Every time a crisis breaks out, it is usually contained by half measures and a period of calm surfaces. This leads financial markets to temporarily focus their attention elsewhere. This also leaves politicians less pressured to take decisions and pretend that the crisis has been averted. But as fundamental problems continue to exist, the crisis usually returns showing the weakness on the measures taken previously.
This has happened in Europe over the last few months, specifically after the European Central Bank (ECB) President Mario Draghi's comments last summer, in which he promised to do whatever was necessary to save the euro (FXE). Indeed, Europe's debt crisis was almost forgotten over the last few months, leading to a general feeling among investors that the worst is behind us. However, this improved confidence was mainly due to the creation of ECB's Outright Monetary Transactions (OMT) program, in which the ECB stands ready to buy short-term debt of those countries that ask for help.
Indeed, this program has been very successful by its mere threat of action, despite its clear lack of rigorous criteria on which basis governments can ask for help and what will be the requirements imposed on them. This shows that probably it was designed to exist on paper, but not to necessarily take action. However, despite its flaws, its short-term market effect does make sense, because it makes highly unlikely that weak countries will lose investors' confidence due to a country's excessive debt or from a possible exit from the eurozone.
This ECB plan substantially suppressed interest rates in the weak European countries, like Spain, Italy, Ireland or Portugal. Even Greece, that is obviously bankrupt, saw its bond yields contract over the last few months. The equity markets also performed very well, with Spain (NYSEARCA:EWP) up 19% since the end of July, and Italy (NYSEARCA:EWI) rose by more than 20%.
Understandably, the crisis in Europe seemed to be a theme of the past, and existed a high level of complacency among investors. For instance, Portugal was recently able to attract a lot of interest from debt investors in its return to debt capital markets (€12 billion in orders for a €2.5 billion bond amount), despite its economic and financial fundamentals being worse than before. Portugal received a bailout in 2011, as I analyzed in my previous article "Does Austerity Work?". This obviously doesn't make much sense, but with the ECB standing behind, the risk of loss seems limited and investors are desperately buying high-yield assets, such as Portuguese bonds, in a near zero interest-rates world despite its risks.
Important policy steps have been taken over the past couple of years to reduce fears about an eventual break-up of the eurozone, with the ECB's OMT program as one of the most important ones. However, it may not be enough to solve Europe's fundamental woes. Although financial conditions have improved considerably over the last few months, if not supported by a stronger economic outlook, the sustainability of this rally on European peripheral assets should start to be questioned.
The improvement in investors' confidence and the rally of riskier assets setting in around the second half of 2012, was not driven by better fundamental data given the rather anemic growth in most developed countries. Indeed, during this period, Europe returned to recession and the most recent data continue to show contraction for the following months. Far too few structural measures were taken in Europe to improve the economic outlook, so growth will probably remain too low for the country's being able to reduce budget deficits sufficiently.
Furthermore, it is worrying that governments in the periphery are showing more decisiveness in raising taxes than cutting expenditures. Higher taxes are lowering the growth outlook, which should lead to lower tax revenues, worse public finances, and higher debt levels. This, over the long term, contributes strongly to interest rates remaining considerably higher in those countries, given their lower debt sustainability. Over the last few months, despite the weak economic developments, interest rates have declined considerably in European peripheral countries, showing a clear disconnect between asset prices and fundamentals. When investors start to realize this, together with the fact that negotiations on a fiscal and banking union remain in a standstill, tensions will probably rise again in Europe.
Over the last few years, politicians only seem to take action when are they are under pressure from financial markets. The latest evidence of this was the last months' Eurogroup meeting that ended, again, with no new announcement on the banking union or supervision, and not much on the way the ESM will work. Much was promised on banking union, but it appears that little will be delivered this year. Progress on direct recapitalization of banks, a deposit guarantee scheme and a bank resolution process seems far away.
Despite the apparent stability in Europe, investors should expect that the bond vigilantes will return to pressure politicians to take more steps in order to complete the European project, with the fiscal union being the ultimate solution. Until that happens, expect more periods of uncertainty and volatility ahead.
Presently, several risk factors could be the spark to a new period of market stress, such as the Italian and German elections, or the financial sustainability in Greece or Cyprus. Moreover, the economic background in Spain continues to be very weak, and the recent scandal towards government officials could be the next catalyst for more turmoil in Europe. If this plays out rapidly, expect volatility to increase substantially. A long position on VIX ETF's, such as the Proshares VIX Short-Term Futures (NYSEARCA:VIXY), may be a good hedge for equity portfolios.
Disclosure: I am short FXE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.