THE CHALLENGES FACING THE EURO

THE EUROZONE CRISIS

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2 | Editor’s comment

The challenges facing Contents

the euro
2 Editor’s comment

3 Saving the day –

and the euro
Ray Clancy, editor of
Investment International,
The euro crisis has severely dented the gives a blow by blow
account of the meeting that
confidence of markets but what is it and saved the euro

what options do investors have? 4 What does the future

hold?
Michael Sneyd, currency
economist at Barclays
Wealth International,

‘I
mportant challenges and risks remain’, so examines the future of the
concluded the first quarterly review of the euro
Greek government’s economic programme by
the European Commission, the European Central 5 Weathering the storm
Bank and the International Monetary Fund. Ray Clancy, editor of
Although Greece has put in place a positive start in Investment International,
terms of putting her economy back on the road to looks at the trouble in
recovery questions are still being asked as to whether euroland that led to the
the €750 billion rescue package is enough, not just in current crisis
terms of Greece, but for the future of the single
European currency. 7 Turbulent times
The euro crisis has severely dented the confidence of Mark Richards, head of
markets in Europe and of investors both inside the sales at Barclays Wealth
region and outside. From Sydney to Hong Kong, International and Barclays
investors have been affected by what has happened and Wealth Intermediaries,
according to analysts and commentators are likely to gives an overview of what
continue to be affected for at least another two years. has been happening and
While a rescue package has been put in place for what might be expected in
Greece, concerns still remain about the state of the the next few years from the
economies in Spain, Portugal and Ireland. Many point point of view of
investments
out that the full brunt of austerity packages have not yet
been realised and in many countries the threat of
national strikes will undoubtedly add to market In this guide we aim to explain what the euro crisis 8 The expert’s view
volatility. is, how it happened and what options investors face in A Barclays Wealth
In times of such unknowns it is not surprising that the coming months and years. In it you can read about International expert guide
investors are being prudent, avoiding risk, and looking to the impact of potential
the behind the scene negotiations in Brussels, the future
volatility in the eurozone on
for options that create a diverse portfolio in order to of the euro and what the experts advise in terms of
investments
spread any risks. various investment options.

Editor
Ray Clancy, 0207 490 0588
ray@thepublishinggroup.co.uk
Editorial Director
Nia Williams, 0207 490 0588
Nia@thepublishinggroup.co.uk
Publisher
Marco Callegari, 0207 490 0588
Marco@thepublishinggroup.co.uk
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Ramesh@thepublishinggroup.co.uk
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The eurozone crisis www.investmentinternational.com


