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This article appeared in the January 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

It's all about Europe in 2012 and not in a good way.

Photo of Alan Kohler By Alan Kohler, Eureka

I was asked by ASX Investor Update to list the five things investors have to watch out for in 2012, but I'm afraid I was only able to count to one: Europe.

Well, OK, China makes two, but there isn't much to worry about with China. Its economy will slow down, that's for sure, but if it slows too much the People's Statisticians will just pretend everything's fine.

It's all about Europe in 2012 and not in a good way. The best that can happen from here is a European recession; the worst, a total collapse of the financial system and a global depression. I'm on safe ground with the first of those because it has almost certainly already started, although you can only know for sure about recessions in hindsight.

The worst-case scenario happens if European officials stick with the current plan of forcing austerity (government saving) on the debtor countries so they balance their budgets quickly, in which case, one or more will default and render many, if not most, of Europe's banks insolvent. In that case, lending will dry up all over the world and a brutal credit squeeze will cause a deep global recession.

To some extent the markets are divorced from all this, and the reality of what's happening in the global economy and banking system is not always reflected in the volatile prices of shares.

That's because the financial markets have become a gigantic three-way tussle between the longs (buyers), the shorts (sellers) and the arbitrageurs (who trade price anomalies), each trying to rob the other and in the process trampling on small investors like you and me.

In the United States, at least 50 per cent of the volume on the sharemarket is accounted for by high-frequency computer traders who are looking for minute pricing differences. Here it's a bit less but still significant.

At various times the long-only institutional investors dominate the market and at others the long/short hedge funds are in the ascendancy. Short positions have been at very high levels lately because of the widespread conviction that the sharemarket is heading lower.

Markets have not yet priced recession in

Most importantly, the sharemarket is NOT pricing in a global recession, as I write, or a US recession or a worsening of the crisis in Europe.

There was a European leaders' summit in December that was meant to fix everything up, but the result was worse for the market outlook than most people think.

Moving towards fiscal unity in Europe, as proposed, is a good thing, but the new limit of 0.5 per cent structural deficit and 3 per cent actual cyclical deficit is unenforceable. This goes to the basic problem that Europe faces: a recession makes it impossible for a country to reduce its deficit, and deficit reduction makes a recession more likely. The European Union cannot and will not force a country with a delinquent budget to take action that would worsen the deficit, so it can't enforce the rules, and never has been able to.

As for the short-term liquidity measures that were agreed on in December, I believe the loans to the International Monetary Fund will not go ahead and the plan to reassess the limits on the ESM/EFSF (European Stability Mechanism/European Financial Stability Facility) will not be enough. Sovereign debt redemptions are very large over the next few months and markets had been hoping, and still are, that the European Central Bank will step in with a "big bazooka" and buy the bonds without limit.

However, the new president of the ECB has specifically ruled that out, saying it is against the EU Treaties. He simply does not have the power to do it, and the Treaties are not going to be changed. Sometime in the first quarter of next year there will be another spike in European bond yields and another crisis as bond auctions fall short.

The lack of a decisive response from Europe's leaders means that the risk of a collapse of the eurozone is rising all the time; it is now probably a one-in-three chance, in my view. But markets do not adjust to such risks bit by bit, they do it in big hits.

Debts likely to be inflated away

Australia's All Ordinaries index adjusted down by 15 per cent in the first week of August to around 4000 in response to the likelihood of Greek default. It has since traded in the range of 4000-4400 as the eurozone crisis enveloped Italy.

In the four months since that August correction, the debt problems of Europe have worsened and no quick-fix solution has been found; Europe has almost certainly slipped into recession; the likelihood of a US recession has increased; China's economy has slowed; and the Reserve Board of Australia has cut official interest rates twice in response to the crisis in Europe and the weakening confidence here.

If the European Central Bank decides to buy sovereign bonds and recapitalise European banks without limit (as I believe it should do) then the sharemarket would probably stage a spectacular rally, my warnings about a major sell-off would turn out to be wrong, and we would miss a few percentage points of the rally.

Potential rally not worth the risk

But just think about that: the risk is all to the downside; if you protect your capital by moving it to safe cash you remove that risk; if you are wrong and the market rallies, the worst that happens is you miss some of the rally.

I have believed for a while, and still believe, that the ECB will act to inflate away Europe's debts because the consequences of not doing so are so horrendous. So far there few signs that it will.

As Mark Burgess, the chief investment officer of Threadneedle Investments, told me: "Debt is simply tomorrow's consumption brought forward to today, and someone has to pay. Countries can either choose to pay it off, lowering long-term GDP growth in the process, or write it off, undermining, potentially fatally, the financial system. There is the third option of inflating your way out of the problem, where ultimately savers pay, and this indeed appears to be the path opted by the UK."

Burgess went on: "In Europe there is almost no debate around this growth problem. Indeed, the austerity policy measures demanded by Germany are, if anything, reducing growth for the region as large swathes of spending are taken out of the system. If one accompanies this with the very significant deleveraging currently being undertaken by the eurozone banks, it is difficult to be anything other than very pessimistic for growth in Europe next year, Germany included.

"One has to hope that this looming recession (in reality we are probably already in it) eventually acts as a catalyst for the introduction of quantitative easing [a form of monetary policy used in US] as the situation is likely to progressively deteriorate until it is."

Even if they do act and there is a big sharemarket rally that would not necessarily mean the bear market is over, because the process of deleveraging the world economy still has a long way to run.

Sharemarket valuations look low compared to the past 10 years, but as I have often pointed out, on some measures shares are still expensive.

Specifically, the Q Ratio (sharemarket value as a proportion of total replacement cost) still has the US S&P 500 15 per cent above replacement cost. In the past it has usually bottomed out at 50 per cent.

Moreover, during previous credit busts, average price-earnings ratios have been between five and 10 times for extended periods. Currently the average market PE is around 12 times, although there are a growing number of shares now below 10.

An impossible merry-go-round

Sharemarkets tend to anticipate economic growth by about six months and are sometimes said to pick 10 out of every five recoveries.

It is now clear that the big rally of 2009 anticipated an economic recovery that did not arrive and as a result the bear market has resumed.

Although the sharemarket will react up or down according to the latest news out of the European Central Bank, and whether it decides to print unlimited amounts of money, the fundamental issue has to do with economic growth, in Europe, the United States and China.

Europe and the US simply have too much debt and are in a bind: growth is insufficient for them to pay the debt off, but the austerity required to pay it off removes the potential for growth and causes tremendous social problems.

The only other ways to eliminate the debt are to default, which would potentially destroy the financial system, or to print money and inflate prices, thereby forcing savers to pay. That's the course decided on by the US and the UK.

At this stage Germany and the ECB are refusing to contemplate the last of the three options and are trying to force austerity on the debtor countries of Europe. That course of action means Europe is in for years of low growth and recession, possibly Depression-levels of unemployment, and the political and social problems that this would unleash threatens the second option - default.

It is this dynamic that prompted my recent warning of a possible major correction in the Australian sharemarket. The market has not really contemplated this outcome. It corrected by 15 per cent in August to account for the prospect of a Greek default, but the potential default of Italy, Spain and, eventually even France, is not yet priced into the market.

That's why I think we should be prepared for another sell-off. But I could be wrong.

About the author

Alan Kohler is the publisher of Eureka Report, a leading investment newsletter.

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