Markets are heading South whilst the politicians are away on their holidays.  Europe’s political leaders thought they had fixed the problem when they agreed on July 21st to give the EFSF new lending powers and €440 billion to play with.  However the markets know better than to trust a bunch of politicians to pass a law quickly and without amendment.  Cometh the return in September there will be many a European politician who will have spent his August holidays planning exactly how to extract the biggest possible advantage in return for voting the EFSF legislation through quickly.  Bond spreads over German Bunds will gyrate wildly as the legislation gets debated in the full glare of publicity.

However all this noise is obscuring a few simple truths which are actually driving market prices at the moment.

Most importantly a lot of countries want to borrow a great deal of money from investors.  These investors are increasingly becoming very discerning as to whom they will lend money to and what rate they will charge the borrowing countries.  Countries which in recent years have become accustomed to borrowing quite cheaply (especially in relation to the rates Germany can borrow at) are suddenly finding that investors are demanding much higher interest rates this year.  Three euro-zone countries (thus far) have pleaded poverty and have been allowed to borrow 15-year money from the EFSF at rates of roughly 3.5% (in return they have been told to bring their budgets back into balance – amidst much bleating).  Never in history have these three countries ever been able to borrow 15-year money at 3.5% in the open markets – weaning them off the EFSF is going to prove to be nigh-on impossible.

Secondly banks who lent Greece money now find themselves having to write off at least 20% of the money they lent.  This has bankrupted most of the Greek and Cypriot banking sector.  Italy has €1.9 trillion sovereign debt outstanding (c.f. €350 bln for Greece) and investors know the same will happen to French, German, Spanish and Italian banks if they are forced to take a haircut on Spanish and Italian debt too.  The ECB has been forced to hold down Spanish and Italian borrowing rates whilst it waits for the EFSF’s new powers to become operational (which will only happen once politicians return from their holidays and also after much political skullduggery amongst 17 voting parliaments has taken place).  Let us not forget that Italy alone has €450 billion of bonds maturing during 2011 and 2012 – but the EFSF has just €440 billion to help out all five PIIGS.  EC President Barroso has worked this one out but he has upset the Germans by publicly calling for an increase in the size of the EFSF before the July 21st amendments to the EFSF have even been voted through.  So the share prices of European banks and insurers (e.g. Generali which owns €50 bln of Italian debt) are cratering as investors worry amidst all the political uncertainty.

Thirdly the US stockmarket got ahead of itself and failed to discount a possible double-dip recession starting in the States in 2011.  The US stockmarket got caught on the hop by the sudden slowdown in the economy during Q2 and was shocked when US Q1 GDP was revised down from 1.9% to just 0.4% in late July.  Normally the stockmarket is quite good at predicting recessions (the joke goes that it has predicted 13 out of the last 5 recessions) and the reaction to the GDP figures has been that of a stockmarket desperately trying to price in a possible 2011 recession.  This is why the S&P 500 has fallen 17% in the last 3 weeks.

So investors are left trying to work out whether the US is actually going to fall into a double-dip recession and quite how much the Fed promising to keep its Zero Interest Rate Policy (ZIRP) for at least two years will help.  Investors also know they face all September watching 17 sets of European politicians drag their feet before eventually voting through the EFSF amendments.  In the end the Germans will reluctantly agree to increase the size of the EFSF and Spain & Italy will not impose haircuts on their bondholders.  Therefore the banking sector is worth buying but trying to correctly time the purchase of bank shares will prove to be impossible – the best option for sensible long-term investors is to spread purchases (buying on bad days) over the rest of August and September.  France may well be recalling its politicians early to vote on the EFSF on Sep 6th but the Germans don’t vote until Sep 23rd and besides it is the 17th vote that matters the most, not the first vote.  The market will probably not bottom until we near the last of the 17 euro-zone members’ votes (including any which vote “No” initially and are then asked (in time-honoured euro-fashion) to vote again).