The European Sovereign Debt Crisis Continues ------ Market News Dec. 14, 2012

Europe's Sovereign Debt Crisis - Controlling Global Markets

Although US markets are down about 3% this week, European markets have been hurting much more, taking all markets on a wild roller coaster ride. Let's focus on a major market mover over the past months, the sovereign European debt crisis, and the policies that are being implemented to try to fix it.

Angela Merkel, Germany's chancellor and central banker, and French President, Nicolas Sarkozy, lobbied for euro zone members to open their budgets in order to deter the crisis. But what exactly does that mean? It means that they want countries to sign an intergovernmental treaty "to make it easier to force governments to balance their budgets and trigger automatic sanctions if they don't" (Latham).

They want to control how much countries are spending, borrowing, etc. so that this kind of debt crisis doesn't happen again. But this runs into two problems. First, who will be the European authority implementing strict budget oversight (will they really be able to say to a sovereign country, you can't spend more money?)? And, how will this treaty help the current European sovereign debt crisis in the short-run?

Simply, the leaders don't know who will be responsible for oversight, and the treaty does not solve the current crisis. In my opinion, this integration of oversight in budgets will only pose a greater political threat in the future, as the countries become too integrated. The countries that agree to the treaty will have to submit their budgets for central review and then may be asked to limit the deficits they can run. Last Friday, 23 countries said they were in favor of the treaty, while one straight out said no: Britain.

A Little History on European Monetary Union

I think Britain knows best, being one of the countries to stay out of the European Monetary Union (they are still on the Pound), they have avoided the structural problems of sharing a common currency with other EMU nations. While some of the goals of the euro in 1991 were to create lower transaction costs, to lower financial risks for independent countries, and to increase international cooperation (rather than wars), the EMU caused unforeseen consequences for its members such as the inability of one EU member, Greece, to repay what it has spent. In the past, countries such as Greece whose governments overspent, would be able to devalue their currency to pay back their debts more easily. Yet by giving up its own currency to join the euro, Greece gave up the power to increase its money supply since power over the euro is granted to the ECB.

While many money managers believe that there may be a partial break-up of the euro zone, I believe that it will stay together. First, there is so much "red tape"; there are many legal ramifications from members trying to leave that breaking up would be extremely complicated; in fact, it is illegal for a member to leave the zone. Secondly, it would be very difficult in terms of feasibility for  these countries to revert back to their old currencies. Third, countries leaving the euro zone could cause a global economic crisis much worse than the debt crisis we are experiencing now.

Furthermore, all of the countries have benefited greatly by sharing the same currency, especially Germany, the economic powerhouse of Europe. Instead, I believe reforms and new policies, similar to the open budget treaty, will be the next steps to be taken after the crisis.

Although the proposed treaty lifted European markets for a day, on hopes that this new treaty will spark an opening of credit to debtor nations, lowering the cost of borrowing (helping to spur growth), the market has been slumping as no short term solutions from EU leaders arise.

Additionally, with no help from the European Central Bank (ECB), stating that it will not buy up bonds to lower yields for the PIIGS (Portugal, Ireland, Italy, Germany, and Spain -- the countries with the largest debt problems), the costs for European countries to borrow has risen dramatically.

US Looks Better As Europe Looks Worse

While the economy in the US is looking better (especially during the holidays with the markets propped up on retail sales and dropping unemployment, although a closer look reveals this is because workers are leaving the workforce, not because of more job creation), Europe has shown no real solutions. The recent EU summit failed in resolving the euro zone's debt problems and Germany is urging now that the ECB not interact in the market to try and put off the debt problems by artificially bringing down the yields of PIIGS.

Opinion: Long US Large Cap Stocks and USD --> Short Europe

Because of the issues above, I believe that in the next few months there will be a large decline in European markets, and recommend being short the PIIGS, and even larger countries such as Germany. The S&P downgrade watch on the EU will especially play a major role, as it pushes the EU countries to get their acts together. I believe that the Euro will fall relative to the USD, as there is a flight to quality (safety), and that US markets will prove to be more attractive. Because we are so connected to the EU through international trade (although not too much) and debt, I recommend buying stable US stocks in the next few months, rather than speculative stocks, just in case Europe does go into a free-fall, bringing the rest of the world with it. As the Euro declines, market participants will search to invest in non-Euro denominated securities, and I believe this search will find its way to large cap US companies.