Europe Headed for Nasty Divorce

02/01/2012 11:46 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

While European leaders crowed recently about lower bond yields, the road ahead is set to get much rougher, writes senior editor Igor Greenwald.

There comes a time in many a failed marriage when the mutually aggrieved parties start communicating through intermediaries, mostly to rehearse complaints about broken promises that they will soon be making in court.

Germany and Greece are at that point.

The Germans have demanded, through the press and to their allies, that the Greeks turn over control of their budget, which has failed to hit German-backed targets. The Greeks have asked what German alimony is for, besides impoverishing their people.

The breakup seems all but certain at this point. As Germany ratchets up its demands, the price of staying together keeps rising for Greece. Soon, it will climb above the perceived cost of a chaotic split, if it hasn’t already.

The ensuing chaos would certainly cut short the happy tune European policymakers have been humming lately. After reversing a run on European sovereign bonds by pumping nearly free money into the continent’s troubled banking system, European Central Bank President Mario Draghi took a brief victory lap in Davos last week.

He claimed to have “avoided a major, major credit crunch,” albeit with all sorts of caveats. One is that, according to Draghi, “credit is [still] seriously contracting” in the troubled parts of the Eurozone. Another is that there is little evidence that the money the ECB has lent to banks has been re-lent to customers.

Draghi’s claims about the “major credit crunch” seem to derive from December data pointing to one. His belief that it has been averted is based on the declining sovereign yields, and little else.

French President Nicolas Sarkozy took to the airwaves on Sunday to also pronounce victory of a sort, while he could. “We can say, with caution, that we see elements of financial stability in France, Europe, and the world,” he said. “Europe is no longer on the edge of the cliff.”

But then what else would he say, with his political career hanging by a thread? Sarkozy, who currently trails his main presidential challenger by ten percentage points in the polls ahead of a two-stage election in April and May, has recently admitted as much out loud.

He’s responded by pledging to hike the value-added tax, in conscious imitation of earlier German policies, and to introduce a tax on financial transactions as well, though neither measure would take effect until this fall even if approved by parliament.

Meanwhile, French consumer spending was down 3.1% year-over-year in December, while unemployment is at a 12-year high, as it is throughout Europe.

The manufacturing sector is still holding up, though only Germany’s is still expanding. With internal demand weak and dropping, and Asian growth slowing, that resilience may not last.

That leaves Europe with one overriding positive: the ECB’s plans to offer another round of unlimited loans at the end of the month. This one is shaping up as an injection of at least a trillion euros, more than double what the ECB dispensed in December.

That refunding operation kicked off a risk rally that has roared ever since, and it is possible to believe that the one on February 29 will provide a similar impetus. The problem is that last month investors knew more cheap cash was on the way in a couple of months. Come March, that backstop will disappear.

Jim Jubak is right that the next refunding will take care of the debt the European banks have coming due this year. But it certainly won’t provide the fresh capital many need to meet the stricter capital requirements taking effect this summer, to provide fresh loans to the many credit-starved European companies, and to take down the trillion euros or so in sovereign bonds coming down the pike.

Will European investors keep buying once all the cheap ECB loans have been dispensed, but Greece’s fate still hangs in the balance? There’s good reason to think they may not.

Shopping on the way to divorce court can be a real chore. Shopping on the brink of a recession is also tough. Until Europe adopts policies that actually work, the safer bet in the medium term is on lower asset prices.

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