Saving the day -
and the euro
Calming the markets after the extent of Greece’s
debt was revealed proved difficult. Here Ray
Clancy, editor of Investment International, goes
over the vital moments when a deal was secured
I
t was Friday May 7, 2010, when US
Treasury Secretary Tim Geithner sat
down in his office to make emergency
telephone conference calls to G7 finance
ministers and central bankers. ‘We need a
clear, strong, unequivocal financial back
stop,’ he said as calmly as he could.
It was the start of a weekend of frenetic
activity to try to save the eurozone from financial
meltdown. European finance ministers rushed to
Brussels to try to thrash out a rescue package to
stabilise the common currency as it became clear
that the €110 billion deal for debt-laden Greece
was not sufficient to convince global markets
that the euro could survive.
The agreement adopted eight days earlier had
not stabilised the currency and in fact the
markets had knocked the euro 4% lower against
the dollar and pushed bond spreads to new
highs.
Crisis
This highly charged weekend marked the start of
what has become known as the eurozone crisis.
By the early hours of the Monday morning there
was a lot of despair. With investors in Asia poised
to start selling again in just a few hours, the
ministers knew they needed to come up with a
plan fast.
‘The atmosphere was like the end of the
world, a lot like 2008. We had our eyes on the
clock because we absolutely had to have an
agreement before the Asian markets opened. No
agreement would have meant disaster, a major
sovereign debt crisis,’ said one diplomat.
There was, however one big problem: the
ministers could not agree on what to do.
Thirteen of the 16 eurozone countries,
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including Austria and Finland, traditional
allies of Germany, wanted to allow the European
Commission, backed by a eurozone guarantee,
to raise money on capital markets and then
lend it to member states in acute financial
distress.
But Germany, Europe’s economic
heavyweight, hated the idea. Finance Minister
Wolfgang Schaeuble had fallen ill on arrival in
Brussels and been rushed to hospital. Interior
Minister Thomas de Maiziere, a confidant of
German chancellor Angela Merkel, took his place
with instructions to hold the line on the loans
idea.
Unacceptable
So when he arrived he told the ministers that
anything more than coordinated bilateral loans
from member states was unacceptable and would
be shot down as illegal by Germany’s
Constitutional Court.
An hour before the opening bell in Tokyo, the
ministers took a short break. Some huddled with
aides; others paced the halls talking on their
phones or tapping out messages on their
Blackberries. Spanish Economy Minister Elena
Salgado, the meeting’s chair, retired to a private
office to call Prime Minister Jose Luis Rodriguez
Zapatero to discuss new austerity measures.
It was then that a little known Dutch civil
servant made the suggestion that saved the euro.
Maarten Verwey, director of foreign financial
relations at the Dutch Finance Ministry, floated
the idea of a temporary Special Purpose Vehicle
(SPV). He pointed out that an SPV could raise
and disburse funds as needed but might also get
around Germany’s objections. A few German
officials, including Bundesbank President Axel
Saving the euro | 3
Weber, had hinted at such a solution in other
meetings that night.
Solution
Verwey was dispatched to test the idea on the
German delegation, which relayed it to Merkel,
huddled in the Chancellery with a small group
of senior cabinet members who were still
digesting a major setback for the ruling
coalition in a crucial state election hours
earlier.
The much awaited reply was yes, an SPV
would be an acceptable solution and there was a
huge collective sigh of relief. Berlin liked the idea
because it could be temporary and the Germans
insisted on a three year limit. It respected the
unanimity rule, kept control out of the hands of
the Commission, and avoided anything that
might look like an embryonic common
European bond or a permanent debt
management office for the eurozone.
With German backing assured, Salgado
reconvened the ministers just before 2 a.m.
to ratify the accord. Christine Lagarde,
France’s straight talking economy minister,
summed up the moment in a single word:
‘Hallelujah’.
The eurozone crisis
4 | The future
What does the
future hold?
With many European countries introducing austerity packages the real
brunt of the euro crisis will be felt in the coming months and years.
Here Michael Sneyd, currency economist at Barclays Wealth, examines
the future of the euro for the short and long term
S
ince November 2009 increasing
concerns that Greece would not be
able to finance its government
budget and roll over its debt have
escalated, triggering the European
fiscal crisis that culminated in the
spring of 2010. Fears spread to other high-deficit
regions, such as Spain, Ireland and Portugal and
investors became uncertain about the future of
the European Monetary Union (EMU),
questioning whether a country may have to
leave, or even if the entire EMU could dissolve.
Fiscal issues stand at the centre of Europe’s
problems as some countries face problems
finding the resources to service their debts, and
even more so that euro-area countries cannot
print money to inflate away their debts. But
beyond these immediate solvency issues, the euro
area has a more severe problem: the
competitiveness of some regions has diverged
and is a threat to the EMU’s existence. For the
euro to survive in its current form, both these
fiscal and competitiveness problems need to be
solved.
Solvency
The combined IMF/EU €750 billion package
announced in May alleviates the solvency
concerns for Greece, Spain, Italy and Portugal for
the next three years by ensuring that these
