Weekly Pulse: Europe on the right track?

Travelling by rail throughout Europe is considered by many to be a safe, predictable, and efficient way to get from where you are to where you want to be. Investors are hoping the changing of political leaders in both Greece and Italy will prove to be equally effective at easing Europe’s ongoing debt crisis. Italy become front and centre this week giving the risk markets a post-Halloween fright as Italian bond yields surged to the highest level since 1999.

Prime Minister Berlusconi lost a confidence vote and became the second European Prime Minister to fall in as many weeks. Mr. Berlusconi will likely resign as early as this weekend. Investors took the optimistic view that Italy’s new interim government will be led by market friendly, Mr. Mario Monti. The stock market also seemed to approve of Greece’s decision to swear in a new unity government led by Mr. Lucas Papademos with his mandate to implement the budget measures and decisions agreed to in the October 26th Euro zone bailout deal.

Noting the charts to the right of the page, this week’s stock market experience is best characterized by Shakespeare’s quote, “Sound and Fury, Signifying Nothing’. Stock prices spiked and plunged great distances on an intraday basis mostly due to headline news out of Europe including higher margin requirements for trading in Italian debt and unfounded rumor of a pending S&P debt downgrade for France. When it was all said and done, stocks finished pretty much unchanged from where they began the week.

Another week of decent corporate earnings combined with better than expected consumer confidence and U.S. jobless claims lower than expected (below the critical 400,000 level) were all fundamentally supportive of stocks and commodities. Crude oil closed in on $100/bbl, heading for its longest streak of weekly advances since April of 2009. The speculation is that U.S. economic growth and Europe’s efforts to contain the debt crisis will ultimately boost fuel demand. Also supportive of commodities was evidence that Chinese lending jumped by more than expected in October, perhaps a sign that the government may be loosening credit quotas to support growth in light of the European situation. The Republican leadership debate demonstrated that this race is Mitt Romney’s to lose and that Rick Perry finds it difficult to recall a list containing more than two items…

The trading week ahead

Friday’s relatively positive market mood will likely continue next week, but this assumes the political processes in Italy and Greece continue as expected over the weekend. Italy’s upper house of parliament passed the Financial Stability Law on Friday, setting up for a vote in the lower house on Sunday and the eventual resignation of Berlusconi. It remains to be seen how the approaches taken by Mr. Monti and Mr. Papademos will differ from Mr. Berlusconi’s and Mr. Papandreou’s. Will they be able to instill a level of confidence in their new governments and in the people those governments represent?

A busier week is in store on the economic front. PPI & CPI data will give us insight on North American inflation. Expectations are that consumer prices probably peaked in September and should decline into year-end. U.S. Retail Sales likely moderated in the slower period between back to school and year-end holiday shopping. Manufacturing output is expected to tick higher, yet another sign that the U.S. is backing away from the likelihood of recession.

Earnings news is starting to slow but there are some bellwether retailers posting their results this week with Lowe’s, Home Depot, and Wal-Mart due to report. Will the improving consumer sentiment highlighted in the University of Michigan data last week be reflected in the numbers? Home Depot and Wal-Mart look to extend their string of positive quarterly earnings surprises. Commodities will continue to be influenced by events in Europe. Currencies and precious metals will also see continued volatility next week. The Euro gained the most against the U.S. dollar in two weeks on the renewed optimism Europe is tackling its problems.

The weaker U.S. dollar provides some support to gold as a currency alternative. Bullion is in the 11th year of a bull market as investors seek to diversify away from equities and some fiat currencies.

Question of the week

There have been rumors recently of separating the “PIIGS” from a “core Euro”. Under this scenario there would essentially be a “north” and a “south” Euro. But would this really fix the problem?

Recently the Euro currency’s guardians (Merkel and Sarkozy) revealed that it is possible for the 17-nation union to shrink where it was once thought that ‘once in the euro, a country could never escape’. Merkel’s German political party is now set to adopt a motion which will allow Euro members to exit. But Germany had better be careful what it wishes for since the value of a trimmed down, “core euro” currency would likely surge due to the potent economic power of the countries using it. This would render the group globally uncompetitive and be quite prohibitive, especially for Germany’s export machine. Also, in a currency union of just a few countries there is still the problem that no one country has currency sovereignty and any of the members would still have the potential to run out of money. Imagine if a French bank was perceived to be in trouble and everyone rushed their money out of France and into Germany’s banks. There would also be the slow develop trade imbalances that countries would not be able to fix through the natural means of home currency devaluation. One central bank trying to manage a single monetary policy for multiple economies all moving at different speeds is really no different than the situation they are faced with now.

You simply cannot have a monetary union without tighter fiscal and economic integration. Finally, both Merkel and Sarkozy need to realize an orderly break-up of the Euro is not possible. A breakup will cause a financial disturbance so great that any perceived benefits will be completely overwhelmed by the costs that will be imposed by the market.