Europe's debt crisis: 'No clear end in sight'

@CNNMoneyInvest January 6, 2012: 5:17 AM ET
The debt crisis in Europe will continue to dominate markets in 2012 as governments and banks face big refinancing needs and investor confidence remains low.

The debt crisis in Europe will continue to dominate markets in 2012 as governments and banks face big refinancing needs and investor confidence remains low.

NEW YORK (CNNMoney) -- Last year was supposed to be the make or break year for Europe's debt crisis. Neither happened.

That means the chronic uncertainty that investors grappled with for most of 2011 is likely to continue, if not intensify, in the first half of this year.

"There are a myriad of factors, both political and economic, that could hit confidence," said Grant Lewis, head of research at Daiwa Capital Markets in London. "Given this backdrop, continued uncertainty is inevitable."

Despite an explosion of political summits last year, there is still no definitive solution to the crisis, which has become the single biggest threat to the global economy and the bane of financial markets around the world.

While a break-up of the euro currency union still seems unlikely, investors are not willing to rule out the nightmare scenario completely.

"The chances of break-up remain low, but non-negligible for sure," said Lewis. "That is not something that we would have said 12 months ago."

Eurozone leaders have taken steps toward a more binding fix for the political and economic problems at the root of the crisis. But they have yet to put the measures into practice, something that has proven difficult because of competing national interests.

To make matters worse, the eurozone economy appears to have slipped into recession at a time when governments across the continent are embarking on new austerity regimes. This sets up a difficult balancing act for policy makers as they confront the need to cut spending and boost economic growth simultaneously.

"As we start the New Year, the investing landscape doesn't look all that different," said Kevin Giddis, director of fixed-income at Morgan Keegan. "To put it charitably, economic conditions in Europe remain tenuous, with no clear end in sight."

Europe: Still a huge pain in the neck for investors

The lack of a comprehensive solution has prompted warnings from credit rating agencies about more government downgrades, which could continue to be a drag on sovereign debt markets.

Italy and Spain both need to issue hundreds of billions of euros worth of bonds to refinance existing debt and raise cash. Italy is expected to issue some €245 billion of bonds in 2012, up from €223 billion in 2011, according to HSBC. Spain will be coming to market with €87 billion of debt next year.

Italy is particularly worrisome because its €1.9 trillion debt burden makes it too big to bail out. But as the third-largest economy in the eurozone, Italy is also too systemically important to fail.

While Italy and Spain have dominated headlines, Greece remains the most at risk of a default. And that could force it out of the currency union.

"The risk of Greece leaving is very serious," said Holger Schmieding, chief economist at Berenberg Bank. "But beyond Greece, all other countries will be kept in the eurozone by forceful intervention if need be."

Greece is due to receive a second bailout package this year, but there is widespread disagreement over whether the requisite austerity will cure the nation's debt problems or push it's economy deeper into recession.

At the same time, the role private sector investors will play in the restructuring of Greek debt -- a key condition of the second bailout deal -- hasn't been fully worked out.

In October, banks and investors agreed, in theory, to voluntarily reduce the value of Greek government bonds by 50%. The talks have yet to be finalized, but negotiators representing Greek bondholders said earlier this week that progress has been made.

Meanwhile, the financial 'firewall' that is supposed to prevent the crisis from spreading is still a work in progress. And few investors expect much progress on fundamental reforms such as issuing common debt in the form of Eurobonds.

European recovery? Wait till 2013 (at least)

If it seems like investors have been fretting over Europe for a long time, that's because they have.

But after being in crisis mode for nearly two years, some investors are sounding more optimistic about the second half of 2012.

"A lot of fear and negativity has been injected into European assets, and the prices are certainly much more attractive than they have been historically," said Lawrence Creatura, a portfolio manager with Federated Clover Investment Advisors. "But investment returns from this point could go either way."

The European Central Bank recently pumped some €500 billion into the banking sector, and will offer more long-term loans in February. That helped ease fears of an immediate credit crisis, but European banks are facing new capital requirements this year and the wholesale funding market remains chilly.

The ECB is widely seen as the only European institution with the financial strength to restore confidence in the bond market, and many investors believe it will eventually step in to prevent the crisis from spiraling out of control. Many investors also say that Germany, Europe's largest economy, won't allow the euro union to fail. To top of page

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