Europe Isn’t Crisis-Free, But It’s Righting Itself

For now, the 'risk on' trade is back on

     

Is Europe’s crisis over? The short answer is “no,” Europe’s crisis is not over. But Thursday’s news was a major step in the right direction.

Europe’s leaders finally acknowledged what we all already knew: Greece is insolvent and cannot pay its outstanding debts. The country has reached the point where higher taxes and lower spending cannot balance the books; they instead cause the economy to contract, tax revenues to fall further, and the debt-to-GDP ratio to rise. Recent estimates had Greece’s debt-to-GDP ratio at nearly 170% of GDP, and with the country’s yawning budget deficit, that number was getting higher every month. It’s a vicious, ugly cycle with no other way out.

Greece had reached the point where its debt load was unsustainable and default was inevitable. The Europeans wisely chose to negotiate a large “voluntary” haircut of 50 percent between Greece and its bondholders rather than run the risk that Greece unilaterally decide to stop paying. It was not a popular move, and Europe’s leaders will no doubt take political heat for it from their electorates. But it was the only sensible move to make.

Although Greece will remain a problem for the EU for many years to come, its new debt load — at 120% of GDP — is sustainable, assuming the country continues to implement its reforms.

With all of the focus on Greece, it is easy to miss three other bits of news that arguably are far more important.

  1. Europe’s banks will be recapitalized. Under the deal, EU banks would be required to have core capital reserves of 9% after writing down the values of their sovereign debt holdings. This is critical to restoring confidence in the European banking sector; without healthy banks, a modern economy simply cannot function.
  2. The European Financial Stability Facility (a.k.a. the “bailout fund”) will be leveraged, giving it total firepower of approximately $1.4 trillion. This should allow for flexibility to stabilize larger EU problem children Italy and Spain.
  3. And perhaps most importantly of all, the European Central Bank will continue its bond purchase program. This should give a jolt of confidence to Spanish and Italian bondholders and prevent a potentially devastating surge in borrowing costs.

All of this bodes well for Europe and for global stock and commodity markets in general. Of course, all of this also hinges on Europe’s leaders overcoming skeptical electorates and delivering what they have promised. The behavior of Europe’s leaders throughout this two-year ordeal has been embarrassing, and it remains to be seen how well this grand bargain holds together.

If Greece — or Italy, for that matter — bows to popular pressure at home and fails to deliver on its promised reforms, or if the national governments are lax about the implementation of the bank recapitalizations, the entire deal could come apart.

But, for the time being, investors appear to like what they hear. The Dow rose by almost 340 points on the news, and some European markets rose by more than 5%.

It appears that the “risk on” trade is back. For investors, this means:

  1. Cyclical stock market sectors — and particularly banks — should outperform defensive sectors for the rest of 2011.
  2. Commodity prices — and particularly economically sensitive commodities such as crude oil and copper — should enjoy a nice rally.
  3. Gold — as much as I dislike it as a long-term investment — probably will drift higher as investors resume their preoccupation with inflation.
 
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