Right Now the Debt Crisis is European, But the Problem is Global

By Comstock Partners

The European debt crisis has not gone away. Concern about Euro debt has ebbed and flowed in the markets for the last two years, but is still far from a solution. Periodically, various high-level meetings and resulting announcements of vague outlines of plans have led to quiet periods, only to re-emerge again when something happens that indicates that not much has really been accomplished, and that there are still serious problems ahead.

The latest eruption of worry burst forth as Unicredit, Italy’s largest bank, had to offer more than a 40% discount to existing shareholders to buy two shares for every one held. The disheartening news set off a chain reaction, as the need to raise capital is not restricted to Unicredit, but applies to almost all Italian banks and many major financial institutions throughout Europe as well. As a result, bank stocks plunged throughout the continent and impacted the general markets as well. Interest rates climbed and the Euro broke below $1.28 for the first time since September 2010. In addition the European Financial Stability Facility (EFSF) had to pay much higher rates to sell 3 billion Euros of debt.

That isn’t all. As potential harbingers of things to come, the Spanish regional government of Valencia is a week late in repaying a 123 million Euro loan to Deutsche Bank. We doubt that many in the investment community were aware of Valencia’s finances before, but this is just the sort of thing that pops up out of nowhere during a financial crisis and snowballs into something much larger. Adding fuel to the fire, the Hungarian forint has hit a record low as the cost of insuring Hungarian debt against default rose to a record high for the third consecutive day. Some European banks have large exposures to Hungarian debt.

The problem is that sovereigns are faced with the prospect refinancing about 1 trillion of debt coming due in 2012 at the same time that European banks have to recapitalize by, perhaps, a similar amount at a time when rates are rising, Europe is falling into recession and austerity measures are being enacted. German retail sales have dropped for two consecutive months. French consumer confidence dropped to its lowest level since October 2008. French statistical agency Insee says that France entered recession in the fourth quarter and that it is continuing into early 2012. Italy’s economy turned down in the third quarter and is continuing to decline.

In addition to the European economic recession exerting a drag on the rest of the world, the real threat of bankruptcy of a major financial institution can rapidly spread throughout the globe as a result of a run on the banks or the opaque interrelationships between European banks and financial institutions in other nations. Although the spotlight is now on Europe, a good portion of the world is burdened by excessive debt that is undergoing deleveraging. This is certainly true of the U.S., which is currently in the midst of an exceedingly fragile recovery that is facing strong headwinds in 2012 as debt remains high and fiscal stimulus is winding down. In our view the stock market is facing major resistance on the upside while the downside risks are substantial.

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