Sunday, January 22, 2012

Europe Looks Better...For Now at Least

Developments relating to the European financial crisis have been the most important macro factor affecting global markets for many months.  For now, things seem to be looking up.

Last month, the European Central Bank (ECB) ended many weeks of indecision and halting measures by extending $630 billion to banks at a rate of only 1%.  The banks will repay the ECB in three years.  In the meantime, it is expected that the banks will use the money to buy bonds issued by European governments in the weeks to come.  Governments will need to issue approximately $1 trillion of bonds this year, to replace maturing bonds and to cover budget deficits.  This will provide support for the European bond market and provide an attractive "carry," or interest-rate spread to banks of about 5%.

So far it seems to be working.  This week, yields at bond auctions were significantly lower than at prior auctions.  The action of the ECB buys time for the banks, whose financial conditions are much worse than those in the U.S., and provides them with a source of profits to offset at least part of the diminished profitability resulting from shrinking their balance sheets by curtailing credit outstanding (and shoring up their capital positions).

This action by the ECB has the added appeal of not imposing further direct costs on (German) taxpayers or of making large direct purchases of government bonds.  As a result, the ECB has substantial capacity remaining for further measures if they are needed.

So far, the ECB has bought bonds in an amount equivalent to only about 2% of European GDP.  The U.S. Federal Reserve's intervention of bond buying has been about 11% of GDP, and in the U.K., purchases by the Bank of England amount to 13% of GDP.

With new governments in Italy and Greece, the ECB apparently relented and provided the substantial help that political leaders had been clamoring for.  But Europe is not past its problems.  Long term demographics are worse than in the U.S., and the debt consequences are grim.  In addition to the large existing debt obligations of the Eurozone, pension obligations amount to an estimated $39 trillion, which is five times the amount of gross outstanding debt.

Though conditions in the U.S. are on the upswing, banks in the U.S. and elsewhere still have considerable exposure to the European credit crisis, which is why I continue to be wary of investing in major bank stocks.  Small, regional banks (particularly in farm states) seem to be a better area of investigation.

Steve Lehman

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