The Euro Recession?

by: Russ Koesterich, CFA

On Monday, stocks and the euro rose as efforts heated up on several fronts to help ease Europe’s sovereign debt crisis. According to a Reuters report, Germany and France increased a drive for coercive powers to reject euro zone members’ budgets that breach EU rules, while a rout of European debt eased on hopes of outside help for Italy and Spain.

This follows some hopeful signs that have emerged in Europe in the past month. Governments in Greece, Italy, and Spain have fallen, replaced in the former two countries by technocratic governments and in Spain by a center-right coalition that won the largest mandate in 30 years. Arguably, all of these developments represent some progress as greater consensus should make it easier to pursue the necessary fiscal and structural reforms.

Despite this progress, there are signs that the continent is heading toward a recession. A general erosion in confidence coupled with an ongoing deleveraging by the European banks are raising the odds that Europe will experience at least a mild downturn in 2012. For many investors one to two quarters of negative growth now represents the best case scenario for Europe.

Source Bloomberg 11/22/2011

Meanwhile, bond investors are rapidly losing patience as they know that implementing necessary reforms will not happen overnight. If they abandon these markets while the reforms are being implemented, borrowing costs surge and solvent countries like Spain and Italy become at risk.

The original solution to this dilemma was to have the European Financial Stability Fund (EFSF) act as a backstop, i.e. buy the bonds, while reforms are implemented. But it has become painfully apparent that the EFSF lacks the necessary firepower.

It appears that the only entity with sufficient purchasing power to halt the slide in European sovereign debt markets is the European Central Bank (ECB). Unfortunately, both the ECB and Germany have argued against expanding their existing bond purchase program beyond its current, limited parameters.

On Monday, the Organization for Economic Cooperation and Development urged the ECB to act to prevent the euro-zone sovereign debt crisis from deepening, but the ECB has shown no sign of doing so yet.

As I’ve said before, if a politically acceptable solution is not found, Europe risks turning a liquidity problem for smaller peripheral countries into a solvency problem that infects most of the continent.

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