The eurozone’s outlook was the most grave since the slow motion train wreck of European sovereign debt began two years ago. The European Central Bank (“ECB”) still needed to show its resolve in backstopping member country debt. The crisis spread throughout the eurozone. Italian bonds went above 7%, causing longstanding Prime Minister Silvio Berlusconi to resign. Previously feeling immune, AAA countries Germany and France had to pay higher interest rates and had difficulty fully subscribing offerings. Belgium’s credit rating was lowered. Belgium looked to be the first domino at risk of falling amongst countries formerly considered safe bets.
Financial contagion was spreading amongst financial institutions owning European sovereign debt until steps were taken this week. Stock prices of many money center banks and brokerages had fallen back to their financial crisis lows, prompting “infected” firms and those seeking to avoid infection to unload their European sovereign debt holdings. Forced selling contributed to pushing European sovereign debt prices further down, throwing markets into dysfunction. European banks were finding it difficult to function in interbank lending and foreign exchange. At risk were successive failures of European sovereign debt offerings, banks, governments and finally, the euro.
ECB Reigns as Europe Wanes
Even though the European sovereign debt crisis was never worse than last week, investors are concluding that Europe’s woes are not as ruinous as had been feared. In response to the contagion, central banks reacted swiftly, jointly announcing a coordinated move to lower the cost of US dollar funding, triggering a worldwide stock market rally. Eurozone finance ministers have come to agreement on leveraging techniques of EFSF (the fund used to backstop European sovereign debt). Greece has received its next tranche of bailout money. The International Monetary Fund (“IMF”), which has had a recent history of good outcomes by successfully enforcing austerity measures, is getting actively involved. Importantly, the ECB is finally taking matters seriously and is preparing a one trillion euro cash injection for the eurozone and is “paving the way for a colossal market intervention in European sovereign debt” contingent on reforms. Details could come at the ECB’s meeting on Thursday. Confidence in European sovereign debt repayment should open up the markets for debt restructuring and avert future financial contagion.
Doing the Right Thing for the Wrong Reason
Policy makers prefer to flush economies with liquidity to dampen or stave off recession because austerity will actually make a recession worse, as has been shown by Greece’s experience. Failing European sovereign debt markets have made more difficult the issuance of additional debt, curtailing the aggressive spending of the weaker countries. Eurozone countries are being forced to become more fiscally responsible, adopt a stronger federalism and an empowered ECB, thus saving the euro and putting the eurozone into a position of economic hegemony and sustainability well into the future.
It’s the Economy
The US trade economy is able to withstand the recession brewing in Europe due to its diverse trading relationships, particularly with Canada, China, Mexico, Japan and a growing trade with South America. US economic data had turned ugly mid-year, sending double-dip shivers through the markets, but now the data are consistently surprising the markets with results above expectations. This past week pending home sales and employment reports were significantly above consensus expectation. Black Friday’s kick-off to the retail holiday season reflected that confidence had returned as consumers once again are spending more and saving less. Analysts are looking for a bottom in US housing prices due to several years of low housing starts against increasing demand, with home ownership levels down to lows. The overhang of foreclosures that are not being processed by banks seems to be the impediment to a recovery. The fundamentals of stocks have looked good all year, despite flat returns year-to-date and bruising bear-market losses in most of the world from recession and bank failure concerns. Stock earnings continue to consistently beat analyst expectations. Stock markets are poised to rally and finally blast through this year’s trading zone ceiling as concerns are discounted or addressed.
The sub-prime financial crisis was caused by excessive investment of bank capital in US mortgages which came crashing down as the US fell into the Great Recession. The financial crisis in Europe is being caused by excessive investment of bank capital in European sovereign debt as Europe falls into recession. Now China is showing signs of losing its characteristic economic robustness. The People’s Bank of China is reacting by increasing leverage on bank capital to increase bank lending. With recession, intervention and recovery going on all over the globe, investors wake up each morning and wonder if they are in the same situation all over again, except each day it’s another country.