Will Europe Kill the Rally?

01/22/2013 9:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

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.

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Italy's Political Wrangling
The story in Italy is similar, though the projected contraction isn't as severe.

Last week, the Bank of Italy increased the depth of the contraction it was projecting for the Italian economy in 2013 to a 1% drop. The previous forecast from just three months ago had been for a drop of 0.9%. That's not a huge change, but the trend isn't positive.

How much the increasingly negative prospects for the Italian economy may be a factor in the rising fortunes of former Prime Minister Silvio Berlusconi is debatable, but Berlusconi is clearly rising in the polls. Berlusconi's right-of-center People of Freedom Party now trails Pier Luigi Bersani's center-left coalition by just 6 percentage points. That's a 4-percentage-point gain in a week.

So far, I don't think the Berlusconi surge is likely to propel the People of Freedom Party to victory in the election scheduled for February 24 and 25. But it could force Bersani to include current unelected Prime Minister Mario Monti's center coalition in a new government. That might actually reassure financial markets, which would react negatively to a Berlusconi return.

The former Berlusconi government showed little inclination to tackle Italy's budget deficit or to pass economic reforms, and I'm sure that financial markets would assume that a new Berlusconi government wouldn't do much better.

I believe that especially because Berlusconi's campaign is based on running as a rival to German Chancellor Angela Merkel in an effort to tap Italian anger at budget cuts and tax increases. Those policies, he has said, were imposed on Italy by a Germany that is out only for its own advantage.

Even if Berlusconi loses, the strength of his support isn't going to make Merkel stronger in her own election position this fall, or incline Germany toward compromising its opposition to any relaxation of the austerity economics advocated by the country during the crisis.

Spain and Greece
The recent dose of bad news from Spain wasn't about economic growth—where past news has been grim enough—but about the country's banking system.

In Spain, the crisis has always been more about bad bank loans than the government budget deficit, and on that front the crisis continues to worsen. In November, the Bank of Spain reported, bad bank loans climbed to 11.4%, a new high, from 11.2% in October.

Although Spain continues to be able to borrow at reasonable rates, thanks to European Central Bank President Mario Draghi's promise to defend the euro at all costs, all but the strongest Spanish banks are still going to need even more support from the Spanish government. And with Spanish unemployment at 25%, it's hard to see how a lot of Spaniards currently teetering on the edge of default on their mortgages won't wind up going over that cliff.

And then there's Greece.

The latest report on Greece from the International Monetary Fund concludes, in my reading, that the current austerity program isn't working. Too many of the rich and the self-employed continue to evade taxes, and what the report characterizes as a bloated and unproductive state sector has been subject to only limited cost-cutting.

Greece faces a need for either higher tax revenue or further spending cuts to the tune of €5.5 billion ($7.25 billion) in 2015 and an additional €9.5 billion ($12.5 billion) in 2016, the IMF calculates. The European Union argues that the actual funding gap is smaller, but Europe's accountants don't disagree with the IMF's basic conclusion.

I'd carry the IMF's logic one step further: Greece will be unable or unwilling to close that gap, and the Eurozone will be asked for more money and another bailout. The sums, so far, are relatively small (although likely to increase as European economies slow in the next year or two).

But I don't think there's any more patience with funding Greece. That's especially the case when the IMF gives the critics of the bailout the ready-made argument that wealthy Greeks are cheating and the Greek government is a poor financial steward.

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Back to Square One?
So what happens now? How quickly do we approach a rerun of the Eurozone debt crisis?

The answer is not very quickly. Spain and Italy, the two economies with problems too big for the Eurozone's bailout funds to handle, have used the calm after Draghi's "whatever it takes" promise to pre-fund a good portion of their debt needs for 2013.

For example, on January 15, the Italian government sold €6 billion in 15-year bonds. That was the first time Italy has been able to sell 15-year bonds in more than two years, itself a sign of how far confidence has climbed.

And this brought total bond sales by the Italian government in 2013 to nearly 10% of its total funding need for the year. Ten percent in two weeks—that's a very good start for a year that will be challenging—though less so than 2012.

