Less than nine months ago, credible investors around the world were bracing for a calamitous breakup of the debt-ridden eurozone that would send the global economy into recession.
Today, Europe is hardly on investors’ radar screen, morphing into a near-afterthought as some believe the worst of the continent’s sovereign debt crisis has actually already passed.
While significant political and economic hurdles loom, the European Central Bank’s pledge last summer to do whatever it takes to keep the embattled currency bloc intact was instrumental in sparking the dramatic turnaround.
“The ECB has been a game changer. The eurozone crisis in its current form has ended,” said Jan Randolph, director of sovereign risk at IHS Global Insight, who warned the crisis could yet reemerge.
Collapse Concerns Fade
The financial markets abound with evidence of the receding eurozone jitters.
“Talk is cheap but it’s been effective."
- Marc Chandler of Brown Brothers Harriman
Yields on government bonds have tumbled away from dangerous levels. The yield on the 10-year Spanish government bond recently dipped below 5%, a far cry from its high of 7.61% in July. Even Greek bond yields have plummeted to 10.39%, compared with as high as 44% last year.
Since late July the euro has soared nearly 12% against the U.S. dollar and retaken levels unseen since late 2011.
On the equity side, the Euro Stoxx 50 has soared 33% since tumbling to 52-week lows on June 1, landing this week at 18-month highs.
The probability of a collapse of the eurozone is “now seen as ‘vanishingly small’ by our biggest clients,” said Laurence Wormald, head of research at SunGard’s APT, whose clients include some of the world’s largest pension, sovereign wealth and hedge funds.
Even economist Nouriel Roubini, aka Dr. Doom, wrote earlier this month that the risks of a eurozone collapse have “abated significantly.”
To be sure, Europe’s economy is still mired in recession, debt-to-GDP levels remain at unsustainable levels and some believe this is just the calm before a greater storm.
Three Simple Words...
Still, ECB President Mario Draghi kicked off the turnaround in July with his promise to do “whatever it takes” to keep the eurozone together, sentiment that was backed up by German Chancellor Angela Merkel, who effectively has veto power over crisis measures.
The comments helped crystallize the growing realization in the financial markets that Europe has the political will to avoid a collapse of the currency union.
“Talk is cheap but it’s been effective,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. “The market didn’t fully grasp the political commitment.”
“Merkel and Draghi basically tangoed their way into convincing the markets they would do enough,” said Randolph.
The ECB backed up its pledge by laying out the framework for a bond-buying bazooka that it has not yet been forced to whip out.
Known as the OMT, short for Outright Monetary Transactions, the program allows the central bank to deploy billions of dollars to buy up the debt of eurozone nations in the secondary markets.
But this bailout only comes after formal approval from eurozone members and can be revoked if aid recipients fail to meet specified targets.
The ECB was in effect saying: “We will keep you afloat and buy your bonds while you undergo fiscal adjustment,” said Randolph. “It seemed to be enough to convince the market it is time to dip your toes back into peripheral water.”
Eurozone Pressures Ease
Earlier this month Standard & Poor’s issued a cautiously optimistic note about the year ahead for the eurozone.
“European leaders have laid, or at least announced, much of the groundwork for the eurozone to emerge from its lingering crisis,” S&P said.
While the ECB is at the heart of the turnaround in Europe, the continent has been helped by a number of other factors, both internal and external.
For example, the watering down of the Basel accords eased pressure on big European banks like Deutsche Bank (DB) by limiting the amount of capital they need to raise.
Further, the U.S. avoided a steep tumble down the fiscal cliff with a last-minute compromise, potentially helping European exports. Likewise, China has shown signs of stabilizing after seven consecutive quarters of contraction, lessening fears of a steeper slowdown.
Others believe that Europe is only in the midst of a short-term reprieve.
“This is the lull before the storm,” Cam Harvey, a Duke University professor, wrote in an email. “The crisis is far from over. Indeed, you can make the case that it has not even begun. So far, it has been feasible to bail out. In the next stage, there will be ‘insufficient funds’ to bail.”
Harvey believes the ECB’s moves have simply bought time. He warned that unless the central-bank support continues for “many years,” interest rates on peripheral countries “will eventually increase with devastating impact on government fiscal deficits -- as debt service costs explode.”
Of course, even bullish European investors acknowledge obstacles remain in the coming months and years.
Chandler said the sovereign debt crisis has probably “just morphed into a different phase,” one that emphasizes anemic economic growth rather than just deficits and borrowing.
Even as Germany’s economy has shown signs of life, the economies of Southern European countries, including France, are still under pressure.
On Wednesday Spain provided fresh evidence of its deepening contraction, saying GDP slumped 0.7% from the third quarter and 1.8% year-over-year.
Southern European economies are struggling to come up with structural fixes that will improve their long-term competitiveness.
Will Europe Grow Complacent?
The fear is that this slow-growth environment could change the political calculus in Europe, where key elections in Italy next month and Germany and Austria in the fall loom.
“The real worry this year is reform fatigue and how that could affect the politics of Italy and Spain. There could be a backlash. That’s still a risk,” said Randolph.
It’s also possible the easing market conditions take the heat off policymakers, paving the way for mistakes.
Likewise, Wormald pointed to the possibility that Draghi, Merkel and other key leaders may “start back-tracking” on their commitments for ECB asset purchases and a eurozone banking union.
“Complacency could lead to the fragile agreements among European policymakers unraveling if some consider that the eurozone's troubles have passed,” S&P warned.