Europe is risking a trade war with US

Allister Heath
ONCE again, the European Union has got it wrong. It doesn’t have a clue about regulating hedge funds, private equity or other financial products and players. Brussels is tilting at windmills, attacking problems that don’t exist, inserting dangerous protectionist barriers into its proposed new rules and all the while ignoring the very real weaknesses and looming dangers at the heart of our macroeconomic and financial systems.

The last thing we need is for London to be caught up in a financial trade war with America over this idiocy. Tim Geithner, the US Treasury Secretary, was spot on in his recent letter to Michel Barnier, the European commissioner for the single market. Geithner expressed his worry about how the fine print of the proposed directive would discriminate against US firms and deny them the access to the European (including British) market they currently have. While Geithner did not spell out what would happen if the Eurocrats refused to relent, such a crackdown against foreign participants in the market would undoubtedly result in retaliation by the US, with disastrous consequences.

Brussels is also on dangerous grounds in its hatred of credit default swaps (CDS), which it is trying to demonise to distract attention from its own failings and the uncontrolled public finances of its members states. There is absolutely no evidence that CDSs have done anything to precipitate or amplify the fiscal crisis and the panic surrounding eurozone sovereign bonds. This is also true of naked credit default swap (CDS) contracts, whereby the buyer has no stake in the underlying asset being insured against default.

This is not to say that the CDS market is perfect, however: it does require a significant reform. Some firms – such as AIG – wrote vast amounts of credit insurance without holding sufficient assets in reserve to be able to pay out on the policy. They simply assumed it would never come to that, especially with AAA-rated assets such as CDOs made up of subprime loans. Needless to say, it all ended in tears. As the assets covered by the CDSs were continuously downgraded in the run-up and aftermath of Lehman’s demise, AIG had to shell out billions of dollars in payments which it could ill afford. In future, just like with regular insurance, firms that write CDSs should have to maintain enough capital. But this radical reform is required to strengthen the market, not kill it off. The City needs sensible change – not wanton destruction.

What do the history books say about year two of a bull market? That is the question asked in a research note by Bank of America Merrill Lynch – and the answers are fascinating. Using the ten S&P 500 bear market troughs since 1926, it finds that the average price gain from a bear market low in year two is nine per cent, which follows an average gain of 46 per cent in the first year. On nine out of 10 occasions, the second year after the trough brought positive returns for US stocks. Fixed income returns were flat.

All of which will have a lot of bearing on the UK markets, which follow the US more closely than ever. The FTSE 100 will probably close up for the year in 2010. However, there is likely to be a growing disconnect later this year between the drastic tightening of UK fiscal policy – which will affect firms that rely on British demand and government spending – and the overall FTSE, an increasingly global index.