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Markets remain highly sensitive to macroeconomic issues and move powerfully with every twist and turn that is the European Debt Drama (now completing its second season).
October saw the halt of a four month losing streak in global stock markets... and Europe remained the driver, with expectations a deal on Greek debt had been reached.
Providing the spark was news of an initial deal reached by France's President Sarkozy and Germany's Angela Merkel on Greece's debt problems. The deal involved European banks and other holders of Greek debt- including the Greek banking sector and public pension funds- taking a 50% cut in the face value of the debt. Next, the EU would fund a financing vehicle to recapitalize banks and to support the sovereign debt of at-risk European countries. In return Greece would implement significant structural changes, which translates to raising taxes and kicking people off the public payroll. Good feelings didn't last long as Greek Prime Minister Papandreou announced he would bring the deal to his people via referendum- a bid to gain a public mandate. This caused an immediate backlash from Greek and other European leaders and a sell-off in world markets, particularly Italian government bonds. Incidentally, it's far more predictably European to tell citizens what they will get, not ask them if they want it.
The chart below illustrates yields on Italian government bonds, which didn't come in much on the initial Greek announcement but moved toward record highs in late October/early November under threat of referendum. This is notable and extremely dangerous for the Europeans because it appeared investors were abandoning Italy, a country too large to bail out.
The chart below shows how expensive an Italian bailout would be. The size of each bubble indicates relative GDP for Spain, Portugal, Italy and Greece. Italian GDP is larger than the three other countries... combined.
Italy's accumulated debt load is second only to Greece's but the Italians run a much smaller annual budget deficit. For this reason, Italy has come under intense pressure from its neighbors to decrease their debt, resulting in the resignation of Prime Minister Berlusconi. The installation of technocratic governments in Greece and Italy in the last week stopped the panic in stock markets but has not calmed bond markets as yields in the periphery European countries remain near highs.
In the U.S. there is less talk of a recession starting in the fourth quarter as the most recent GDP report showed 2.5% annualized growth and economic data has remained steady, albeit at depressed levels. To pick two coincident indicators, here are the charts of initial unemployment claims and retail chain store sales (via Retail Sails) year to date: both show a similar story in that the data seem 'range bound' but certainly not 'recession' bound...
Looking ahead, markets will continue to react to the European sovereign debt situation. Until investors are assured European banks will be able to survive much needed sovereign restructuring and realignment, there will be a risk of financial contagion resembling the crisis in 2008. The upside: Europeans get through this crisis, leaving themselves in better fiscal condition and unleashing demand pent up during a slow recovery in the developed world.
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