The markets keep moving up, based on the belief that the world's central banks will keep pumping money in to boost the economy. A replay of Europe's debt crisis could test that faith, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
Financial markets rallied in 2012 and have continued that rally so far in 2013, despite worries over slow growth in the United States and the realities of no growth in Europe and Japan.
Why? The combination of money from the world's central banks and investors' belief that those banks have the power to backstop financial assets.
The traditional advice has been "don't fight the Fed." For 2012, that advice broadened into "don't fight the Fed and the European Central Bank." It was good advice, as cheap money from the Fed and the ECB—and promises of even more cheap money if necessary—more than made up for slow growth in the US economy and no growth in European economies. Markets moved up on the central banks' guarantee.
But I can see a major test of the belief in that guarantee shaping up around the middle of this year. And should it tank your stocks, you can blame Europe.
Back to the Crisis
The big challenge to the markets this year, in my opinion, isn't going to be the US fiscal cliff, the battle over the debt ceiling, or a continuing resolution to keep the US government going. By around the middle of the year, we're likely to see a return of the Eurozone debt crisis that could challenge the market's belief in the central banks' guarantee.
Now, I don't think that crisis will be enough to shake the market's faith in the power of the world's central banks permanently. That won't happen yet—in large part because the markets want to believe.
But we know from experience that, at some point, a market that believes it has a guarantee will overextend itself—the technology stock crash of 2000 and the housing crash of 2006 to 2007 are good examples. At that point, central bank guarantees turn out to be less powerful than everyone assumed and inadequate to head off the crisis.
As I watch money flow back into Spanish and Italian bonds, despite the lack of any solution to the underlying problems of the Eurozone, I wonder if I'm seeing a replay of that dynamic.
I think the faith in the power of the central banks will weather this replay. But I can't rule out the possibility of the crisis getting serious enough to rattle that faith for a while and do some damage. With that in mind, I think it's worth taking a look at the shape of the likely replay of the Eurozone debt crisis in an effort to see how much danger it represents to global financial markets.
Signs the Trouble Is Back
I think I can make a strong case that we're headed back to something like the same conditions that roiled markets in the first half of 2012. I think it's even fair to say that all the problems that were kicked down the road last year are about to come back to bite us in 2013.
What's happened recently to convince me that we're nearing crunch time in the Eurozone again? Last week saw a series of reports and warnings that focused on exactly how fragile the recovery in financial markets in Portugal, Ireland, Spain, and Greece might be.
For example, on Friday, the International Monetary Fund said that Portugal had done all the right things to reduce its budget deficit and to reform its economy since it received its €78 billion bailout ($103 billion) in May 2011.
But fund officials said that the country could be thwarted nonetheless in its goal of returning to the financial markets by September 2013. (Portugal plans to sell five-year debt in the next few days. That would be the country's first sale of anything other than short-term debt since the start of the European debt crisis. And it would put the country ahead of that September timetable.)
The problem, the IMF said, is that economic growth is slowing all over Europe, even in northern European economies, such as Germany, where growth had held up well during the crisis. Because of that slowdown, the Bank of Portugal said in its own forecast a few days earlier, the recession in Portugal will be worse than expected. The Portuguese central bank had cut its forecast for economic growth in Portugal in 2013 to a contraction of 1.9%—double the bank's previous forecast.
The Portuguese government of Prime Minister Pedro Passos Coelho, perhaps because it is facing intense domestic opposition to its austerity policies, isn't as pessimistic as the IMF or the central bank. The government is still predicting a return to growth in 2014.
The IMF, however, doesn't see Portugal recovering enough to achieve 2% economic growth—hardly a robust figure itself—until 2017. If the IMF forecast is accurate, that would amount to zero real growth for the decade from 2007 to 2017.