Even with short-term fixes, European future bleak

June 14, 2012 - 4:16 PM
Of Mutual Interest -Europe

This undated photo shows James Swanson, chief investment strategist with MFS Investment Management, a Boston-based mutual fund company and asset manager. Europe's on-again, off-again progress in tackling its debt problems has kept U.S. investors on edge for the better part of two-and-a-half years. It seems like this ride should be over by now, but risks continue to grow. (AP Photo/MFS Investment Management)

BOSTON (AP) — Europe's on-again, off-again progress in tackling its debt problems has kept U.S. investors on edge for the better part of two-and-a-half years. It seems like this ride should be over by now, but it isn't. Risks continue to grow.

An election in Greece on Sunday could be a turning point in the crisis. A newly popular leftist political party wants to renegotiate or scrap austerity measures agreed to as part of Greece's bailout. If it wins, that could lead to Greece's exit from the group of 17 countries that use the euro.

Investors' fears are also focused on a much larger country due west of Greece: Spain.

European leaders agreed last weekend to bail out Spanish banks reeling from a real estate bust, but the relief was only temporary. A stock market rally lasted just a few hours as investors balked at the lack of detail in the program. Also, the deal leaves Spain's government with the responsibility to repay the banks' rescue loans, and it's hardly in a strong position to take on more debt as it presides over a shrinking economy.

Escalating worries about Spain's finances led bond investors to demand higher interest rates on the country's bonds. Spain's borrowing costs this week jumped to the highest level since the country joined the euro in 1999. The yield on its 10-year bond spiked close to 7 percent. That's the level that led Greece, Ireland and Portugal to seek financial rescues from their European neighbors. Yields on Italy's debt are also surging.

Expect borrowing costs to rise further for Italy and Spain if Greece drops the euro and resurrects the drachma as its currency. Much is at stake, because their economies are the third- and fourth-largest among eurozone nations, while Greece is one of the smallest. The crisis has even spread to Cyprus, whose finance minister warned this week that his tiny Mediterranean country may become the fifth to ask for European Union bailout money.

The European debt crisis is expected to be a key agenda item at a summit of leaders from the Group of 20 major economies, who meet Monday and Tuesday in Mexico. European Union leaders hold their own summit the following week.

The crisis is a big concern in the U.S. because Europe is a key trading partner. American banks also have close ties with European financial institutions.

If the crisis still seems remote, check the recent hit that your investment portfolio may have taken. Growing risks in Europe are a key reason why a U.S. stock rally petered out more than two months ago. The Standard & Poor's 500 index is down more than 6 percent since April 2.

Money managers are watching closely. Below are outlooks from veteran market strategists on opposite sides of the Atlantic Ocean.

Alan Brown is a senior adviser and former chief investment officer with Schroders PLC, a London-based manager of $319 billion, including eight U.S. mutual funds. He's been a European market specialist for 12 years. James Swanson is chief investment strategist for MFS Investment Management, a Boston-based mutual fund company and manager of nearly $268 billion.

Here are comments made this week, from Brown in an interview, and from Swanson in a call with journalists. Comments are condensed and edited for clarity.

ALAN BROWN:

It's clear after the market reaction to last weekend's bailout of Spanish banks that the short-term fixes are becoming more short-term in nature. Every time we kick the can down the road, we seem to be able to kick it a shorter and shorter distance. The rally from the news about the Spanish bailout lasted less than a day. And the rise this week in Spanish bond yields is extremely worrying.

Another short-term worry is the money that people have recently taken out of Spanish and Greek banks. They're putting it into other countries: Germany, the Netherlands, and Switzerland. That way, there's no likelihood that people will wake up the next morning, and see that their euros have been converted into (Spanish) pesetas or (Greek) drachmas.

The more that's withdrawn from Greek and Spanish banks, the less the European Central Bank is prepared to lend to them without restrictions. And then, you eventually end up with a ghastly credit crunch, and it's kind of, 'Game over.'

I'm on the pessimistic side compared with most people. But if Europe can continue to muddle through this crisis, the recession in Europe would not be enough to derail the growth in the U.S. at all. But if we had a contagion where Greece leaves the euro zone, and the dominoes start falling, and Spain and Italy also leave the euro, then we would all be in for a very, very difficult time.

The saying now on this side of the Atlantic is, 'The only people who can get Obama re-elected are the Republicans. And the only people who can stop him from getting re-elected are the Europeans, by destroying the world economy.'

JAMES SWANSON:

The euro zone countries have responded to the crisis with a series of partial measures that have been enough to hold the eurozone and the banks together. These crises will continue to haunt us. But in the meantime, Europeans are living through a garden-variety recession, not as bad as the 2008 recession. It should last two more quarters, at the most three quarters.

If Europe's sovereign governments did default, and you assume a 50 percent loss rate, the losses would be around one-third to 40 percent of the losses that the housing crisis imposed on the U.S. economy. The magnitude of the losses is different, and the knowability of the losses are different. We know where the losses are. They're in the banks, and money-market funds around the world.

If the Europeans hold on — and we think they will — the outlook is to exit recession after two or three more quarters, and then have a mild recovery. But they can't have a robust recovery until their chronic problem with high labor costs is solved.

It's the number one problem, and the reason why Europe has been losing its share of global export markets for years. Those costs continue to rise much faster than in competitive areas, including the U.S. and Asia.

Overall, none of the actions in Europe suggest a permanent solution. The solution is to grow your way out of the debt problem. But you need to be competitive, and they're not.

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