Is Europe on the Mend?

Magnotta@AmyLMagnotta, CFA, Brinker Capital

We have spent so much time focusing on the U.S. fiscal cliff that the concerns regarding Europe seemed to have been pushed to the sideline. On the positive side there has been progress in Europe. Mario Draghi, head of the European Central Bank, can take some credit for the progress. The Financial Times even named him their Person of the Year.

The €1 trillion Long-Term Refinancing Operation (LTRO) put in place in late 2011 helped fund the banking system. In July, Draghi pledged to “do whatever it takes to preserve the euro.” His words were followed up by the ECB’s open-ended sovereign bond buying program called Outright Money Transactions (OMTs) designed to keep yields on Eurozone sovereign bonds in check. The next step could be establishing the ECB as the direct supervisor of the region’s banks.

Source: FactSet

Source: FactSet

These actions have brought down borrowing costs for problem countries such as Italy and Spain, helping to change the trajectory of the crisis and prevent an economic collapse. Yields on 10-Year Italian and Spanish bonds have fallen over 200 basis points to 4.4% and 5.2%, respectively. The Euro has also strengthened versus the U.S. dollar since July, from a low of 1.21 $/€ to 1.32 $/€ today.

Source: FactSet

Source: FactSet

I wonder how long this lull in volatility in the region can continue in the face of a weak growth in the region. Seven Eurozone countries fell into recession in 2012 — Greece, Portugal, Italy, Spain, Cyprus, Slovenia and Finland. The Greek economy experienced its 17th consecutive quarter of contraction, while Portugal completed its second year of recession. There remains a stark difference in the economic performance of Germany and the rest of the Eurozone. Unemployment rates are at very high levels and continue to increase. Youth unemployment is above 50% in both Greece and Spain, a recipe for social unrest.

The ECB’s actions have bought time for the Eurozone economies to get their sovereign debt problems under control. However, continued austerity measures implemented in an attempt to repair the debt crisis have only served to further weaken growth in the region and exacerbate the situation by pushing debt to GDP ratios even higher. While some confidence has been restored to the markets, policymakers should attempt to implement more pro-growth measures to pull the region out of recession.

12.28.12_Magnotta_Europe_ChartCombo

Europe’s equity markets have rebounded nicely in 2012, leading global equity markets on a relative basis since the second quarter; the rally helped by the ECB’s actions. I remain concerned that the ECB’s measures, while improving confidence, do not address the underlying problems of weak to negative economic growth combined with deleveraging. Weak growth in the region should weigh on corporate earnings and keep a ceiling on equity valuations. The deleveraging process takes years to work through. Because the situation remains fragile, we are likely still prone to event risk and periods of increased volatility in the region.

Source: FactSet

Source: FactSet

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