relative to its triple-A rated euro-zone peers.

Fitch's warning comes amid mounting worries that the euro zone's second-largest economy could lose its top investment-grade ranking, with wide repercussions both at a domestic and at a regional level.

The move also came as Fitch also placed its ratings on six other euro-zone nations, including Spain and Italy, on watch for downgrade after it concluded a "comprehensive solution" the region's debt crisis is "technically and politically beyond reach."

Fitch said the measures agreed to at the Brussels summit and by the European Central Bank "were not sufficient to put in place a fully credible financial firewall to prevent a self-fulfilling liquidity and even solvency crisis for some non-AAA euro area" countries.

For France, Fitch said: "The fiscal space to absorb further adverse shocks without undermining its triple-A status has largely been exhausted."

President Nicolas Sarkozy's government has already passed two rafts of austerity measures this year —a total of €19 billion—as it seeks to stick to its public-finances targets despite an economic slowdown.

On Belgium, Moody's cited sustained deterioration in funding conditions for countries in the euro zone with relatively high levels of public debt. It said the deterioration heightened risks to Belgium, which could hinder the government's fiscal consolidation and debt-reduction efforts.

Furthermore, it said Belgium's small and open economy faces increasing medium-term risks to its growth because of the continuing need for deleveraging and austerity in the euro area.

Moody's also said the government's balance sheet is more uncertain and faces new risk stemming from the banking sector, especially related to liabilities linked to Dexia Credit Local, a unit of Dexia SA.

The governments of France, Belgium and Luxembourg agreed to provide €90 billion of guarantees for Dexia funding over the next decade when it was dismantled in October.

In its move, Fitch said it expects France's ratio of government debt to GDP to peak at about 92% in 2014, a higher rate than other triple-A rated nations—with the exception of the U.K. and the U.S.

Still, Fitch said France's triple-A rating is underpinned by a wealthy and diverse economy and effective institutions. The firm noted that the country has taken steps to strengthen the creditability of its fiscal consolidation effort. The company said that even France's high debt load is consistent with a triple-A rating as long as it is placed on a firm downward path by 2013-14.

But Fitch noted that since May when Fitch last affirmed France's ratings, the euro-zone crisis has intensified and the outlook for the nation's economic 2012 growth has fallen to 0.7% from 2.1%, with a 25% chance of an economic downturn.

Fitch said it doesn't expect to resolve the negative outlook until 2013—unless there is a material shockmost likely related to a worsening of the euro-zone crisis.

The ratings firm also put on downgrade watch several investment-grade-rated euro-zone nations that already had a negative outlook. In addition to Italy and Spain, that action snared Belgium, Slovenia, Ireland and Cyprus. Fitch said it expects to complete the review by the end of January. It said it would likely downgrade the ratings by one or two notches.

Belgium, rated double-A-plus, is the highest-rated sovereign of the group, while triple-B-rated Cyprus is the lowest.

On a positive note, Fitch said the nations with ratings on review for downgrade have embarked upon significant fiscal consolidation and structural reform and that those efforts are being weighed.

However, Fitch said the nations are still vulnerable to the worsening economic environment and said the systemic nature of the euro-zone crisis " have a profoundly adverse effect on economic and financial stability across the region."

—John Kell and Tess Stynes contributed to this article.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved