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Earlier this week, I noted that very elevated Italian and Spanish bond yields remain a short-term risk for both the European and global economies. Several other major European-related risks also continue to threaten markets.

1.) In the short-term, a key risk remains European banks. While bank funding needs have been addressed by European leaders, capital adequacy still is an issue. For example, the capital shortfall for German banks is estimated to be 13.1 billion euros, up from 5.2 billion in October. In the absence of new capital - from either private investors or the sovereigns - we are likely to continue to see deleveraging by the banks. This will keep pressure on financial assets and raises the likelihood of a prolonged European recession.

2.) A broader risk remains in the form of the interplay between economic policy and domestic politics. In efforts to solve Europe’s sovereign debt problems, domestic political considerations have too often trumped economics. We had further evidence of that last week. Under pressure from his Tory party to extract concessions regarding European banking regulations, David Cameron vetoed the proposed European Union treaty. This leaves EU countries uncertain as to whether they can use EU institutions, such as the European Court of Justice, to enforce new budget constraints.

These types of domestic political calculations are likely to continue, and in particular, I would watch Italy. Portugal, Spain and Ireland have all recently had elections and obtained at least a nominal mandate for reform. But Italy hasn’t gone through an election, and it’s not clear if the existing technocrat government will have the political base to impose painful structural reforms.

Given this landscape, what developments should investors keep an eye on in the coming weeks, and what does this all mean for global asset markets?

From a monetary perspective, the critical deliverable continues to be a plan from the European Central Bank to maintain, and expand, its bond purchasing program. Going forward, policy choices will also be critical. The many flaws in the design of the European Union can’t be addressed in the next three to six months. But policy makers - particularly in the northern European countries - could alleviate some of the stress by combining long-term structural reforms with short-term stimulus.

Addressing European fiscal issues would be easier in the context of a global expansion, even a weak one. To that end, investors should watch this week’s discussions in Washington regarding the extension of long-term unemployment benefits and the payroll tax holiday. Short-term stimulus could help to prop up a fragile U.S. consumer.

Finally, I would place the odds of a European meltdown - like a disorderly default, collapse of the European Union or a sovereign banking crisis - over the next six to 12 months at around 25%. That is lower than the 35% odds I’ve put on chances for a global recession, although I do believe Europe will experience at least a mild recession next year.

As I mention in my recent Market Update piece, assuming a European meltdown doesn’t happen, global equities look cheap compared to leading economic indicators and compared to sovereign debt. The same argument holds for corporate credit as well. In fact, the main reason that stocks and corporate credit currently appear so inexpensive is arguably the prospect for a meltdown in Europe.

Disclosure: Author is long EWG, EWN and LQD.

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Source: The European Overhang And Odds Of A Meltdown