comparing Japan 1992 with the Eurozone 2012

creating an EU timetable

It seems to me that all of the elements of the Eurozone crisis have been out in the open for some time.

The Papandreou government took power in Greece in September 2009 and triggered the crisis by announcing that the national accounts had been falsified for many years by the prior administration.  Greece, as many had already suspected, was in much worse financial shape than the official figures showed.  But that was 33 months ago!

It has been clear from the outset that financial contagion could easily spread from one member of a currency union to the others.  The rolling nature of the Asian financial crisis of the late 1990s showed vividly how this could happen, even outside a tight economic linkage of the typce that binds the Eurozone together.

It has also been evident from the beginning that the Eurozone banks were intimately tied to the weaker countries by their large holdings of those countries higher-coupon sovereign debt.  So they were in trouble, no matter what country they were domiciled in.

We’ve also seen the shoes drop, one by one, as market attention has shifted from Greece to Italy to Spain, just like in Asia–and the PIGS countries have revealed the extent of their financial messes.

We’ve recently seen capital flight, as corporate and individual investors have (sensibly) shifted their euros from banks in weaker countries to those in Germany or other stronger ones.

Finally, I think we’ve reached a political tipping point in Germany, where the political cost of not addressing the woes of southern Europe exceeds the cost of taking action.  Hence the recent moves to consider more than austerity as a solution.

for investors, where to from here?   

I’m looking at the situation as a foreign investor, not as a citizen or resident of the EU.  I’m more concerned with the stock market implications of today’s Eurozone situation than the political and economic.

My question, then, is:

when will the EU’s fiscal problems stop being the dominant factor influencing the movements of its stock markets–and the markets of the rest of the world?

looking at Japan in 1989

We do have one example of this kind of situation during my professional lifetime.  It’s the Japan of late 1989.

That’s when the new head of that country’s central bank began to raise interest rates to force the government to bring highly speculative banking and  financial market activity under control.  The subsequent failure of Tokyo to fix its broken economy ushered in the first of Japan’s two (so far, at least) Lost Decades.

To my mind, Japan’s case was at least as bad as the EU’s.  And Japan more or less deliberately–but very clearly–made a bad choice.  It opted to cover up its problems to preserve a traditional way of life and a traditional power structure, rather than to evolve in a way that would gradually fix them.

It’s not a great roadmap, but it’s the best we have.

what happened in the Tokyo stock market?

The main indices peaked in December 1989, as rates began to rise.

They fell until June 1992, 31 months later.

From that point, the Japanese market drifted, with high volatility, for the remainder of the decade.  This ran counter to a rising trend in the equity markets of other industrialized countries.

The most sobering news is that today, twenty years after the initial bottom, the Tokyo market hasn’t recovered an ground.  On the contrary, it’s half its level of June 1992.  Today, it’s an investing backwater, lost in dreams of the 1980s, and with highly restrictive rules against any foreign attempt to change the status quo.

my conclusions

If Japan is any guide, we should be close to the end of the initial downward phase in Europe.  To me, it makes sense to be on the alert for signs of stabilization.

In Japan, the strongest stocks by far after the initial bottom were either multinationals or export-oriented firms.  That is, they were companies headquartered in Japan but with their operations elsewhere.  To the extent the Japanese citizens bought stocks during the first Lost Decade, those are the ones that they–as well as foreigners–favored.  I think the same will be true in the EU.  Companies located in the EU but not in the Eurozone will probably do the best.

The crisis was by no means over in Japan in mid-1992.  In fact, the first inning had barely begun.  But Japan’s problems ceased having a major negative influence on other markets.

Europe is much more entwined in the fabric of world commerce than Japan was in 1992.  The EU may have a tougher time than Japan over the coming years, in the sense that world economic growth will likely not be as strong as it was in the second half of the 1990s.  On the other hand, Japan benefited less from strength elsewhere than the EU is likely to do.  So a general picture for EU stocks–in the absence of a dramatic political evolution of the EU–is probably flattish, with a lot of volatility.

On the crucial question of whether the EU will follow Japan down the same path to economic irrelevance I have no answer.  I didn’t think Japan would be as inflexible as it has been.  But it shows that when a country has deeply ingrained notions of its cultural superiority and the interests of the status quo are very powerful, denial may be the easiest road to follow.

My bottom line:  it’s probably safe to dip a toe in the EU water today, but not much more than that.

A final note:  once Europe leaves center stage, I think market focus returns to economic policy in the US.