Wednesday, February 20, 2013

Uh, Oh - Looks Like Europe Could Get Ugly Again

Last June, when it seemed like the euro zone was about to collapse, European stock prices plunged. 

Valuations on many European companies hit historic lows, and the dividend yield advantage relative to government bonds of many well-known European stocks hit wides not seen in a century.

Collapse was averted, of course, helped by the resolve of the major European governments (mostly Germany) to make sure that the euro remained intact.

In addition, European Central Bank (ECB) head Draghi's announcement in July that the ECB would do "whatever it takes" to preserve the euro helped calm markets.

But while the markets were soothed, and prices on stocks rose sharply from their June lows, no one seriously believed that all of the fiscal and economic woes of many of the euro blocs weaker partners had been truly solved.

And now, it appears, risks have reappeared with a vengenace.

Here's what the German magazine Der Spiegel wrote yesterday:

It had become a trend among top European politicians to forecast that the worst of the euro crisis had passed. A pledge by the European Central Bank to buy up unlimited quantities of sovereign bonds as needed, promising numbers from Greece indicating that the country was finally getting its budget deficit under control and a reform-minded government in Rome -- 2012 seemed set to go down in history as the year the crisis lost its bite.

This week, the outlook is looking less rosy. And much of the pessimism is focused on the two countries long seen as potentially the most dangerous should the euro crisis grow: Spain and Italy.

The article goes on to note that there have been several large scale bankruptcies in Spain relating to real estate.  German and Spanish banks still have large loans outstanding in Spain based on real estate whose value has declined by 40% since 2007.

Then there's the election in Italy.  To the surprise of virtually all outside observers, former Prime Minister Berlusconi has become a viable candidate to regain the Prime Minister's seat in next week's elections.  Many austerity-weary Italians, it seems, are willing to overlook the economic stagnation and lurid scandals that marked the previous Berlusconi administration in return for a promise of better times ahead.

But a return of Berlusconi would be widely viewed as a disaster by many outside observers.  Here's Der Spiegel again:

Despite the troubles in Spain, however, it is Italy that has Europe -- and Berlin in particular -- holding its breath this month. The reason the country's general election scheduled to be held on Sunday and Monday -- and the real risk that former Prime Minister Silvio Berlusconi might actually win the vote.

Though public opinion polls are banned in the country for the two weeks prior to elections, the Italian media is reporting this week that the camp of center-left candidate Pier Luigi Bersani's lead over Berlusconi's coalition has shrunk to a mere 3.5 percent. And if Berlusconi returns to the helm, most expect that Rome will return to the abyss it found itself staring into at the end of 2011. Indeed, Italy's largest investment bank Mediobanca said this week that it believes a Berlusconi victory would trigger an investment market shock, ultimately leading to the need for an EU bailout of the debt-laden country.

Still, even if Berlusconi wins, the Economist notes that the Italian economy might yet revive:

The Italian economy still has strengths that could help restore its health. Its myriad small and medium-sized firms, especially in the north, are sometimes ill managed by family owners and always overregulated. They have suffered more than their German rivals from global competition, especially from China. But they still provide exports, and a manufacturing base that is stronger than those of Britain and France. Private debt is low and savings are high. The Monti government’s pension reforms are now looked to as a model by other countries in similar demographic straits.

 It would thus be wrong to conclude, as some pessimists do, that it is impossible to change Italy.... The authors of an IMF report published in January run through various previously proposed reforms in energy, transport, professional services, the judicial system and public services. They also suggest further labour-market reforms. If all these reforms were done at the same time, which magnifies their effect, the IMF reckons they could add some 5.7% to GDP in five years’ time and as much as 10.5% in ten years’. Throw fiscal reforms into the mix—a shift in taxation from direct taxes on labour to indirect taxes, and a switch of some public spending from unproductive transfers towards investment—and this number rises to as high as 21.9%. In a country used to no growth, an expansion of GDP by over a fifth would have a colossal effect.