regions will be able to fund their deficits and roll
over maturing debt. This does not provide a
solution to the fiscal problems, but does provide
some time for these regions to dramatically cut
their deficits and get their debt outlook under
control.
The eurozone crisis
However, if Greece is unable to turn around in
time, and European policymakers are unwilling
to provide more support at the end of the three
years, a crisis in the currency union may take
place. Greece’s fiscal challenge will be made more
difficult by the economy being pushed into a
deep recession (we expect Greece to contract 4%
this year and a further 2.5% next year) by the
existing fiscal cuts.
The euro area’s competitiveness issues stem
from some countries having joined the monetary
union but letting their labour costs rise, causing
their competitiveness to deteriorate. Italy, Spain,
Greece and Portugal have all seen their
competitiveness fall relative to Germany and
France. Outside of a currency union a country
could allow its currency to depreciate to restore
competitiveness. Rather, these countries will need
to reduce wages and improve productivity, which
can be a slow and painful process.
A member can resolve its competitive issues by
leaving the EMU, but we expect the likelihood of
a country doing so is low. The cost of leaving the
euro is high, to both the country itself and the
rest of the euro area. But there may be little
choice in a situation where debt is unsustainable,
competitiveness is low, and when other euro
members are not willing to offer support.
Future
What does this mean for the future of the euro?
Whether Greece can turn around over the next
three years will be important for the EMU to
remain in its current form. Other high deficit
countries will also need to put their house in
order over this time.
The IMF/EU support package should help to
secure the EMU over the next three years, but
any concerns that a country may leave the euro
would most likely trigger an increase in investors’
risks aversion and cause market volatility to rise.
Contagion effects across Europe would push
other European currencies lower, although the
euro itself would likely be the greatest casualty.
We would expect that wider market sentiment
would be impacted as any knock to Europe’s
recovery would hamper the wider global
recovery, causing “risky” currencies such as
commodity currencies and emerging market
currencies to fall. We expect that the “safe haven”
currencies - the US dollar, yen and Swiss franc -
would be the best performers.
EMU will survive
We judge that the most likely outcome is that the
euro area muddles through and that the EMU
will survive (in fact, it may even grow, with
Estonia set to adopt the euro next year). Even if
Greece does not turn around in time, it may be
offered some more support by other members if
it is on the right path. We do expect that the euro
area’s sluggish growth will cause the euro to
weaken over the next year or two, especially
against other European currencies – such as
sterling and the Swedish krona - which it
continues to appear expensive against.
However, we are not forecasting the euro to
lose much value against the US dollar over the
next few years. The US has its own fiscal
problems which aren’t being addressed by
policymakers and do not appear to have been
fully considered by markets.
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Weathering
the storm
With the warning that ‘important challenges and risks
remain’, Ray Clancy takes a look at the trouble in
euroland and examines how the euro crisis panned out
T
he first quarterly review of the
Greek government’s economic
programme by the European
Commission, the European
Central Bank and the
International Monetary Fund
declared there has been a strong start in terms
of putting Greece on the road to economic
recovery.
Published at the beginning of August, a joint
statement declared that the end of June
quantitative performance criteria was met, led
by a vigorous implementation of the fiscal
programme and reforms are on schedule.
But hidden in the statement was a warning;
‘Important challenges and risks remain’.
Questions are being asked as to whether the
€750 billion rescue package is enough, not just
in terms of Greece, but for the future of the
single European currency. It is only now that
years of problems are becoming public and the
underlying weakness of the system is being
exposed.
Fireworks
The euro came into being on January 01, 1999, as
fireworks lit up the skies of various European
capital cities and everyone looked forward to a
strong currency and the warnings of critics went
largely unheeded.
Ten years on at the end of 2009, Europe’s
common currency appeared to have weathered
the worst global financial crisis since the Great
Depression with barely a scratch. Countries
outside the eurozone from Iceland to Ukraine
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had seen their economies collapse, but most of
those within the zone were hailing the euro as an
‘anchor of stability’.
But it was like a mask, hiding deep problems
in euroland. The Maastricht treaty had set
out the terms for the creation of the single
currency and targets for countries to meet
including limiting their debt and controlling
inflation. Failing to meet the criteria, it was
thought, would exclude weaker economies from
joining the euro.
Creative accounting
But instead the rules were flouted left right and
centre. Europe’s debt was being fudged. Low
interest rates meant that countries like Greece,
Portugal and Ireland could take on cheap debt
and there was no central authority to keep an eye
on things. It has now emerged that there was a
lot of creative accounting going on. Figures were
massaged so that countries could meet the
criteria to join the euro.
And it wasn’t just countries like Greece, even
France and Germany have been accused of
