The year started with a monster rally stemming from the latest in a long stream of “fixes” to the eurozone’s crisis. But after one of the best first quarters in history, the second quarter proved to be a rude awakening.
Worries that Spain and Italy would require bailouts sent the yields of the sovereign bonds of both soaring. And the higher the yields went, the more skittish investors became about “risk on” assets such as equities and commodities. Investors legitimately feared that the eurozone would rip itself apart, and the fear of what that might mean led investors to sell first and ask questions later.
By mid-June, the S&P 500 had surrendered all of the gains of the first quarter before finishing the month strongly.
And what led to the strong finish? Why, Europe, of course.
On the eve of the last trading day of the second quarter, Europe’s leaders pulled an all-nighter to hash out the details in the latest latest fix to the ongoing sovereign debt crisis. And the markets liked what they heard. When the markets opened the next day, the S&P 500 rose 2.5%, and Spanish stocks rose more than 7%.
And what were the details that led investors to celebrate? In truth, it wasn’t so much the specific details (of which there were few) but an apparent change in attitude on the part of Germany. German Chancellor Angela Merkel seems to “get” that major German concessions will have to be made if the eurozone is to be saved.
Germany has been living under the delusion that all the eurozone’s problems could be solved by cutting government deficits, and inflation was the chief concern to prepare for.
Yes, inflation, as utterly absurd as that might sound. In the midst of what still could snowball into a deflationary, debt-loaded collapse, Germany is concerned that aggressively loosening monetary policy will cause consumer prices to rise. How Germany could stubbornly cling to this view for this long is beyond all comprehension.
In any event, there were a handful of specifics that sent “risk-on” assets into blast off mode:
- A bank bailout will be administered directly to the banks, bypassing the Spanish government. This is a major concession by Germany and fantastic news for Spain because the Spanish state will not be responsible for the debts and it keeps the country’s debt-to-GDP ratio at a manageable level (Ireland will be given similar treatment).
- The Spanish bank bailout will only come to pass after the creation of a eurozone banking regulator to be run by the European Central Bank. This too bodes well for financial stability, as this is the first (small) step in the creation of banking union. This was a necessary move to keep Germany and its northern allies pacified.
- The bailout funds would not get special seniority over existing private bondholders. This is important in convincing private bondholders that their interests are being protected and is a major concession by Germany.
Before we get too excited, we should remember that Spain’s original bank bailout earlier in June initially was met with applause. But after having time to dig into the details, the bond market found it wanting, and Spanish yields marched even higher. This has unfortunately been a recurring theme of eurozone summits.
Perhaps I am ever the optimist, but I have a little more faith this time. Germany has started making concessions that the country would not have made a month ago, and there is a growing consensus for a need to separate bank risk from sovereign risk, hence the decision to lend bailout funds to the banks directly and to create a single banking regulator for the eurozone.
Europe is close to having a solution in place, but more is needed. Other countries facing banking crises — such as the United States and United Kingdom — have the luxury of using their central banks as a lender of last resort. Finally — and after overcoming stiff German opposition — there is talk of using the European Central Bank in the same fashion. The banking union makes this far more plausible.
With all of this said, what should investors expect for the third and fourth quarters?
Because the summit failed to deliver anything quite as bold as, say, the U.S.’s TARP program of late 2008, I would not expect a rally in European stocks on par with the rally in U.S. stocks in 2009. But I most certainly do expect a rally, and I expect it to be substantial.
With bond yields likely to fall in Europe’s problem economies, I would expect Spanish, Italian and Irish stocks to enjoy the best returns. And within these markets, the most beaten-down sectors should see the biggest bounce.
Investors looking to ride a European re-flation rally can consider the iShares MSCI Spain (NYSE:EWP) and iShares MSCI Italy (NYSE:EWI) ETFs. Both have taken a beating in the first half of 2012, and I expect to see both do quite nicely in the second half.
Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. Sizemore Capital is long EWP. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”