The topic on everyone’s mind is what is wrong with Europe and more importantly how does it affect me?
And when I refer to “me”, that can be the active investor, the average investor that has a retirement account, a homeowner under water with their mortgage, or the unemployed. I will explain how Europe could affect us all.
First, I must lay out in elementary terms what has happened to get Europe to where it is today.
Again, this is in very simple terms so you can get a grip on what is happening. It started with countries in Europe borrowing money at low interest rates to fund projects and spending and to get out of the financial mess of 2007/2008. The money was borrowed by issuing bonds in which the countries make periodic interest payments to the buyers of the bonds. In this instance, the majority of the buyers were European and other banks.
As countries such as Ireland and Greece began to get into situations where they borrowed too much money, it was clear they could not afford to pay back their loans in a timely manner. It would be similar to you using a low-interest credit card to live a lifestyle above your means and eventually you realized you racked up a credit card bill you cannot pay off – for two reasons. One, you cannot borrow any more money (or if you can borrow it is at very high interest rates). And two, you are not making enough money via your job to pay back the loans. Greece is an example that was not bringing in tax revenue to pay off its loans (Greeks and taxes is a whole separate topic.).
For the last few months the stronger economies in the European Union (EU) have been picking up the slack for the over spenders with mini-bailouts as the offenders agreed to not spend as much through what is called austerity measures. This was good enough at the time. However, it was just the tip of the iceberg.
Recently it has been highlighted that the economic troubles spread beyond just Ireland and Greece and to large European nations such as Italy and France. The most recent market swoon was caused by Italy and their soaring bond interest rates. As buyers of the bonds (the lenders) require a higher interest payment because they do not have as much faith in the country (Italy) and the current bond holders sell their holdings (send bond prices lower and interest rates higher), it is a very bad combo for Italy.
As the yield on Italian 10-year bonds moved above 7% it increased the borrow cost for Italy to levels that many experts do not believe are sustainable. This goes back to you needing to borrow more from your credit card, but now they are charging you such a high interest rate that you are not able to make the interest payments.
SO NOW WHAT?
If Italy or any other country cannot make interest payments it will result in a default or at a minimum a need of a bailout from the ECB or IMF or possibly the US. Or they could settle to pay most of the payments, but not all.
If it were you in this situation it would result in you filing bankruptcy or possibly settling with the lenders for a lower payment. Either way your borrowing costs will be high for years to come – This is a big fear for Greece, Italy and any other nation in trouble.
So, in the end does somebody (ECB, IMF, US, etc.) bailout the European nations and entire EU? Or does everyone look the other way as the EU falls apart along with the Euro?
The stalwart, Germany, may want to get out of the EU and go back to being the strongest and most stable nation in Europe. But at what cost would that be? Ending the EU could create years of economic turmoil for nations around the globe and in particular Germany and its neighbors.
Only time will tell, but the action today suggests something will get done to place yet another Band-Aid over the gaping wound of Europe. This Band-Aid may be enough to keep the stock market and economy afloat for another few months or up to a year’s time. BUT, eventually a long-term solution must be achieved.
As far as the stock market and your portfolios are concerned, I will remain cautious based on the Europe situation. However, I am cognizant that a Band-Aid may be used and it could lead to higher stock prices and will be ready to capture that. Honestly, it will take some outside-the-box thinking on my part in the coming months, but I am confident we can get out of this unscathed.
The chart above is a snapshot of the S&P 500 since July. As you can see during that time the index is down slightly with no real trend in place. More importantly there is the "resistance zone", which is between the two horizontal green lines (1230 to 1250).