making themselves look good on paper when in
reality they were not. Germany, long a stickler for
fiscal discipline, had successfully pushed for a
loosening of the rules after it repeatedly breached
them in the early 2000s.
What effectively happened was that money
was transferred from rich northern European
countries to struggling southern ones to help
them pay their debts.
For example, interest rates were in reality too
low for a country like Spain. Borrowing money
Risk warning | 5
seemed easy and cheap. Suddenly Spain could
spend its way out of the troubled country it has
become post Franco and be up with the big boys
on the European stage.
Spain, Greece, Portugal and Ireland built up
huge public debts but they just kept spending as
borrowing was so cheap. They didn’t stick to the
Maastricht rules and no one was prepared to
stop them, such was the rush to make the single
currency work.
For much of the 2000s, it seemed that markets
had effectively mutualised the risk of eurozone
debt by treating all government bonds as equal.
Spreads between German bunds and the debt of
countries such as Greece, Italy and Belgium were
minuscule, even though the latter states had
debt-to-GDP ratios of close to 100%, far above
the 60% ceiling set out by the Maastricht Treaty.
Signs of trouble
The first clear sign of trouble came in October
2009, when a newly elected Greek government
shocked financial markets and its eurozone
partners by announcing a huge upward revision
of its budget deficit forecast. After years of barely
distinguishing between the debt of different
eurozone countries, investors could suddenly see
the massive fiscal divergences within the bloc.
Markets turned on the euro and began
demanding higher interest rates to buy the debt
of struggling southern European countries, first
Greece and then Portugal and Spain.
The key question now, is whether the deep
problems in the eurozone are fixable? As the IMF
report pointed out, Greece has a lot to do – it
The eurozone crisis
6 | Risk warning
needs to tighten expenditure control and
monitoring and further strengthen its tax
administration, including reducing tax evasion
by high income and wealthy individuals. But
years of not paying tax in Greece has made tax
evasion a national past time and the challenge of
change on this issue mirrors the need for change
throughout the eurozone.
Indeed, the bailout of Greece is an
The eurozone crisis
acknowledgement that Europe’s existing tools to
prevent a breakup of the bloc are woefully
inadequate. Both the euro and the bloc remain
vulnerable.
On one hand Germany’s Chancellor Angela
Merkel wants a radical strengthening of EU
budget rules as well as changes to the Lisbon
Treaty to prevent such profligacy from ever
happening again. She blames the crisis on a lack
of fiscal discipline on Europe’s periphery - that is
countries like Greece, Spain and Portugal.
Berlin wants quicker and harsher sanctions for
countries that fail to keep their deficits under
control including denying them access to EU
structural funding and suspending their right to
vote on matters of bloc wide importance.
On the other hand French President Nicolas
Sarkozy believes it is up to politicians to take a
lead, not central bankers and finance ministers,
setting himself in direct opposition to Merkel.
Confidence
Analysts believe that winning back the
confidence of the markets and investors largely
depends on whether Berlin and Paris can agree
on a way forward. But in France there is a belief
that Germany has failed to grasp the real message
of the eurozone crisis, that a currency union
cannot work without deeper political
cooperation on a range of economic issues.
Sarkozy would like to see an economic
government for the currency area, with regular
summits of the 16 national leaders and a
dedicated secretariat to oversee the coordination
of economic policy and address imbalances in
competitiveness.
Role of the EC
Another issue has to be addressed – the role of
the European Commission. Berlin and Paris have
both pinned partial blame for Greece’s meltdown
on the failure of the Commission to police the
EU’s budget rules.
Although the EC has recently raised its 2010
economic growth forecasts for the EU and the 16
countries that use the euro, saying strong growth
in industrial exports is driving a faster than
expected recovery from the economic crisis, there
is still a lot of concern.
The EU’s unexpectedly strong growth in the
second quarter, fuelled largely by strong sales
from Germany’s export sector, will lift the
region’s growth prospects for the entire year, the
Commission said. But growth during the second
half is unlikely to repeat the second quarter’s
performance, according to the commission, even
though a double dip recession is unlikely.
Stunted growth
But at the same time it said fears of a resurgent
eurozone debt crisis are likely to stunt European
economic growth prospects this year, warning of
‘lingering tensions’ in Ireland and elsewhere.
‘The global recovery is still expected to be
uneven and is surrounded by major
uncertainties,’ the EC said in its autumn forecast,
citing ‘the resurfacing of global imbalances, high
debt levels and lingering tensions in sovereign
debt markets’.
It added that despite the partial recovery
since the emergency bailout was agreed, the
future remains ‘tenuous’ and ‘adverse effects
on bank credit provision to the economy cannot
be ruled out’ and sovereign bond spreads in
most European countries ‘are still significantly
above the levels seen at the beginning of the
year’.
EU finance ministers agreed in September to
submit budget plans for early review by the EC
and other EU governments as part of moves to
strengthen fiscal discipline in the bloc, starting in
2011. This is the most tangible result so far of
work done by the ministers since May in an
