The eurozone story has escalated. Forget about the PIIGS. It now all comes down to the FINS. And these will be critical for stock investors to monitor in the coming days and weeks to help determine whether the market will soar or crash.
The PIIGS, of course, is the acronym for the five eurozone economies that have been on the brink since the outbreak of the financial crisis several years ago. These include Portugal, Ireland, Italy, Greece and Spain. Until the past few months, the most severe sovereign debt risks had been confined to the much smaller economies in Portugal, Ireland and Greece. But starting in August, signs of extreme stress began to spread to the vastly larger nations of Italy and Spain. And in the last two weeks, the game has started to completely change altogether.
The focus of the problem has now spread in earnest to the very largest economies in the eurozone. These include the FINS – France, Italy, the Netherlands and Spain – that together make up 56% of the entire eurozone economy (Germany accounts for another 26% - thus these five economies constitute 82% of eurozone GDP). It’s not that Portugal, Ireland and Greece still don’t matter, as they make up 6% of eurozone GDP in their own right, but here’s the difference. The eurozone had the capacity to effectively absorb the debt problems in these three smaller economies if necessary. But a debt crisis among these larger FINS nations would almost certainly be too overwhelming and could ultimately lead to a uncontrollable banking crisis that brings down the entire euro currency altogether.
What is at the core of the problem? The primary holders of the sovereign debt of these countries are the major banks and financial institutions across the eurozone region. If countries began defaulting on their debt, banks would be forced to write down the value of this debt on their balance sheets. And given that capital levels are already thin at many institutions across the region, such write-downs may quickly place some banks at the risk of insolvency. This would likely lead to contagion effects, as banks would likely begin liquidating assets including the debt of other at risk sovereigns, which would compound the problem. At the same time, short-term liquidity markets would also likely seize up, as banks become increasingly cautious about providing money to other institutions under the concern that they may be on the brink of collapse and unable to repay the loan. Given the interconnectedness of the global banking system, this could quickly lead to a late 2008 style global crisis outcome.
Obviously, such an outcome would have a severely negative impact on the stock market. And recent stress has been evident. While the U.S. stock market is hanging in there for the moment at around 1,220 on the S&P 500, it is struggling mightily to hold this support level. This is why global leaders continue to remain engaged in aggressive monetary stimulus since the crisis began several years ago in order to prevent another 2008 style crisis from erupting again. This is likely the primary if not only reason that stocks have not already broken sharply lower by now.
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But one key factor differentiates the situation in 2008 from today’s crisis in Europe. In 2008, the problem was first a U.S. banking problem concentrated in mortgage loans. When the crisis struck, the U.S. government as well as other major sovereigns around the world had the capacity to step in and more than absorb the overall impact of the crisis. Thus, the sovereigns provided the backstop to the banking system in 2008. Fast forwarding to today, the problem is first a European sovereign problem that threatens to spread to the banks. Thus, if another banking crisis erupts, many sovereigns across Europe will not have the capacity to backstop their banks and stem the crisis. This is why the current problem in Europe could end up being much worse than the 2008 crisis.
Thus, the situation in Europe must be watched extremely closely by stock investors and markets in general as events unfold in the coming days, weeks and months. And this becomes increasingly true as the problems across the region continue to escalate.
In order to quantify the magnitude of the problem on a daily basis, the following are the four key indicators to watch. These are the 10-year government bond yields for France, Italy, the Netherlands and Spain. Direct links to each are provided below along with yield levels on selected dates. In short, if yields are rising, this indicates signs of increasing stress, as the cost for countries to finance their debt is increasing. And in the case of Italy and Spain, in particular, if yields rise above 7% or beyond for a prolonged period of time, this indicates that stress has elevated to unstable extremes.
July 22: 3.41%
August 8: 3.15%
October 4: 2.56%
November 18: 3.48%
France is no longer serving as a safe haven for investors. While German 10-Year Government Bond Yields have continued to decline to levels below 2%, the comparable yields in France have spiked sharply higher. This indicates that stress is spreading toward the higher quality core of the eurozone, which is a very bearish signal, as France is one of the countries that is being relied upon to help rescue the others.
July 22: 5.41%
August 8: 5.29%
October 4: 5.49%
November 18: 6.64%
Italy is under severe pressure at the moment. On several occasions in recent days, it has seen its bond yields spike well over 7%. While bond purchases by the European Central Bank have helped pull these yields back below the 7% threshold, this is not the first time that the ECB has intervened to bring Italy’s bond yields lower in recent months. Unfortunately, any past success by the ECB to contain the problem has proved temporary at best.
July 22: 3.17%
August 8: 2.69%
October 4: 2.13%
November 18: 2.51%
While the debt situation in the Netherlands remains relatively stable, it is worrisome that yields have begun to diverge from Germany and move higher in the past two weeks. A continued rise in these yields going forward would present yet another potentially brewing problem for the eurozone to overcome.
July 22: 5.77%
August 8: 5.16%
October 4: 5.10%
November 18: 6.38%
Until about two weeks ago, Spain was the PIIGS country in which investors could take comfort. Although Italy’s bond yields had spiked higher, Spain’s had remained under control. This is no longer the case, however, as Spanish yields have skyrocketed in the past two weeks and were flirting with 7% in recent days. If the fires burning in the Italian debt market weren’t bad enough, now the ECB has fires ranging on two fronts with Spain now in the mix.
The yields from the FINS provide a leading indicator for the market outlook. If yields become markedly better on a sustainable basis in these countries, attention can then revert back to the smaller PIG countries with problems that are more readily contained. Although more stock market turbulence could be expected along the way, such a shift lower in yields would be an overall bullish outcome for stocks. Conversely, if these yields continue to rise in the days and weeks ahead, the stress on European banks and the subsequent threat of a global financial contagion is likely to escalate. Stay closely tuned.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.