Editor’s note: Meg Woods, director of the private client division at Veritas Asset Management, gives her views on the state of play in the world economy and implications for investors. As always, while this publication is delighted to publish these views, it stresses that it does not necessarily endorse them.

In 1973, as a part of establishing free trade within the Common Market, work began in Brussels on defining chocolate for human consumption. The directive was finally signed 27 years later, in August 2000. In 2000 European Union leaders vowed to create a common patent system by the end of 2001. An agreement was reached in June this year.

It should therefore not come as a surprise that the euro crisis rolls on. The agreement in the wee hours of Friday, 29 June, received enthusiastically on the day by markets, in fact merely activated an existing but unused facility for the European Stability Mechanism to purchase bonds in the open market. German liabilities were unchanged by the agreement.

One can sympathise with the German voters to whom chancellor Angela Merkel is accountable. The issue of Greek fiscal deficits is as much to do with the Greek aversion to paying taxes as it is to public sector largesse. The retiring Greek finance minister admitted just before the first of this year’s general elections that tax collections had virtually completely dried up. A diamond trader friend disclosed that, when billing Greek clients, he incorporates value added tax into the price because if the client sees VAT itemised separately, he refuses to pay it.

For Germany to accept Greek demands for a bailout now would be tantamount to introducing a permanent transfer mechanism, effectively taking the Greek population’s generous benefit systems onto German fiscal books.

A bitter pill to swallow

Germany is entitled to take the moral high ground; she did all the hard work of regaining competitiveness in the early noughties. Corporate taxes were cut, social security slashed, regulation on part-time employment shredded, unfair dismissal rules diluted. This paved the way for the export renaissance that the world has been admiring ever since. The German people observe that they went through change - why shouldn’t the "Club Med" countries?

Labour costs rose by 7 per cent in Germany in the decade of the noughties, by 30 per cent in Italy, 35 per cent in Spain – and 42 per cent in Greece.

There has as yet been no meaningful effort to address the EU’s structural flaws – the widely differing levels of competitiveness, the high debts and the unaffordable social welfare commitments. The EU leaders continue merely to address the symptoms and not the causes of the crisis. Until they do, the healing process, which must involve writing off debt and not merely issuing more of it, cannot begin.

Deficit addiction

The "€uropeans" are not the only ones kicking their problems into the future. The US is facing a "fiscal cliff" of $600 billion per annum of automatic tax hikes and spending cuts, to start in January 2013. This would reduce GDP by 3.5-4 per cent and tip the economy into recession. However, there is already talk of the start date being pushed back to March and a compromise is widely expected.

In the UK George Osborne, the finance minister, is proving himself a master of fiscal u-turn, similarly deferring the political pain of deficit reduction.

Government debt in advanced economies has risen from an average of 75 per cent of GDP at the start of the credit crisis in 2007 to 110 per cent now. The average government deficit in these countries has ballooned from 1.5 per cent of GDP to 6.5 per cent. The budgets of most advanced countries, excluding interest payments, would need 20 consecutive years of surpluses of 2 per cent of GDP just to bring debt to GDP ratios back to pre-credit crisis levels. (Source: Bank of International Settlements 2012 Annual Report.)

François Hollande, president of France, wants to focus on growth rather than austerity. Does he not realise that the proponents of austerity want growth just as much as he does? The only question is how to achieve that growth - whether on the back of debt or, German style, on the back of increased competitiveness. The reality is that, with debt having reached unsupportable levels in the world, austerity is a prerequisite for growth.

Monsieur Hollande might also gainfully reflect on an economic principle known as the "Laffer Curve", which states that there is a revenue-maximising rate of tax. Above this, revenues fall for a variety of reasons - people work less, the black market mushrooms, more transactions get paid for in cash and do not “go through the books”. Ronald Reagan was rather taken with this logic: he consequently slashed US tax rates – and revenues indeed rose healthily.

Both the Federal Reserve and the Bank of England have stated publicly that their policies will be supportive if necessary, but the fact is that their unconditional support feeds their government’s deficit-spending addiction.

These continuing loose monetary policies have implications for investors. Charles Richardson, manager of the Veritas Global Equity Income Fund, some time ago coined the phrase the "policy markets". Successive bouts of central bank support, by flooding the system with liquidity, have buoyed markets. As each package draws to a close, so markets subside. Each response is, however, more muted than the previous one.

Policy fallout

What of inflationary consequences of these successive stimulus packages?

It may indeed come to the point where inflation becomes a risk, but, for the moment, these loose policies are counter-balanced not just by excess debt levels restraining spending, but also by several structural forces. One is the deflationary fallout of the retirement of the baby boomers, with the attendant softening of demand and economic activity.

For the time being, concerns over inflation are not a constraint on Western authorities determined to soothe the path of the voting public in the wake of a crisis that wiped out 18 years of gains in the median American household’s net worth.

However, these loose policies are not without cost. Financial repression, the official suppression of interest rates, is estimated to be costing UK savers and pensioners £18 billion ($28 billion) a year in lost income: annuity rates have tumbled. The US Accounting Standards Board has just decreed that pensions must use more conservative assumptions about returns. US pensions are already under-funded by $3.4 trillion, and this will add $600 billion to the hole. By suppressing interest rates, the authorities are robbing savers and pensioners to bail out the profligate. This will exacerbate the deflationary effect of the retirement of the baby boomers.

Opaque challenge

Markets are opaque and challenging. At Veritas, we do not pretend to know the outcome of the euro crisis, nor indeed how long the laboured de-leveraging of the Western consumer and governments will take.

Fixed income securities are no longer priced to deliver real returns, but equities offer a different valuation metric. Major indices have struggled over the past dozen years, but, during that time, the fundamentals of many companies have improved. Profits and cash flows have grown. Balance sheets are robust. Dividend yields are at historically attractive levels.

Even with the current opaque backdrop, we can find attractively valued companies with the tailwind of our themes of "structural growth’ and "scarcity" - all dependable compounders that we believe we can rely on to deliver solid compound growth in the years ahead. Fresenius Medical, the global dialysis provider treating diabetes, a disease now sadly labelled an epidemic in China, will deliver solid growth in profits regardless of events in the eurozone.

Share prices may fluctuate in response to short-term macro pressures, but, in the long term, the value in underlying profits will out. We are even taking this thinking a step further with the evolution of a new theme: “2020 Winners”. With this, we seek to look through the current volatility to ferret out those sectors and companies that will grow to dominate the decade of the 2020s. Automation to improve corporate efficiency and cost structures is strong on the radar.