Disaster in waiting

“It would be a disaster if we leave the euro.” That wasn’t a Greek speaking — it was an Italian tour guide in Turin. Concern is growing that the entire eurozone might collapse. It is no longer just a disorderly Greek exit that’s feared — in fact that has almost been accepted as inevitable. Now the overriding concern is that we could see a complete meltdown that would lead to the return of drachmas, lira, pesetas, francs — the old Babel of European currencies.

If that seems unlikely, keep in mind that this whole crisis could not have been imagined just four years ago. Then the collapse of Lehman Brothers set in motion a cascading spiral of financial failures that have brought us to this point.

Many Europeans are frightened and fear the future. A lot of them were opposed to the idea of a common currency when the euro was launched but now they are terrified to think what the economic consequences would be without it. Even the overwhelming majority of Greeks want to keep the euro, according to the polls. They just don’t want to pay the price for it.

And it’s a high price. The austerity plan demanded by the European community for continued financial support is gutting Greece economically and pushing unemployment to depression levels. That in turn has driven political support to extremist parties that promise to roll back the cuts and restore prosperity — all while keeping the euro. Dream on! At least the Irish were smart enough to grasp the reality facing their country and voted overwhelmingly in a May 31 referendum to support the European Fiscal Stability Treaty.

The harsh reality is that without domestic monetary control, countries like Greece and Spain are in an impossible position. Power over fiscal policy lies outside their borders and they have little influence over the course of events. In fact, their fates are being decided in Berlin and the government of Angela Merkel seems to be showing little sympathy to their plights.

It’s increasingly obvious that the only way to preserve the eurozone is through much tighter fiscal integration, which would include the introduction of eurobonds and a multi-national deposit insurance program to ward off destabilizing bank runs in troubled countries. But Germany’s resistance to such measures, which it sees as rewarding the profligacy of the PIIGS, has prevented any action that might ease the pressure.

Prime Minister Stephen Harper’s comment that Europe is “running out of runway” is right on the mark. Western leaders are increasingly frustrated with the inability of the Europeans (read Germany) to take decisive action. So is European Central Bank president Mario Draghi, who has practically been on his knees pleading with the politicians to get off the pot. No wonder he’s alarmed. Spain’s banks are going down the tube, Italy’s borrowing costs are approaching unsustainable levels, and even France is starting to crack but no one is doing anything. It is uncomfortably reminiscent of the 1930s when politicians turned a recession into a depression by pursuing narrow self-interest policies such as the erection of trade barriers. We’re well down that same road.

The investment implications are clear. Stocks need to be selected with great care, with an emphasis on dividend-paying companies with good cash flow and strong balance sheets. With a few exceptions, such as Switzerland, European securities should be avoided. Emerging markets must be treated with caution until such time as the extent of the slowdowns in China and India become clearer. Bonds should continue to have a key position in your portfolio. In short, play turtle and focus on preserving assets while generating some cash flow.

This could be a long haul. The U.S. Federal Reserve Board has already pledging to keep interest rates at record low levels through 2014. That suggests we are unlikely to see a return to strong growth until at least the middle of this decade.

There are ways to make money, even in this kind of environment. The model Defensive and Very Conservative portfolios I have devised for my Internet Wealth Builder newsletter are both performing well. But financial success in this situation requires more than good advice; discipline, constant monitoring, and careful risk management on your part are critical. There will come a time to take some flyers and go bargain hunting but this is not it.

Photo ©iStockphoto.com/ Yong Hian Lim

For information on a three-month trial subscription to Gordon Pape’s Internet Wealth Builder newsletter go here.

Gordon Pape’s new book, Retirement’s Harsh New Realities, is now available for purchase at 38 per cent off the suggested retail price.