2/5/13 – What’s Happening in Europe?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 5, 2013 11:40:49 AM

and tagged Market Updates, Europe

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The market hiccup yesterday was widely attributed to Europe, which raises the question—what’s happening in Europe? I haven’t written about Europe for a couple of months. The last time, just after Thanksgiving, I noted that the situation was normalizing but we could certainly expect storms ahead. Two months later, the storm warnings are starting to sound.

Economic improvement has continued since then, with a start at recovery in the northern tier of the European Union. The southern tier, however, has continued to weaken—not so much economically as politically. Greece, for a change, isn’t the driving factor this time. Instead, two of the largest countries in the EU, Spain and Italy, are now showing cracks.

For Spain, those cracks are both political and economic. On the political front, news is breaking of a bribery scandal that went all the way up to the prime minister’s office and back for two decades. A weakened government is a problem, given all of the challenges Spain faces, and a Saturday speech by the prime minister was widely panned. Economically, the unemployment rate remains sky high, at more than 26 percent, and Spanish GDP just shrank for the sixth straight quarter in a row, decreasing at the fastest pace in a year.

A big part of the improvement in Spain’s situation came from the normalization of interest rates, which have come down from above 7 percent, an unsustainable level. Recently, foreign investors have returned to the market. But if foreign capital flees, interest rates, which just bounced back above 5.4 percent, may rise again to unsustainable levels.

In Italy, the technocratic government that oversaw much of the recent progress in resolving the country’s economic problems has resigned, and an election campaign is underway for its replacement. The problem is that a recent banking scandal has significantly reduced the chances of a clear electoral outcome, bringing political uncertainty back front and center. Former prime minister Silvio Berlusconi has run a populist campaign and seems to have benefited from his opponents’ apparent involvement in bailing out a corrupt bank. From the markets’ perspective, those opponents, including Mario Monti, the outgoing prime minister who steered Italy through much of the crisis, are the preferable winners, and the damage to their chances has knocked Italy’s stock market.

In both cases, the sudden political uncertainty has shaken the positive momentum that had developed around the “Europe is on the mend” narrative. One worrying sign is that cash has started to flow out of the peripheral markets and into the northern markets—a trend seen in the financial crisis. The fact that both countries are among the largest in the eurozone, with Italy third and Spain fourth, makes the uncertainty all the more powerful, as they are too big to be forced into action and may be too big to rescue.

Storm season may be starting up again, depending on how the situations in Spain and Italy develop. France is also showing cracks, although no immediate risks are apparent. Overall, the markets have been reminded that Europe still faces risks and that all of the problems are not solved.

Let’s keep that in mind.

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