HOLDING NO STOCK IN EURO DELIVERANCE
INVESTOR sentiment has turned decidedly bearish over the past week. As usual, the primary concern is the slow motion train wreck that is the European debt crisis. This means that Eurozone sovereign bond yields remain in focus, with the spreads of Spanish, Italian and even French debt over German bunds under intense scrutiny.
Once again, it is equities that are playing catch-up, as bond markets have been pricing in doubts about sovereign solvency for months now. Stock market investors have used every sell-off as a buying opportunity. This is particularly evident in the US, where, until recently, equities have held up better than their European counterparts. A recent improvement in US economic data (housing, unemployment, retail sales, producer prices and manufacturing numbers among others) has convinced many that the fears of a global recession, so prevalent this summer, were overdone.
There is also a popular opinion that the US economy has decoupled from Europe, while US banks have minimal exposure to the Eurozone, and in any case are far less leveraged. This theory is about to get tested. However, for years now investors in US equities have been able to draw comfort from the readiness of the Federal Reserve to step in and provide liquidity whenever the stock market looked vulnerable. This has led a number of observers to suggest that ensuring price stability and maximum employment (the Fed’s dual mandate) should be extended to include supporting equities at any cost.
Now the European Central Bank (ECB) is coming under increasing pressure to do something similar. There are constant calls for it to step up and start printing to monetise sovereign and banking debt. Germany is the principal objector, as the cost of such action is estimated to be anything from €2 to €6 trillion (£1.7 to £5.2 trillion). The Bundesbank is also concerned that bailouts provide only temporary relief and encourage profligate countries to put off making the painful fiscal adjustments necessary to bring their budget deficits under control. The alternative would seem to be some sort of Eurozone break-up.
If past experience is any indication of what we can expect in the future, Eurozone policymakers will fail to act decisively until they run out of choices. This severely weakens the odds on a year-end equity market rally.