effort to toughen EU budget rules and prevent
another sovereign debt crisis like the one
triggered by Greece.
But many of the austerity measures are yet to
hit. It is early days. The stories about medicines
not being available on the state, or of childcare
being cut, or of teacher shortages, are still
anecdotal. But in many countries the public
sector is set to shrink. Analysts expect that some
time during the autumn some governments will
wobble over their austerity programmes due to
the threats of national strikes.
Public protests
In France, trade unions have already organised
strikes and massive street protests against
unpopular reforms that raise the retirement age
by two years to improve public finances and in
the UK, which is not part of the single currency,
trade unions began warning in the middle of
September that mass strikes are potentially on
the cards.
Other EU countries seeing public protests over
austerity plans include Hungary, Italy and
Romania, where public sector pay is to be slashed
by 25%.
Behind the scenes there are real fears that
democracy could ‘collapse’ in Greece, Spain and
Portugal unless urgent action is taken to tackle
the debt crisis. A warning over this has already
come from Jose Manuel Barroso, the head of the
EC.
He stunned the world when he recently
outlined an apocalyptic vision in which crisis
hit countries in southern Europe could fall
victim to military coups or popular uprisings
as interest rates soar and public services
collapse because their governments run out
of money.
The stark warning came as it emerged that EU
chiefs have begun work on an emergency bailout
package for Spain which is likely to run into
hundreds of billions of pounds but which Spain
denies it needs.
Barroso’s warning lays bare the concern at the
highest level in Brussels that the economic crisis
could lead to the collapse of not only the
beleaguered euro, but the EU itself, along with a
string of fragile democracies.
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Time for
helping hands
The last two or three years have been turbulent ones for investors
in the eurozone and this is Barclays Wealth International's view
N
ot only did investors have to re-
adjust to the global economic
downturn sparked by the
collapse of Lehman Brothers on
the back of the sub-prime
mortgage crisis in the United
States, but Europe suffered its own crisis with
high levels of debt in Greece resulting in a €750
billion rescue package and ongoing concerns
about Portugal, Ireland and Spain.
Here Mark Richards, head of sales at Barclays
Wealth International and Barclays Wealth
Intermediaries, considers what has been happening
and what investors might expect over the next few
years.
Over the last two to three years, Barclays
Wealth International has witnessed significant
shifts in client investment preferences.
Increasingly, clients have focused on two key
areas: using investment products to supplant the
lowered interest rates on traditional bank
accounts and secondly a pronounced switch in
preference to products that promise to repay
some or all of the original capital upon maturity
provided certain conditions are met.
The move to investors requesting rate-based
products has obviously been driven by the
reduced interest rates available on standard and
term deposit accounts. At the same time, many
investors have been seeking certainty of income
returns and capital preservation.
‘There is a crisis of confidence and views on
how to deal with that are polarised. Barclays
Wealth International has a strong belief that
there are opportunities in equities that are
generally underpriced, however, the downside of
equities is that they need to be seen as a long
term investment and your capital is at risk,’ said
Richards.
Diversification
There is also a belief in security in stronger
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government bonds and that these should be part
of a diversified investment portfolio in the
coming months of ups and downs that are
expected to dog the markets. However, as with all
investment, you should ensure that these
products offer the risk mix of risk and reward in
line with attitude to risk.
Long term structured deposits and notes,
typically between five to six year terms, have
proved popular with investors seeking higher
interest rates and Barclays Wealth International
has been seeking to meet this demand.
Property has continued in its position as a
popular investment following the global
downturn and the euro crisis. It would seem that
investors have an emotional attachment to
property and view it as a tangible investment - a
theme explored in Barclays Wealth Insights
Volume 10: Investor Perceptions of Property.
Barclays Wealth Intermediaries has seen a 60%
increase in enquiries in certain areas of
properties. Richards points out that London is
popular with investors who see it as offering
good prices at present. The company’s
Knightsbridge-based office has been particularly
busy as a result of the growth in demand for
property investments. Richards adds, however,
that you should consider buying property as a
long term investment as there are relatively high
initial costs and the buying process can be
reasonably lengthy.
Confidence
Overall the strategy at Barclays Wealth is to
restore confidence among investors and to
encourage them to see their portfolios over the
long term. Yes, concerns about Greece are likely
to persist in the short term but a balanced
portfolio can see the investors beyond this,
Richards points out.
‘Communication is vital. For example,
our monthly and quarterly global investment
Turbulent times | 7
committee meeting reports give investors
an insight into the latest thinking from a
worldwide perspective and helps make
them aware of new ideas and strategies,’ he
explains.
‘It is through this kind of contact and
communication that we can restore confidence,’
