Thursday morning, October 27, global markets awoke to an equities rally fueled by the appearance of European fiscal and monetary unity. I have long stated “all for one, one for all” as the ultimate goal and challenge for the European Union. Recent developments have taught us that achieving monetary unity is much easier than achieving fiscal unity. This week, European policy makers traced out a plan for an attempt at fiscal unity.
Just as the final season of your favorite television series tempts you to return each week, waiting for the grand finale, Europe has successfully enticed investors to keep coming back. Hopefully, the European finale will not just “fade to black” as did “The Sopranos.” However, I have to believe that along the way some characters will be lost (Greece? Portugal?), which is okay as long as it is not a main character such as Italy, or, even worse, Spain.
The headline news is that Europe has bought more time, and the recent European flare-up will not be enough to derail global markets. October has been a historic month for equities and confirmed that the comparisons to 2008 were incorrect. It appears the floor for the S&P 500® Index has been raised. The next move is to raise the roof beyond 1325 – a difficult task as the 2011 calendar is quickly running out. I suspect the December 31, 2010 closing price of 1257.64 to 1325 has a high likelihood of being the center of gravity through year end.
Over the next few months, I will be watching the following from Europe; I suggest investors do the same:
• On November 1, Mario Draghi replaces Jean-Claude Trichet as president of the ECB. I expect Draghi will be far more willing to continue the process of ECB sovereign debt purchases. Trichet’s legacy was his hawkishness, and in the final days of his ECB presidency, that hawkishness was an obstacle for risk asset appreciation.
• Italian bond yields – the 10-year yield rose in early August above 6%. In the days that followed, the ECB purchased Italian debt to suppress yields. That worked for a few weeks, with yields below 5%. Now as yields rise back toward 6%, there must be a willingness for the ECB, private investors, and others to suppress yields again (Figure 1.1).
• Greece, in my opinion, has defaulted already, and the market should fear contagion risk into Italy, Europe’s third largest economy, or Spain. I expect enough was done to provide a ring fence.
• The end of the Silvio Berlusconi administration is coming – a favorable condition for the capital markets and European fiscal unity.
• The plan to have banks hold 9% in core reserves after debt write-downs will be enough. The bank recapitalization plan is the easiest and the least of investors’ concerns.
• Finally the ultimate mechanism to eliminate this crisis, not just neutralize it, will be to cure the disease via GROWTH. Europe has been treating the symptoms. If growth returns to the region, most importantly, to Germany, which matters most (Figure 1.2), Europe will grow its way out of the crisis. Growth cures all . . . .
Figure 1.1 Italian 10-Year Government Bond, Year To Date
Figure 1.2 Germany GDP, September 2008 to Present