Is This Really An About-Face In The Euro Crisis?


[credit provider=”Reuben Whitehouse on Flickr” url=””]

The Athens Stock Exchange rallied an incredible 9.8% last week, and is up more than 5% today. Not to mention a dramatic reversal in the EUR/USD downward trend and incredible rallies we’ve seen across the board in European equities and increasingly positive consumer sentiment.What’s more, we’re hearing increasingly positive outlooks for Europe on the Street and economic indicators have been surprising expectations across the board.

Yet analysts remain cautious about the prospect of a lasting reversal, or even the idea that improving conditions in Europe are leading a reversal in non-European markets. Here are a few items to ponder looking forward.

Greek equities

The real head-scratcher seems to be coming out of Greece, where equities have been going nuts. While the reversal in stocks doesn’t appear as dramatic when one considers the fall of the Greek stock market since this time last year, it nonetheless demonstrates that investors are ignoring the generally negative headlines about the debt swap talks—a decoupling from the close relationship between markets and headlines that we saw at end 2011.

athens stock exchange 1 month
The Athens Stock Exchange has staged a major reversal in the last month.

[credit provider=”Bloomberg”]

Effect of the LTRO

A lot of this enthusiasm for equities—particularly for financial stocks—is coming in the wake of long-term refinancing operations by the European Central Bank last month. That would understandably put more faith in troubled peripheral banks, like those headquartered or highly exposed to Greece.

From Morgan Stanley’s Graham Secker today:

The improvement in market sentiment on Europe is more geared around the introduction of LTROs than growth, in our opinion, although we also highlight that the economic surprise index has been on a rising trend since early 4Q. In our base case assumption for 2012 we have always assumed a more aggressive approach from the ECB at some point…

But as this passage shows, these developments are less about the LTROs themselves than the prospect of further action by the ECB. The fact remains that nothing has really changed in Europe, regardless of investor sentiment.

Fundamental Risks And Growth

While LTROs do appear to be loosening credit conditions in the short run, they do nothing to change European fundamentals and exposure to sovereign risk in the long-term. Again, from Morgan Stanley:

Positive macro developments over the past two months have reduced the risk of negative tail events more than they have improved our base case assumptions. Extra liquidity is helpful, but equities should ultimately follow growth expectations…

From a European perspective, we think the probability of a somewhat ‘normal’ economic cycle is relatively low, given that the widespread deleveraging of the European government and financial sectors is likely to weigh heavily on growth. As we highlighted in our year-ahead report, we think the end of the debt supercycle in Europe makes Japan an increasingly valid comparison, and against that backdrop we should assume that fiscal austerity will meaningfully weigh on growth absent a strong offset from exports.

A Citi report released on January 20 mirrors this outlook, as analysts emphasise that their model—based on credit spreads, bank lending, M1 money supply, demand expectations, Swiss financial market expectations, and the OECD leading indicator—remains unchanged in supporting a bearish 2012 outlook.

citi gdp model europe

[credit provider=”Citigroup Global Markets”]

Should you trust the positive vibe?

Depending on how you see it, increasingly positive investor sentiment marks both a meaningful and a meaningless development. On one hand, investors are reassessing sovereign risk, something that has probably been mis-priced lately. Economists Paul De Grauwe and Yuemi Ji argue in VoxEU today that analysts have recently begun overpricing risks after a decade of discounting them altogether:

Since the start of the sovereign debt crisis they have been making errors in the other direction. In other words, they are now overestimating risks. Using a panel data model, we find evidence that a large part of the surge in the spreads of the periphery countries between 2010 and 2011 was disconnected from underlying increases in the debt-to-GDP ratios and current-account positions, and was the result of negative market sentiments, even panic, that became very strong starting at the end of 2010.

On the other hand, the recent positive change in investor sentiment is predicated on the prospect of future action, not necessarily the events on the ground. Because optimism is driven by hope and not fundamentals, it stands subject to sudden reversals. Looking forward, if EU leaders do not support talk of new, more activist steps to “fix” the problems that started the crisis when they meet in Brussels next week, we could see the end of this rosy outlook.