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There are plenty of dangers to fear in the year ahead but Proinsias O'Mahony advises that it will probably pay to buy into weakness.

Market volatility is back, the so-called Greek tragedy inspiring the biggest falls in global stocks since last March's capitulation. Double-digit index falls were followed by a prompt rebound but there's no doubt that the bulls, so cock-a-hoop in January, have been rattled by the sudden about-turn in market mood.

The realisation that government debt is not risk-free has shaken investors. It shouldn't have. As we've noted many times over the last year, sovereign defaults typically follow banking crises (a lag of two-three years is normal, as outlined in Rogoff and Reinhart's definitive This Time is Different: Eight Centuries of Financial Folly). 

As for Greece, it needs approximately €53bn to refinance existing debt and pay for borrowing necessitated by its glaring budget deficit. Default is not an option as it would crucify already vulnerable euro zone banks who've stocked up on Greek bonds and therefore further inhibit credit availability.  Secondly, further sovereign defaults could follow as contagion hits the remaining members of Europe's much-maligned PIIGS - Portugal, Ireland, Italy and Spain. 

Financial blogger Yves Smith (nakedcapitalism.com) notes that sovereign crises are a, "frontal assault on the main mechanism used to cope with the global financial crisis: liberal use of government debt, both to recapitalise wounded banks and to compensate for a sharp fall in

private-sector demand."  While fiscal austerity in Greece might not greatly affect aggregate euro zone demand, things might get very "dangerous", as Trinity economics professor and Great Depression expert Kevin O'Rourke has noted, if the entire periphery is forced to counter market panic by excessive cutbacks, "especially if Spain, or, God forbid, Italy, became involved as well."

How dangerous? The idea has inspired apocalyptic thought aplenty, with former IMF chief economist Simon Johnson warning that "precipitate fiscal austerity" was a major contributor to the 1930s Depression.  Hong Kong-based research house Gavekal, meanwhile, has cautioned that European government spending cutbacks could be "a lot more brutal than everyone currently anticipates; think Thailand in 1997 and Korea in 1998."

Note, too, that banks have been selling insurance against default by European sovereigns. If state credit ratings are pressurised, banks will have to post additional collateral to satisfy their derivative obligations. AIG's inability to do so led to their downfall in 2008 and fears of counter-party risk have once again been aired - the possible Lehmanification of Europe, as some are calling it. 

The above are dire scenarios and fund manager surveys confirm that most expect a tidier resolution, probably in the form of a last-minute bailout. However, there is no easy way out. Northern Europeans don't want to be the sugar daddy to profligate southern peripherals and it's difficult to see troubled nations getting their houses in order if the impression is given that Germany is perpetually on hand to save the day.   

Spain has also been occupying markets of late - unsurprising, given its well-publicised problems. What is surprising is that Spanish people seem blind to the gravity of their situation. Spain's consumer confidence index is at its highest level in six months. More pertinently, break down the components of the index and you see that the expectations indicator is showing its second-highest reading ever, only just below the all-time high set in the go-go days of January 2005. Spanish politicians, who blame "speculators" for recent developments, clearly aren't preparing their people for the adjustments that will be necessary in coming years.

There are other issues.  China and India have moved to dampen growth while global economic data has deteriorated of late. UBS produces a global economic surprise index which tracks whether global statistics miss or beat consensus expectations. Recent weeks have seen a surprise faltering in data, it notes.

In the US, consumer sentiment readings show the public to be still in recession mindset - the most recent reading, Gluskin Sheff analyst David Rosenberg notes, is actually below the average reading seen in prior recessions and way, way below levels seen in genuine economic expansions.

Rosenberg is also sceptical towards the "eye-popping" 5.7% GDP growth rate recently recorded.  Never before has such a rate been accompanied by a rise in the unemployment rate. "Expect big-time revisions", he warns.

Bulls can at least take some comfort from US earnings season. With most US companies having reported, almost 80% have beaten expectations. Estimates have been trounced by a near record 11%.  Revenue beat rates, a concern in past quarters, have jumped dramatically while guidance has also been strong.  

Bears, however, can take comfort from the market's ‘so what?' reaction to it. In a market seemingly priced for perfection, they say, ‘better than expected' is no longer going to cut it. Of course, one could respond that sovereign issues have simply overshadowed earnings season but with analysts projecting huge earnings growth in 2010, it's fair to say that markets are no longer going to jump for joy over improved corporate health.

There remains one obvious question mark over whether companies can actually live up to full-year growth expectations. Robert Buckland, Citigroup's global strategist, notes that even during the downturn, profit margins actually remained above their 30-year average of 4.5%. Analysts, however, forecast notable margin expansion in 2010-11, exceeding the heady levels of the late 1990s and within touching distance of the record highs of 2005-07.  Buckland broadly agrees with this thesis.  However, it seems reasonable to question if global profitability can really reach a new and higher plateau.  Excellent earnings have not protected the market of late; it's fairly obvious what would happen if earnings disappointments creep in later in the year.

Despite all this, it will probably pay to buy into weakness, at least for now. Bull markets climb a wall of worry and technicals suggest that this one has not yet run out of steam. JP Morgan analysts, who have been particularly prescient over the last year after correctly calling the recovery trade, say that continued scepticism will drive the market higher.  Everyone knows that it will take years to repair the damage done to private and public sector balance sheets, they say; just because this is a mere "bounce towards malaise" does not mean that it should not be bought. 

Still, given the raft of dangers that exist, it would be surprising indeed if 2010 turned out to be plain sailing for investors.

A sharp decline in euro ahead?

Last October, we argued that fundamental and contrarian analysis suggested that US dollar weakness was overdone and that the euro was set to fall. Fall it has, declining 10% since last November.  Might the euro now be worthy of a contrarian bet?

Probably not. A very short-term rebound might happen - after all. Commitment of Traders' reports confirm a record net short speculative position, setting the scene for some kind of bounce. It will likely be short-lived, however.

Euro-land GDP is awful, slowing from 0.3% to just 0.1% in the last quarter. There was shrinkage in Italy, Greece and Spain as well as flat recordings in Germany and Portugal. Were it not for France's 0.6% growth, the overall euro zone would likely have contracted. The euro benefited last year, Morgan Stanley analysts argue, because of the ECB's "passive" quantitative easing policy, with the active dollar and sterling being punished. It reckons the single currency to be overvalued by 19% and is calling for a fall to $1.24 by the end of 2010.

As for Greece, only by a massive bending of the rules can it be saved, causing further euro selling. Not only would a weaker euro help the more fragile euro zone countries, it would benefit the stronger northern European countries. Opinion polls show that 92% of Dutch people want Greece to be booted out of the EMU while 72% of Germans don't want to transfer funds into the hands of the PIIGS. As BNP Paribas currency analysts argue, a bailout would be "politically suicidal" for both governments.

And yet, Greece cannot be allowed to fail. A weaker euro would stimulate German exports beyond the euro zone, helping offset falling European demand, BNP Paribas say. A "sharp decline" in the euro, then, "could be part of a European solution", helping to compensate Northern Europeans through export profitability.

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