The following comments were made by Climb securities. What does the very last sentence, which speaks of recovery and calamity, mean for the lay person?

“Many of Europe’s issues seem to be simply glossed over by economic and investment commentators. Whilst Europe may not be a significant trade partner of Australia, its financial markets impacts upon Australia, particularly through its provision of wholesale debt funding to our banks. Europe has a major impact on world economic growth and its recovery is needed to stabilise developed economies and create “non-Asian centric” demand into commodity markets.

We see three potential economic scenarios that could play out in Europe. These scenarios will have different impacts on the Australian economy and our financial markets. The first scenario is that Europe somehow drags itself into a normal sustained recovery. We regard the likelihood of this occurring in the next few years as remote. There is simply not enough confidence across Europe and the recovery rate, some six years after the GFC, is the one of the weakest on record. This recovery is anything but normal.

The second scenario is that Europe succumbs to a deflationary cycle (like Japan) that lasts a decade or more. Unfortunately the key financial indicators, particularly bond yields and the lack of credit demand, suggest that this is a real possibility. This scenario suggests that bond yields stay low for years and that equity markets decay due to anaemic profit growth. This scenario becomes more likely because Europe has an ageing demographic and natural population growth is slowing.

The third scenario is a blowout financial bubble that erupts following years of cheap credit and the introduction of too much liquidity into the financial system. Normally this would be quickly snuffed out by an inflation surge. However, this is not evident today and it is financial assets that are rising to inflated levels rather than consumer prices. A blowout could occur for no other reason than the rapidly spread perception that market prices have run too high against fair value. Buyers become sellers en mass and the market turns. To some extent this is playing out across world equity markets that have gyrated over the last twelve months at elevated levels. But it is the bond market that remains the true bellwether for investors. Keep an eye on European bonds, for it will be the movement in yields that will forewarn of either market calamity or economic recovery.”

Many thanks.