The end of the euro is nigh, and it will affect Australia's markets

I have had the pleasure of spending three and a half weeks walking through central Italy.  Many have asked me since my return about what is happening over here in relation to the European Union (EU) and the euro.

The European condition (outside of Germany and maybe the Nordic block) can best be summed up in nine words – “the ruins proclaim that the city was once prosperous.”

For mine, we are witnessing the dying gasps of the EU and the euro as we know it.  The world-renowned American economist Milton Friedman said that the EU wouldn’t make it past its first recession – it looks like he was right.  And this is not a trivial event.

In short, European countries are just too diverse to create a long-lasting currency zone.  Languages, cultures and mindsets are very different across its membership.  Most locals I spoke to during our trip identify themselves via their city or region first and foremost, then country but never as a “European”.

While the thrusts behind the creation of the EU are numerous, it isn’t a military alliance (such affairs are linked to NATO) but an economic one.  The idea was that free-trade, regulated by a central bureaucracy, would unite greater Europe, suppressing nationalism and creating prosperity without surrendering what it means to be French or Italian.  The common currency – the euro – is the ultimate expression of this hope.  But in the end, Germans are Germans and Greeks are Greeks.

And “united” does not mean “even”, and Europe’s wealth is not evenly spread.  There is deep-seated resentment between countries and even regions across Europe, which, as history shows, can be suppressed when times are good but resurface when things go custard.  This is especially the case when the controlling identities (Germany and to some degree, France) play by the rules while many others don’t.  For example, it is estimated that 10% of all employment across Italy is “off the books” and in some southern European states the black market accounts for close to half of the country’s trade.

I witnessed such first hand, with the official numbers suggesting recession, but many Italian streets indicating a much stronger real economy.  Most cafes and restaurants ask for payment in cash, while the Italian police wait outside asking customers to see receipts, in some half-baked effort to slow down black-market trade.  It is little wonder that the German and French public don’t want to continue to bail out their neighbours.  As a result, the level of distrust is growing; resentment is on the rise and so too are the local calls for nationalism.

An important sidebar here is that the formation of the EU removed the once-strong legal barriers to migration between European countries. For example, in the last 10 years alone, close to 4 million new migrants have moved into Italy – many from poorer European countries – adding to the growing unrest.

Major action and political leadership is needed and now, but I cannot see the current crop doing anything much about it.

Even if the political elite muscled up, the EU restricts any sensible economic response.  Most economic policy makers would like to achieve three goals – open up their markets to international capital; use monetary policy to help even out their economy; and maintain a stable currency.  Ironically, you cannot achieve all three at once, but you need two working at the same time to prosper.

The US has chosen the first two options; China the second and third.  The troubled EU countries have no monetary choice, cannot influence their currency and also now have very limited fiscal options available to attract foreign capital.  Something has to give. and the public will demand that their governments use all the economic tools available to a sovereign country.

I expect the unrest to increase and spread across Europe.

There will be winners and losers there, with Germany and the emerging Russia and Turkey getting the upper hand, while the “PIIGS” are somewhat doomed, economically.  Europe will, of course, remain a large economy, and it will still consume goods and services; and the best case scenario for the region is little or no real economic growth over the next, say, five years.

The most likely outlook, however, is that the “European” economy will shrink. Major capital/bond listings are likely to be required, which will cause inflation to rise and maybe to hyper levels, resulting in higher global interest rates.

The Bank of England’s decision last week to pump £75 billion ($A 119 billion) of newly created money into the UK economy won’t be the last quantitative easing we will see.  QE typically raises the price of the assets bought, which lowers their yield or economic return.  In short, such action can be very inflationary whilst reducing an investment’s return and underlying value.

England’s latest move clearly illustrates that the political elite will continue to dribble out economic assistance in the hope that prosperity will return, instead of fixing Europe’s economic problems.  On the one hand who could blame them as there is really little to hold the EU together except for the promise of prosperity?  In the meantime, the European public are accumulating grievances, with some remembering how to hate.

I will not go into the history behind the last two world wars and I am not suggesting WWIII, but there are some common elements emerging, and armed conflict in Europe isn’t out of the question.

This bluster aside, we had a fantastic time, visiting close to 20 Tuscan towns and cities and walking about 350 kilometres from Orvieto to the sea.  The food and wine was so good that I, despite the exercise, put on weight!

Oh and by the way, if you want to visit Europe, I would maybe do it sooner rather than later.

Also, whilst the RBA’s present monetary policy stance is mildly restrictive, I don’t expect rates to fall on Melbourne Cup; to do so would suggest that the world’s economy is indeed going pear shaped, and as we argued in a previous missive such action might be counter-productive.  Interest rates here are likely to remain steady for some time.  But they will rise in the future and maybe more than many think.

We have been advising snapshot subscribers that they need to be able to comfortably service a mortgage 1% higher than today’s rates.  Also buyers need to hold a residential asset for at least five years in order to see any worthwhile capital appreciation.  But if Europe’s economy takes a turn for the worse then our suggested 1% buffer needs to be lifted to 2%, maybe 3% and any half-decent asset growth will take much longer.

It might be time to prioritise achieving the return of your capital, not the return on your capital.