Investors have been preoccupied with the fear of contagion.
But it’s not Ebola, which seems to be less alarming in the U.S. this week as no new patients have surfaced and as investors have been buying the airline and cruise line stocks they dumped at the height of contagion fears about a week ago.
Rather, the infection that’s unsettling investors is the fear that the economic disease that wasn’t fully treated in Europe after the 2011 debt crisis is showing up again in the economies of Germany and France as well as Spain, Italy, Greece and Portugal. And if a new bout of recession and deflation takes hold in the eurozone, investors worry, the U.S. could be infected too.
The U.S. and European Union each account for about a quarter of global GDP. And while the U.S. economy is driven mostly by domestic consumption, exports to Europe are important to the profits of many U.S. companies.
Some earnings reports of companies such as Illinois Tool Works calmed investors Tuesday. About 30 percent of its sales are to Europe, and the company provided a positive outlook for the future. Other similar earnings reports Tuesday helped lift the Standard & Poor’s 500 1.9 percent. Europe’s Stoxx 600 index rose 2 percent as investors began anticipating more stimulus from the European Central Bank.
Yet solving Europe’s problems now looks like a long-term endeavor, and analysts aren’t sure stimulus from the European Central Bank will be enough to make Europe healthy.
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Adding to the concern about Europe’s economic problems is the fact that 18 different countries in Europe must agree on the remedies, and politics in countries with various cultures and economic health make it difficult for all to swallow any medicine. Some want more economic stimulus for the eurozone, in the form of a quantitative easing, or QE, program, modeled after the interest-rate cutting mechanism the Federal Reserve used to help the U.S. economy recover.
Others, such as Germany, oppose such stimulus and claim it will burden the European Central Bank with debt and allow countries to ignore the reforms they ultimately must undergo. Germany has insisted that financially weak countries such as Italy need to take the hard medicine of reducing debt and eventually building growth through reforms in the labor markets. Some rules now protect jobs, and changing those rules is politically explosive.
To increase growth in the eurozone, countries “need to increase their competitiveness,” said Andreas Dombret, a member of the executive board of Germany’s Bundesbank, during an interview in Chicago. He claims that eurozone requirements imposing debt-cutting rules and reforms are working, although unpopular, in countries with high unemployment.
“Austerity worked well in Spain,” despite unemployment of about 25 percent for the general population and 50 percent among youths, he said. Countries such as Portugal and Spain are not in recession, he added. “We are back to growth,” but the remaining question is: “Is this growth enough to overcome unemployment?”
Currently, Italy and France are balking at eurozone requirements to make cuts in their national budgets so they meet debt thresholds. They claim that with much of Europe on the verge of recession, it is not the time to make government cuts that will leave more economic distress. Technically, a country can be fined by the other countries as a group if one fails to meet debt limits.
Meanwhile, while investors would like to see the calming effect of a European Central Bank QE program, some of the angst showing up in the stock and bond markets lately arose because “the market has been very skeptical that it would be possible to assemble the majority necessary to proceed with a broader QE program,” said Citigroup analyst Hans Lorenzen.
Investors on Tuesday were encouraged that perhaps a full-scale QE program will eventually happen because of reports that the European Central Bank is considering buying corporate bonds. That’s not the same as buying government bonds, which is controversial in Europe and is what the U.S. Federal Reserve does with Treasurys. But some analysts think that the ECB is inching its way toward quantitative easing through first steps such as buying covered bonds and asset-backed securities.
The goal in those programs is to relieve pressure on banks and to stimulate lending at a time when lending has been limited and consequently blamed for holding back growth.
Andrew Bosomworth, Pimco head of portfolio management in Germany, wrote on the Pimco website Tuesday that “QE can sooth the Eurozone’s problems, but not solve them. The Eurozone needs to get its debt to sustainable levels through economic growth.”
Bond buying and interest rate cuts, he said, “potentially kick other big problems down the road without solving them.” And while low rates are supposed to help individuals and businesses borrow, “low interest rates aren’t working,” he said. “Low interest rates only work if people are borrowing money,” and he notes they’ve been preoccupied with paying off loans rather than borrowing more.
Dombret anticipates that upcoming stress tests of European banks will help free up money for lending. Banks preparing for the test, which will be announced Oct. 26, have been building up capital so they would be financially healthier and able to deal with the stress of a major recession. Once the results of the tests are made public, he thinks, confidence in the banks will rise.
“The most important thing is tough stress tests,” he said.
Some analysts are warning investors that the lull in the stock market this week could give way to volatility as investors anticipate and see which banks are strong and which are not.
Twitter @gailmarksjarvis