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Assessing European Debt Concerns

11/28/2010

Once again, concerns emanating from the euro zone are front and center for investors. The debt crisis which began in Greece has been a challenge to the market throughout 2010.

Currently, Ireland faces an immediate need for EU and IMF financial assistance in the amount of somewhere around $100 to $125 billion. On Wednesday, November 24, an austerity plan was announced by Ireland.  Believe it or not, my main concern was that the plan would unfortunately raise the corporate tax rate above 12.5%.  The attractiveness of the Irish economy is its very favorable corporate tax rate.  Hewlett Packard (HPQ) mentioned their concern regarding investments in Ireland, if the rate was raised, on their conference call this week. Smartly, the Irish austerity plan maintains the corporate tax @ 12.5% alleviating one of the biggest concerns.  Maintaining the current corporate tax rate is necessary to battle the unemployment crisis in Ireland. The unemployment rate (Fig1 below) has risen from 4.80% in February 2008 to 13.60% currently.  

The price of select European Sovereign Credit Default Swaps (CDS) suggests that the debt contagion will spread next to Portugal and to Spain. The fear that is warranted involves Spain, which is a much larger economy than Greece, Ireland, or Portugal and would be of "systemic risk" to the euro zone. Germany and France are Spain's largest creditors.

However, Germany and France also represent 35% of Spain's export destinations.  That is favorable, as the economic data suggests a sustained recovery is well under way in both those nations.  French consumer confidence (Fig 2 below) came in strong this week, while the IFO German Business Confidence (Fig 3 below) recorded an all-time high.  Germany's 2010 GDP is remarkably strong, slightly under 4%.

There are significant challenges ahead for Spain.  That is reflected in the uncomfortable pricing of its 5 year CDS above 300.00.  The 10 year government bond yield continues to rise, now above 5.10%.  In the near term I believe there will be continued risks that are reflected in further uncomfortable CDS pricing and rising European government bond yields.  Those risks may also place the euro currency (Figure 4) under selling pressure and support the U.S. dollar as a safe haven asset once again.  Ultimately though, I do not believe Spain will need EU / IMF financial support, a bailout.    

Thursday, December 2 sets up to be an important day across the pond.  Q3 GDP figures for the euro zone will be released and European Central Bank (ECB) will also meet. ECB Council member Axel Weber has attempted to calm the debt markets by stating that, if necessary, the European Union bailout fund size can be increased beyond the current $750 billion. Internally, the conversation at next week's ECB meeting will probably center on the divide between strong EU economies and weaker EU economies. The stronger economies run the inflation risk if the current stimulus remains in place too long. The weaker economies run solvency risks if the current stimulus is withdrawn too quickly. For me that is the real conundrum challenging the EU.

Ireland Unemployment Rate (Fig 1)

Source: Bloomberg


France Consumer Confidence (Fig 2)

Source: Bloomberg

IFO German Business Confidence (Fig 3)

Source: Bloomberg

Spot Euro Currency (Fig 4)

Source: Bloomberg

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