The Europe crisis

Europe Crisis: 3 Big Risks That Remain

CNBC,

28 March, 2012

As European markets recover from their longest losing streak since November, but the correction has been a healthy one. Europe shares are still up more 8 percent for the year, despite many of the region’s problems remaining unsolved: Italy’s labor laws, Portugal’s dampened deficit reduction and the Europe Central Bank looking to unwind support provide significant risks.

The latest disappointment for Europe, a manufacturing industry contracting more than forecast, is merely the next knock in on the euro zone. Just this month the European Central Bank reduced its outlook for growth this year to a 0.1 percent contraction, keeping the region in recession . So looking forward, what are the main challenges that remain before Europe can resolve its ongoing crisis?

Italy is struggling to free its labor market, which is essential to restoring confidence and easing debt.

Crucial for Italy in order to restore confidence in its markets and bring down hefty borrowing costs is the structural reform of its labor laws. The country’s growth has lagged the euro average for more than a decade, and with unemployment at the highest level since 2001 (9.2 percent), the fear is the nation will be left further and further behind. Unfortunately, talks between the government and unions have failed to ease firing laws, a halt of which would stop older workers being protected to the detriment of the youth, who suffer from a massive 30 percent unemployment rate. With elections early next year, time for progress is running out.

Portugal may need further rescue funds, and investors are not convinced long term.

Portugal, seen as the next potential card to fall after Greece, may have succeeded in recently auctioning 4-month bills at their lowest yield since late 2010, but long-term bond yields remain elevated. Investors require 12.5 percent in order to lend to Italy for 10 years, indicating a severe lack of confidence. With a 3.3 percent economic contraction expected this year, unemployment at 14.8 percent and strikes over pay, welfare cuts and tax hikes, the long-term outlook is difficult. The deepening slump has dampened deficit reduction. The fear is that more rescue funds will eventually be needed.

The ECB has not yet resolved banks' problems, and unwinding support to banks is dangerous.

The European Central Bank’s Long-Term Refinancing Operation (LTRO) liquidity effort was lauded as a game-changer. However, throwing liquidity at the issue of solvency has not been fruitful for the wider economy. Banks may have taken up 530 billion euros ($706.6 billion) of loans, but instead of being used to strengthen their balance sheets and kick-start lending to companies and consumers, they have been used to generate returns internally. Profiting by borrowing cheaply to lend for a higher yield via periphery sovereign bonds has been too tempting an option, it seems, to resist. Spanish bank holdings of periphery debt rose by a massive 29 percent in December and January alone, after the first round of LTRO lending.

Most interestingly, the ECB may be giving with one hand and starting to take with another. Despite the potential pitfalls, it seems to be withdrawing some support and scaling back certain bond purchases. Prior to the recent LTRO, a measure to buy 40 billion euros of bonds was set. Since then, only 9 billion euros has been bought, and the policy expected to last until autumn may be wound down sooner.

What to watch

Friday's planned meeting of Europe’s finance ministers has the potential to drive markets.

The two-day meeting will be closely watched for signs of an expansion in the firepower of the euro zone's rescue fund. The deadline to do so draws near, and the pressure for progress grows. Germany could provide some opposition and, even if a strengthening of the fund is achieved, the figure agreed upon may still not be enough.

As expressed by Tim Geithner in the U.S., Europe is “only at beginning of a very tough, very long, hard road.”

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Gemma Godfrey is head of investment strategy at Brooks Macdonald Asset Management in London.