EU talks failure was the only possible solution

The headlines proclaim that EU treaty change talks have failed. We were told that so much was riding on this, and yet the response from markets this today has been something of a shrug, or even a sigh of relief. Why?

In our view, full-blown treaty change was never really a runner, given the well-known position of the British government. However, if treaty change had been agreed, markets quickly would have come to recognize the risk that the talks would get bogged down and/or be susceptible to the vagaries of political approval within the member states, encompassing several referenda. The timetable would have been unfathomable. For any solution to provide meaningful relief now, it would need to be deliverable within a speedy timeframe. Full-blown treaty change could not have provided this.

What we have instead is Plan B – a fiscal compact amongst a sub-set of 23 nations (and maybe more). As with any EU deal, there are plenty of ifs and buts, such as can it be legally-binding and will it have sufficient enforcement “teeth”? However, the key things it has going for it at this moment is that its aims are relatively clear and uncontentious (at least in principle) and it should be deliverable quickly (by next March we are told). As such, they should provide for greater political clarity, at least in the short term.

Of course, what this is all really about is providing the political and economic justification for the ECB to get going with a heavy duty bond support operation. There are some signs of encouragement here. Mario Draghi at the ECB has given it his blessing and it looks like a three step plan is beginning to fall into place. Step one, allow the bond markets to bully the weaker states into fiscal rectitude. Step two, lock these responsibilities in with constitutional changes. Step three, engage the ECB in support.

Perhaps the most important news of Thursday was lost in the noise. The additional liquidity enhancement measures taken by the ECB were very aggressive – in some respects even more so than those used in 2008. It is probably safe to say that the European bank liquidity squeeze is over. Unfortunately, the credit squeeze caused by the EBA’s misguided tier 1 capital directive is not. Meanwhile, there are still no fiscal transfer mechanisms in place to offset the retrenchment plans being implemented in the more vulnerable economies. It’s still going to be a very tough first half of 2012 for the Eurozone economy.

During the turmoil of November, we took the opportunity to pick up short-dated Italian and Irish government bonds at what we thought were very advantageous interest rates. The events of the last week encourage us in our hope that we won’t see those very distressed levels again. There is still plenty of work to be done however. Peripheral bond yields have improved, but they are still too high, and threaten to crowd out private sector investment.

This is why, whilst we think the death of the Euro may have been declared prematurely, we are still very cautious on the global economic outlook. Already we have seen signs that the economic malaise is spreading from Europe to Asia. In 2012, we expect its tentacles to start to reach across the Atlantic to the US. Investors betting that the US can de-couple from this global phenomenon should beware.”

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