HAMISH MCRAE: Is Europe next as crisis spreads?

What happens now? It has been an extraordinary week and, for Britain, a miserable one. So let’s take stock first.

The reaction in the gold market and foreign exchange wiped out any hope we had that the growth package would work. Any tax incentive will be offset by higher interest rates.

The damage done by our Prime Minister and Chancellor who failed to understand the need to get the markets to their side – and that meant approval from the Office for Budget Responsibility – cannot be undone. Going to the OBR now helps in the margins, but its assessment, which will be delivered to the Treasury next Friday, will be duly leaked and won’t be pretty.

Our own mess wasn’t the only thing that got confused, though.

There was a collapse in confidence in US markets. The leading stock index, the S&P500, plunged below its previous low in June, and the Nasdaq index of high-tech stocks was also close to bottoming. They are down 24 percent and 32 percent respectively so far this year.

The yield on US ten-year Treasuries, which has reached 4 percent, is still at 3.7 percent, compared to 10-year Treasuries at 4.1 percent. Ironically, it was the Bank of England’s intervention in the gold market that lowered US interest rates, demonstrating that central banks can act decisively when needed.

But US financial confidence remains very fragile. We look at the strong dollar and worry about the weak pound; Americans see distressed stock sellers and a housing market that is settling.

The other vulnerable element is Europe. German inflation is 10.9 percent higher than ours. In the Netherlands this is 17.1 percent. Italy’s 10-year public debt yields 4.5 percent, higher than ours. In contrast, inflation in France is only 6.2 percent.

Still, the European Central Bank has to set interest rates for a different set of countries in very different circumstances. It has signaled that interest rates will rise sharply next month, with further increases on the horizon.

So what should you look for? Let’s start with the UK. The question here is whether this government can meet its planned budget on November 23 without the intervention of some market (or political) event.

There was disappointment on Friday that the official OBR forecast hadn’t been put forward, and I wouldn’t give the government much better than evens if it got there without some radical shift.

Meanwhile, interest rates will continue to rise and that will take its toll on the mortgage market. The current shock will subside and loans will soon become available again. But they will be more expensive. Some people won’t be able to keep up with the payments and others won’t bid on houses at all.

However, I don’t think that even if prices fall, the downturn will be as severe as the last one in 2008/9, when they fell by an average of 15 percent.

With luck, we’ll get stable prices and a gradual improvement in affordability as incomes rise. Does that mean a recession next year? We don’t seem to be beeping this year, but what happens in 2023 will be determined more by international factors than by what we do or don’t do.

I’m sure both the pound and UK equities are undervalued by world standards, but they could be undervalued even more before sentiment turns. Much of what happens to us depends on what happens in the US. There is a real possibility that the Federal Reserve will push interest rates too hard. An enormous amount of wealth has already been destroyed.

Stock strategists are crawling over the data from past bear markets and the consensus seems to be emerging that it still has a long way to go before it hits the bottom.

I also see a kind of financial crisis in Europe when interest rates rise. There may be a repeat of the 2010/11 eurozone crisis. But this time, the cause is inflation rather than the country’s debt burden.

And the turning point, when the clouds lift, rates and inflation fall again?

What usually happens is that there is some sort of seismic event, like the Lehman Brothers collapse, which forces central banks and governments to work together to keep things stable.

We’re not there at the moment, so this bumpy ride will take a while.