In 2013, it's now estimated that Italy will need to sell €186 billion in debt, a hefty sum but substantially less than the €235 billion sold in 2012. The Italian Treasury has been so encouraged by bond sales this year that it plans to offer 30-year bonds—when the time is right, according to Treasury sources. Italy hasn't been able to sell 30-year bonds in the market since September 2009.

The story in Spain is also positive, although less so than in Italy. Spain has to sell about 8% more debt in 2013 than it did in 2012—about €122 billion this year. So far, as with Italy, the Draghi promise has brought interest rates down and given Spain renewed access to the bond markets.

 Foreign investors who had shunned Spanish debt before Draghi's pledge have returned to buy Spanish debt. I wouldn't call foreign holdings of Spanish debt robust, but the level has rebounded from a summer low of 33.86% of total debt to 35.44% in November.

I think the good news on bond yields and bond sales from Italy and Spain—and from Portugal and Ireland, where those countries have said they hope to return to the bond markets as early as 2013—pushes a return to crisis further down the road. I think optimism about European sovereign debt has enough momentum to hold until summer.

3 Signals to Watch For
After that, the date on which the financial markets might see a return of the crisis depends on three things:

  • First, it hinges on the strength of a new Italian government after the February elections.

The goodwill that sustained even the minimal economic reforms that Mario Monti pushed through is largely gone. A weak coalition government will have a hard time convincing the European Central Bank or the International Monetary Fund that Italy's debt is under control. I don't think a weak Italian government will create an immediate negative reaction in the bond market, but it would be the start of a creeping unease.

  • Second, it depends partly on how quickly the finances of Spain's regional governments deteriorate in 2013.

Already, one-third of the planned €71 billion in new debt that Spain plans to issue in 2013 (the rest of next year's total consists of refinancing debt that matures) is headed to Madrid's bailout fund for regional governments. Yes, Spain's weaker banks are likely to need further bailout funding, but I think the market already understands that and that previous bailouts have put a structure in place.

Regional government debt raises much more troubling issues for the bond markets. We've already seen the beginnings of a battle over the subordination of this debt to Spanish national debt, with holders of existing regional debt protesting Madrid's efforts to make this debt junior to the national debt.

Regional debt has exposed the unsettled political questions about the relation of the central government to the regional governments. With Catalonia pushing for more autonomy, regional debt could be a flash point for a genuine constitutional crisis that would unnerve bond markets. I think Spain is the likely catalyst for any revival of the Eurozone debt crisis.

  • Third, it will be partly determined by whether Merkel can postpone any action likely to rile German voters until after fall elections.

She certainly will try. The idea of more money for Greece is extremely unpopular in Germany. So is anything that implies joint responsibility for debt. German—and, to a lesser degree, Finnish and Dutch—politics will severely limit what the Eurozone countries can do to head off a crisis.

I don't think this moves the return of the crisis closer to us in time, but it does suggest that any effect from a return to the crisis would be addressed slowly. (This is even more likely if, as now seems to be the case, the International Monetary Fund is having second thoughts about the effectiveness of austerity economics.)

Negative trends could well gain momentum. In a political vacuum, even more will depend on the European Central Bank. Draghi's promise to do whatever it takes to defend the euro might get tested.

Defending the Euro
This last factor is the one that most worries me, because it, unlike an actual deterioration in the budget deficits of Spain or Greece, has the potential to significantly weaken the market's faith in Draghi's promise.

I can see a political situation arising in Germany where the opposition of the German central bank, the Bundesbank, to further support for the troubled economies and banking systems of Italy and Spain and the rest of the Eurozone-crisis countries threatens Draghi's ability to deliver on his promise.

 And I can see a political situation arising in Germany where Merkel's position is so weakened that she can't push back against the Bundesbank. She would have to behave like the "Germany first" leader that so many in Europe fear—wrongly I think—she already is.

And that would change the game. If investors start to think that the European Central Bank doesn't guarantee the markets and that the solution to the crisis depends instead on European politicians, then I think we're looking at not only a replay of 2012 but also an escalation of the crisis to something that could significantly damage global financial assets.

I'd say the odds are against that very negative outcome. But I can't, unfortunately, rule it out.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.

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