The main mover for the markets in Europe (and the rest of the world) over the past month has been the recent developments in the European sovereign debt crisis. It has caused volatility to remain high and severe political overhaul throughout the Eurozone. With only the 32nd largest economy in the world, the prospect of Greece defaulting does not spell a death knell for Europe.
However, the risk that a Greek default will lead to contagion of defaults of other heavily indebted countries such as Italy, Spain, and France along with the financial institutions holding their debt is what is dragging down the markets. Even though Italy passed significant austerity reforms over the weekend, the debt crisis is far from resolved as a lack of economic growth in Italy, Greece, Portugal, Spain, and France will erode any budgetary gains from these measures.
Going forward, the key question for the European debt crisis and financial markets as a whole is whether the European Central Bank will abandon its current mandate and print money. Monetizing the sovereign debt is the only way that to provide unlimited liquidity that is needed to keep Greece, Portugal, Italy, France, or any other country that is struggling to raise money. The EFSF experiment so far has been a failure as European leaders have been unable to convince foreign governments to support to fund and had to resort to buying their own debt. As a result, the only way Europe can realistically finance all of the continent's troubled sovereign debt will be through the debasement of the Euro.
If they do go the path of becoming the lender of last resort, equity markets will respond positively due to initial relief that the debt crisis is over and the in the long run inflationary pressure. The basic materials sector and companies with pricing power will be stocks that benefit the most. As for the Euro, it will fall overall, but can move either way versus the dollar as the speed of easing in the US may outpace Europe.
On the other hand, if the Germans remain resolute in their hawkish stance towards inflation, the markets will crash and European yields will skyrocket. Several European nations will be forced to default as they cannot realistically finance the debt through austerity measures or through EFSF financing. Equities will fall below October lows and the financial sector will be hit the hardest. However, the global economy will have a more resolute base to recover from after the debt damage versus the alternative of inflating away the debt.
Even though inflation may cause long term pain to EU citizens, it is the most likely outcome of the debt crisis. The reason is that because it helps politicians in two ways; it eliminates the need for further politically harmful and it also keeps banks solvent and delay the short term pain in the equity markets and macroeconomy caused by the bankruptcy of European financial institutions. The time to buy for investors will be when the ECB announces its full commitment to monetizing European debt. Until then, stay cautious as the market causes a lot more pain and possibly fall below the October lows before Germany backs down from its hard anti-inflation position.
Disclosure: I am short SPY.