he adds.
Perhaps the biggest impact of the eurozone
crisis is that cash does not currently offer good
returns, especially for investors who are looking
for an income from their investments. This has
seen a demand for alternative income products.
Although each investor's needs vary according to
their individual circumstances, there has been a
strong demand from expats who need a regular
income from their portfolios.
Balance
‘Those that are concerned are taking a long term
view,’ Richards said. ‘We have also seen an
increase in investors seeking a second opinion, so
to speak. Where they might have acted on their
own knowledge and instinct in the past, they are
seeking another opinion via their relationship
manager even if that just reinforces what they
had already intended to do. This is an important
role for us too, one of reassurance,’ he adds.
The key trend for the coming months and
years as the eurozone crisis hopefully settles
down is one of diversification. That has resulted
in more demand for structured products over
three to five years to see investors through the
crisis.
‘The key is balance and diversity, looking at
equities and secure government stocks. It is not
about short term wins and gains, but about
going steadily forward. This may not offer the
highest possible return and it might be regarded
as an old fashioned approach, but it is one that
needed in this very modern crisis,’ concludes
Richards.
The eurozone crisis
8 | Ask the expert
The expert’s
view
With volatility in the eurozone likely to continue,
what does the future hold for investors and
investments within Europe?
W
ith volatility likely to
continue in the eurozone
for some time, experts
from Barclays Wealth have
given their expectations for
various investments over
the next few years.
Funds
In the short term, the crisis and the bimodal
nature of investors’ expectations are likely to
provide a challenging backdrop for investment
funds and fund managers. In this ‘bimodal’
world, investors’ views are polarised with some
expecting a deflationary ‘bust’ and others
expecting a stock market ‘boom’.
In reality, this means that stock markets are
likely to remain volatile; a ‘muddle through’
scenario looks unlikely and consequently a
‘barbell’ fund strategy (combining high quality
government bonds at one end of the barbell and
equities at the other) could make a lot of sense.
‘In between’ assets, such as corporate bonds,
could struggle in this environment and
consequently we no longer favour them in our
own model portfolio.
Over the longer term, the impact of the crisis
on the funds industry is harder to discern.
However, the eurozone crisis has shown beyond
all reasonable doubt that some assets that would
normally be thought of as being relatively ‘safe’ –
such as sovereign bonds – may not perform at
times of major economic stress. One way to deal
with this is to ensure that your portfolio isn’t just
The eurozone crisis
focused on one particular market or asset class.
As always in investment, diversification is key.
Conclusion: A ‘barbell’ fund strategy should
make sense over the coming months, given that the
crisis has led to polarised views in markets.
Bonds
The crisis provided a major blow to peripheral
European Union sovereign bond markets.
However, more recently, fixed income markets
have been reassured by the austerity pledges and
fiscal consolidation plans announced in Europe
and Japan.
But, as market participants downgrade their
economic forecasts, the risk is that fiscal
tightening hits activity just at a time when the
economy is somewhat fragile, magnifying the
social cost of the adjustment. Developments in
Greece could underscore just such a message, for
although debt-rollover risk has collapsed
following decisive IMF/EU intervention, debt
sustainability remains far from assured as a
contracting economy bears the burden of an
ambitious fiscal tightening programme.
Over the longer term, as we have alluded to
above, question marks are likely to remain over
the sustainability of debt levels in some EU
states, particularly if the euro area registers low
levels of GDP growth over the next few years, as
now seems likely.
Conclusion: Investors who are worried about
sovereign debt risk should focus on the lowest-risk
government bonds – such as US Treasuries or
German Bunds.
Stocks and shares
Stock markets have made gains on recent
months despite worries about the strength of
the global recovery. A further expansion of the
level of economic recovery has, however, also
lifted the ‘fair value’ of equities in our equity
valuation model. Equities may, therefore, still
appear ‘cheap’ and fundamentals would, on the
face of it, also appear supportive with strong
levels of profitability and higher credit
worthiness and liquidity than a year ago. More
generally, fundamentals remain supportive:
corporate profits continue to grow; credit
worthiness is improving; and liquidity levels
remain high.
How things turn out from here is highly
uncertain however, reflecting the ‘polarised’
market expectations we discussed earlier. While a
stock market ‘boom’ scenario could lead to
positive returns and possibly quite high ones –
especially given the recent decline in equity
prices – more signs of the recovery faltering
could result in further equity losses if investors
begin to fear a deflationary bust.
Over the longer term, austerity cuts in Europe
in response to the crisis mean that Europe is
unlikely to contribute much to global GDP
growth over the next few years. However, a
renewed weakening of the euro would mean that
European firms with a euro cost base and
revenues in other major currencies could be
attractive, assuming that the global recovery
continues, of course.
Conclusion: Euro-area GDP growth is likely to
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 Ask the expert | 9

