Eurozone Crisis: From Periphery To Core

Includes: ERO, FXE, UUP
by: Disruptive Investor

Mario Draghi, who succeeded Jean-Claude Trichet as President of the European Central Bank on 1 November 2011, tasted his first victory with the OMT program.

The new bond buying program, with an indefinite time frame has been used to buy time for eurozone countries in crisis (especially periphery economies). Mario Draghi's announcement to do whatever it takes to save the eurozone and the subsequent bond-buying plan has had an immediate impact on the government bond spreads for Spain and Italy.

The charts give the 10-year and 2-year yield differential between the government bond of Italy and Spain and Germany's bonds.

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The open-ended nature of the bond purchase program might ensure that yields for the PIIGS remains relatively low in the foreseeable future. Of course, this is subject the peripheral economies availing this aid package.

Further, the OMT program is a short-term fix to the problems. The political unity among the eurozone countries is still debatable and the critical aspect of having a common monetary and fiscal policy is still out of the picture.

The chart in real GDP per working age (15-64) person is reflective of the core problem in the eurozone, which is in no way addressed by the policymakers.

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However, the focus of this article is not on the sovereign debt problems faced by the peripheral economies. This article discusses the increasing concern of the growth, unemployment and debt contagion spreading to the core eurozone economy in the foreseeable future.

The biggest reason to be concerned is evident from the next chart, which gives the real GDP growth contribution coming from core and peripheral economies.

With the peripheral country's growth contribution being already negative, the real GDP growth contribution from core economies (Belgium, France, Germany and Netherlands) is also dwindling fast. Therefore, the resilient part of Europe is also heading toward a very likely contraction in the foreseeable future.

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Germany, in particular, deserves a mention as the country can be considered to be an important pillar, which is holding the eurozone together. For an export-oriented economy, the shrinking manufacturing PMI is a reason for concern. Further, a meaningful slowdown in China is likely to impact the German export market for relatively long.

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A slowdown can result in renewed efforts to boost economic growth through government spending. It is very likely that austerity will be thrown out of the door and the government debt continues to trend higher for peripheral as well as core eurozone economies.

The concerns will mount if global economic growth remains anemic for a relatively long time. I am of the opinion that growth will remain sluggish globally as the new easing measures announced by central bankers do little to boost real economic activity. The stimulus has been directed toward helping financial institutions, asset markets and governments struggling with the sovereign debt crisis.

Therefore, the problems in the eurozone are likely to escalate going forward with the spotlight being equally on the core economies than the peripheral economies. Policymakers in the euozone need to think beyond the current short-term fix and address the core problems in the eurozone.

From an investment perspective, the euro is a sell on any further rally while the eurozone banking system is a complete avoid. I am of the opinion that the dollar will continue to perform relatively well compared with the euro over the medium- to long-term. Also, the biggest problems and challenges for policymakers in the eurozone are yet to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.