The Blatt Watch by Peter Blatt: Should We Be Afraid of the European Front? In a Word, Yes

From the desk of Peter Blatt

May 15, 2012

Greece’s economic prospects, and those of its monetary partners, caused the US stocks and bonds to go up and down and up and down. Those were crazy days. We all knew that Greece couldn’t pay its bills.

So now that Europe’s leaders have “fessed up”, Greece has defaulted and the European banks holding worthless Greek paper have been protected…is the drama over?

Growth and Employment Prospects

Without economic growth, it’s hard to see Europe’s debt and deficit situation improving. Unfortunately, Eurozone GDP projections keep getting worse. Technically, their economy is in recession and worsening.

Even Germany reduced their 2012 GDP growth projection to 0.6% from 1.0%.

Employment is closely linked to economic growth, as with our own domestic recession and recovery demonstrates. Unemployment in those countries that use the Euro is rising. It currently stands at 10.8%, the highest level since the Euro was introduced. Spain leads (lags) the way with 23% unemployment.

Sovereign Debt (Bond) Yields

The cost of borrowing is the most worrying financial problem created by the excessive debt levels currently being carried by developed nations. The yields on sovereign debt is the yield those countries are paying on their bonds. Therefore, if bond yields rise, the repayments and deficits faced by these countries will also rise and will be multiplied by their excessive debt levels.

This vicious circle of rising deficits causing bond yields to rise was the major reasons for Greece defaulting. How can you continue to service debts with double digit interest rates?

Ten-year Spanish debt is climbing back near 6%, a psychological level beyond which their continued survival comes under the spotlight. Yields have been higher prior to last year’s bailouts, but they started the year closer to 4.5%, a rapid movement in the wrong direction.

Bottom line: Yields are still within their “safe zone”, but perhaps not for long. The trend is not promising by any means.

European Bailout Fund Levels

Just as the U.S. Government operated a relief fund for the emergency bailout of troubled financial institutions, Europe has a cash pile it can use to staunch any sudden financial bleeding. Last week, European ministers agreed to increase their permanent bailout fund to well over $1 trillion (€800 billion). Is this overkill, or precisely the necessary prep work for battles yet to come? Probably not overkill, I’m thinking!

Therefore, whilst we are enjoying the continued renaissance in U.S. equity indices, the dangers still lurk out there.

Until next time,