The Eurozone and Investor Confidence: What’s the connection?

Volatility and uncertainty in Europe persist. How sensitive are investors to the European situation? When the troubles of a nation that makes up only 0.2% of Eurozone output is blamed for downward movement of the U.S. stock market, that’s a sign of tremendous sensitivity. More on that country and why it has made investors skittish later, but first let’s look at current state of Europe and especially those nations that use the Euro currency (commonly called the Eurozone).

There are two interrelated issues we need to consider when evaluating the European situation: the state of the economy, as well as the severe financial pressure brought on by the enormous debt obligations of governments. This is the vicious circle that Eurozone countries find themselves in: there is a need to reduce government spending in order to improve the debt obligations, and this reduced spending weakens the economy. The weakened economy reduces tax receipts, and the reduced tax receipts make it more difficult to pay the debt obligations they were seeking to reduce. This not only keeps the debt obligations high, it also makes investors demand a higher interest rate on the debt, which makes it more difficult for the country to afford the payments. In the end, the real fear is that governments will default on their bonds and that these defaults will have a fatal effect on the banks that own the bonds. The banks going under would then have a domino effect and cause more and more banks to become insolvent. Because the consequence could be disastrous, even a small move toward that scenario has a large impact on investor confidence.

So, what is the current state of the Eurozone? The Eurozone as a whole has entered another recession after a short period of meager growth coming out of the global financial crisis.  The combined economic output of the 17 countries that make up the Eurozone shrank by 0.6% in 2012 and is projected to lose another 0.3% this year. Unemployment has been steadily increasing and is now at an alarming 11.9%.  In summary, the economy is not in great shape, but, to date, it is still your typical garden-variety recession—not a sign of Armageddon.

On a slightly better note, the debt side of the equation has been showing some improvement. The countries on the periphery that have been under the most stress are showing some improvement in their account deficits. In a normal situation, the financial condition of a country would have led to a weaker currency, thereby supporting export growth and foreign investment. But because these countries share a currency and such devaluation is not possible, other market forces must ultimately work. In this case, market forces have gradually reduced wages, making goods cheaper. Also, the European Central Bank’s pledge to support the Eurozone’s banks “at any cost” helped to lower the interest rates of government debt, enabling countries to better afford their debt payments and reducing investor concerns.

Even with the improvements, the immediate outlook remains challenging. Political turmoil reduces investor confidence. As we’ve seen, reduced confidence increases the interest rates that investors demand for a country’s debt. Italy, Greece and Spain abound in such political turmoil. Additionally, the record high unemployment in several countries further deteriorates their economies and sends them deeper into recession. Then there are events such as the one plaguing Cyprus, the aforementioned nation that makes up only 0.2% of Eurozone output. The Cypriote situation is one in which banks actually were fatally harmed by the defaults of Greek government debt. Cyprus was forced to close the country’s second-largest bank and inflict large losses to its biggest depositors. Because this was a visible step toward the disastrous outcome that investors have long feared, markets reacted. The real economic effects of the Cyprus situation are negligible, but the real damage was to investor confidence: “If it can happen there, who is next?”

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

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