Blowout Black Friday retail sales sent stocks higher on Monday by nearly 3 percent on light volume, reversing a seven-day stock losing streak. Bond markets in Italy and Spain were the key negative culprits as yields on both countries’ debt breached the dangerous 7 percent level – crippling funding costs that previously pushed both Ireland and Greece into seeking bailout packages. The markets clearly sense that the size of Europe’s revised rescue fund is still inadequate to address the region’s dual sovereign debt and banking crises. Contagion has now reached the core of Europe. Optimistic policy statements out of Europe have been able to consistently generate rallies for 18 months, but I sense that this time we really are at the end game and painful specifics will finally be required.
With the heat turned up, Germany’s Chancellor Angela Merkel tried to thread the needle – talking in grand, but very vague terms about the economic and political benefits of European federalism while putting the brakes on the notion of joint Eurobonds (which would “mutualize” the Eurozone’s debts). She also pushed back against the notion of expanding the role of the European Central Bank (ECB) as “lender of last resort,” citing inflation concerns.
Germany’s constitutional court has warned Merkel that any further integration would likely overstep German law, and her own Christian Democratic Union (CDU) party appears to finally be suffering from bailout fatigue – to say nothing of the German people, who answered the call for sacrifice under Merkel’s predecessor, Helmut Kohl, only to feel betrayed by southern European profligacy. Merkel has back-tracked on hardline stances several times in the past, however, and there is enormous pressure on the Germans to save the Eurozone.
The good news is that meaningful political and labor market reforms finally have at least a fighting chance in Italy and Spain. Silvio Berlusconi and his clownish fourth government are finally gone from the stage in Italy, replaced by technocrat and finance expert, Mario Monti. Monti quickly surrounded himself with a cadre of capable academics and financiers. Whether Monti possesses the requisite political skills to negotiate byzantine Italian politics has yet to be seen. Berlusconi’s Northern League still controls the upper-house of Italian politics after all. But the bond market distress seems to have given Monti the brief leverage to push for unpopular measures.
Spain’s Socialist Prime Minister, Jose Luis Zapatero, is also out after seven-plus years, replaced by the center-right People’s Party (PP) candidate, Mariano Rajoy. You may recall that Jose Maria Aznar, a close ally of George W. Bush in the war against terror, was the previous PP leader. Zapatero was inexcusably slow to acknowledge that Spain’s banking sector was awash in bad construction loans.
Both Monti and Rajoy have mandates for reform, and austerity in Ireland seems to be showing signs of real progress. Leaders in Spain and Italy are both now essentially saying, “We are getting our house in order. Just give us a little breathing room by helping to bring yields down.” I would watch for Merkel to attempt to sell the German people on a temporary or emergency expansion of the ECB’s powers and of the leveraged firepower/first loss guarantees of the proposed European Financial Stability Facility (EFSF) bailout fund – in exchange for much stronger governance and control over Europe’s national finances.
Instead of buying the bonds of Greece, Italy, etc. in the secondary market, the EFSF could provide insurance guarantees (up to perhaps 30 percent) to make the debt more attractive to investors, or the EFSF may issue its own bonds through a special purpose vehicle (borrowing at a lower rate) to then purchase troubling sovereign debt or issue more insurance. In either scenario, it would enable European authorities to do more with less through “leverage.”
The ball is in the Germans’ court. We need to keep a close eye on the make-or-break December 9 summit of Europe’s leaders to see if a “new, radically transformed Europe” can emerge. I will also be watching the U.S. jobs report on Friday, always the most important economic release of the month, and also to see if the S&P 500 can regain its technically important 50-day moving average around 1205.
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