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Forget the PIGS, it’s the UK really infecting Europe

Australia’s dollar is holding steady amid better news out of Europe. But the real worry now is Britain, where a return to recession is now a dangerously real possibility.

Financial markets are full of boom and zoom talk at the moment; if it’s not Japan trying to inflate itself out of a deflationary swamp by spending more money it doesn’t have, it’s the US edging away from the fiscal cliff, or the cost of Italian and Spanish debt falling to more sustainable levels as the eurozone grows more confident it has escaped a bullet for a third year in a row.

The eurozone hasn’t imploded — the area’s banks have repaid €137 billion of the more than €900 billion of long-term (three-year) loans that were extended at the end of 2011 and in early 2012 which helped steady wobbling banks.

Stockmarkets have surged with a strength that has surprised the bears and even some bulls. Our market is up 20% from mid 2012. Even the basketcases in the eurozone — Ireland, Italy, Spain, even Greece — are attracting funds from offshore. The Financial Times today put the inflow of private capital in the past few months at €100 billion.

It’s nowhere near the €400 billion euros that left the basketcases and other parts of Europe in the first half of 2012, but it is a sign that confidence is retiring, despite the still weak fundamentals for the region.

To get a good idea of the change in risk and confidence, look at the way currencies have gone since the start of the year as optimism has grown. Those safe havens such as the Swiss franc, the US dollar or the Japanese yen no longer look as desirable The Swiss franc has fallen more than 3% against the euro so far this year; the yen has fallen almost 5% against the dollar and 7% against the euro; the euro has risen against the US dollar.

And the Australian dollar, one of last year’s surprise “safe havens”? The usual thinking is the surge in optimism would help the dollar fall, which would be welcomed across the economy (and especially by the Reserve Bank). In some respects the first month of trading for 2013 is a sort of action replay of the start of 2012 when the values of other currencies moved sharply in January and February, but the Aussie dollar remained mostly stable, or appreciated slowly, thanks to consistent buying by official foreign investors such as central banks (Switzerland was one) and big private investors (insurers like Berkshire Hathaway companies, controlled by Warren Buffet).

But the reality so far in 2013 has been quite different: the outbreak of optimism has seen the euro gain and the yen fall (because of the Abe government’s attempt to inflate its way out of a rut). As a result, as far as the Aussie dollar, the strength of the euro has tended to offset the weakness in the yen, meaning we have risen against the latter and lost ground against the former. But we have also traded steady against the US dollar, which indicates that Australia’s AAA stable rating still holds attractions for offshore investors (especially as we pay 3% or more on Australian dollar assets and the chances of official interest rates falling further this year are lessening). On a trade weighted basis, the dollar is up slightly since the start of the year at 78.0 compared with 77.7 on December 31.

Improved growth and other data from China and higher iron ore prices have added to the attractions of Australian dollar assets, such as shares. The local market was up 11% in 2013 (and 20% since midway through last year) and has started 2013 solidly. In fact, the Australian share market is now at its highest level since April 2011, confounding a number of bears who forecast late last year the market would lose ground over 2013, or make minimal gains at best.

Australian bond yields are unchanged this month — they closed around 3.28% on Friday from 3.27% on December 31 (and are down from a peak of 3.47% when they spiked earlier this month, along with yields on government bonds in the US and Germany, triggering fears a broader sell-off may be looming). Gold prices have fallen 8% since October as investors rediscovered the joys of risk and moved away from searching just for yield.

… the biggest danger to all of this could be the change in sentiment towards bonds, especially government debt.”

But in all this outbreak of sunniness, there’s one surprising black hole that stands out: in the UK figures last week suggested the economy went backwards in the December quarter. Yet UK shares are set to have their best January in 13 years, as economists warn of the rising chance the British economy could enter a triple dip recession if growth in the March quarter is negative. Preliminary estimates suggested the UK economy shrank 0.3% in the December quarter, after the solid growth seen in the preceding quarter, thanks to the London Olympics.

Rather than Italy or Spain, the UK is the sick economy of Europe. The former two economies are in recession and expected to remain there for most of 2013, but Britain continues to struggle as the economics of austerity practised by Prime Minister David Cameron retard rather than revitalise the economy. The economy had a rough 2012, but after the Olympics and subsequent solid growth, the feeling was it would remain out of recession. Now with the first estimate suggesting a contraction of 0.3% in the December quarter, no one is quite as sure as they were a week ago.

According to analysis of UK growth data for the past five years, The Economist reckons the British economy is much weaker than it was in the Depression back in the early 1930s.

Howard Archer, economist at IHS Global Insight, described Britain’s situation as “dire”. “We believe the economy is essentially flat at the moment. We suspect that GDP will not return to the level seen in the first quarter of 2008 until the first half of 2015 — a gap of seven years,” he told London media.

The pound has fallen 5% so far in 2013 and hit a 10-month low on Friday on a trade weighted basis. There are growing fears the UK will lose its AAA credit rating this year because of weak growth outlook and the poor state of the country’s finances. Austerity is on the nose and the government knows it, but can’t do anything except hope that signs of a change appear as the year goes on and are not swept away by another loss of momentum.

Britain’s woes have little or no impact on us. The growing possibility it could leave the EU will add to the sense that Britain has lost its way and that austerity is no longer an acceptable policy direction for a government looking to improve its finances.

But the Italian elections and the spectre of Silvio Berlusconi lie ahead in February, and all the possible destabilisation he could inject into the mix. Germany goes to the polls in September and a change in government could happen, despite Chancellor Angela Merkel’s undoubted strength as leader. And, of course Australia will go to the polls around the same time and the result could change the fundamentals here with the opposition promising spending cuts that UK voters are rejecting and which are strangling the UK economy.

But the biggest danger to all of this could be the change in sentiment towards bonds, especially government debt. It’s been flavour of the year now for more than a year amid the various stages of the crises in Europe and America’s fiscal cliff. That could spell a sell-off that sends interest rates surging.

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