lag that of the US and Asia, providing a headwind
for euro area equities.
Savings
Fiscal austerity measures may have pleased the
sovereign bond markets and credit rating
agencies, but lingering worries that fiscal
tightening could tip fragile economies back into
recession mean that interest rates are likely to
remain very low for the foreseeable future.
This, in turn, mean that returns on ordinary
savings accounts are likely to remain meagre over
the next few years, and those investors who are
dependent on savings accounts for income will
have to find ways to meet the shortfall – perhaps
by investing in a high-quality bond fund or by
building a portfolio of equities with high and
secure dividend yields. The drawback of these of
course is that you may get back less than you
originally invested, although protected or
structured products can remove some or all of
this risk.
Looking further out, there is some hope for
savers: interest rates are at, or very near to, 0% in
most of the major developed economies and rates
should start to rise in the latter part of 2011 once
it is clear that the global economy is firmly on a
recovery track.
However, a ‘double dip’ recession – by no
means an impossibility at this stage – would
mean that interest rates could remain low well
into 2011 and perhaps beyond.
Conclusion: Look for other ways to supplement
income from savings accounts.
investors’ confidence in the fiscal outlook. Thus
we expect sterling to recover mildly this year as its
risk premium is reduced, substantial short
positions are unwound, and its valuation stays
cheap.
However, risks to sterling’s recovery remain:
UK growth could slow once spending cuts take
place next year and might be further hurt by
increasing inflation concerns after the VAT hike.
Over the longer term, doubts over fiscal
sustainability are likely to act as a drag on the
euro, as are worries that current EMU projections
may have to be revised from its current form.
Conclusion: Expect sterling and other cheap
currencies – such as the Swedish krona – to
strengthen against the euro over the next 12
months.
Interest rates
The euro area fiscal crisis has prompted
governments in many parts of the world to
introduce austerity measures.
While this has placated bond markets, it has
also raised the spectre of a further economic
downturn, given that many developed world
economies remain fragile.
The upside to all the fiscal tightening is that
many economies’ interest rates will be able to
stay lower for longer.
In the euro area, we expect official
interest rates to remain on hold at
1.00% throughout 2010 and by the
end of 2011 we would not expect them to be any
higher than 1.75%. In the US, we expect interest
rates to end 2010 in their current 0 to 0.25%
range and we would not expect the Federal
Reserve to start raising rates until 2011.
Meanwhile, in the UK, monetary policy is
extremely accommodative and is likely to stay so
for some time. Indeed, the decision of the
coalition government to tighten fiscal policy
aggressively is likely to keep the Bank of England
on the sidelines until 2011, and there is a risk that
the Bank may even have to re-start its
quantitative easing policy next year.
Further afield, Japan is taking measures to
reduce its huge levels of public debt and here we
expect official rates to remain at 0.10% for the
foreseeable future.
Conclusion: Expect interest rates to stay lower for
longer in developed nations as austerity measures
reduce the need for central banks to act.

Exchange rates
Relative interest rates and fiscal
outlooks are likely to be the main
drivers of currencies for the
rest of the year. A few of the
peripheral G10 central
banks have started raising
interest rates, and their
economies also have
strong fiscal outlooks
too. Meanwhile the
four major
currencies - the
dollar, yen, euro and
sterling - have weaker
interest rate and fiscal
outlooks.
Given the continuing
uncertainties over EMU,
the euro is likely to
remain under pressure
against other European
currencies such as the
Swedish krona and Norwegian
krone. These currencies should
be supported by more favourable
growth, interest rate and fiscal
outlooks than the euro.
Meanwhile, in the UK, the budget was
initially positive for sterling as it boosted

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Item Ref: PP1163. September 2010