European Debt Crisis: You Haven't Seen Anything Yet

By: Jeff Cox

Though the daily market gyrations might indicate otherwise, realization is beginning to creep in that the European debt crisis and its effect on the U.S. will not take days, weeks or months to unwind—but years.

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How many years is up for debate, but a common range bandied about among investment experts is two to five.

That prolonged time frame — which entails the period it will take to reduce government spending, come up with workable debt repayment plans, and, most likely, witness the contagion that will follow — means that the market tumult that the crisis has brought also won't be going away anytime soon, either.

"Despite rebounding market confidence over the past week, the recent worsening in the larger sovereign bond markets of Europe suggests greater risk to the U.S. and other regions," Steven C. Wieting, Citigroup's managing director of economic and market analysis, said in a research note. "The impact of Europe is no longer a question of isolating weakness to peripheral countries, but one of how Europe's instability/austerity is isolated from the larger world."

The increasingly sober view of how deep the European problem will run has come with the realization that relatively tiny Greece is not alone with its sovereign debt problems.

Jeff Cox
Senior Writer
CNBC.com

Italy has seen interest rates soar, then fall, then climb again over the past week, with an auction Monday producing a high yield for two-year debt at 6.29 percent. That's better than the 7.20 percent blowout last week, but still unsustainable for financing a 1.9 trillion-euro debt.

Policymakers, though, largely have avoided frank discussion over just how long all this market turmoil will last.

"Nobody wants to be that person to get up there and say this is going to be about four or five more years to really work through all this stuff," says Robert "Hap" Sneddon, portfolio manager at CastleMoore, an Ontario-based investment firm. "That's why there's a disconnect between what's good for us today and what's good for us two years from now."

And it could be much worse than that.

Ben May, European economist at Capital Economics in London, expects the debt mess in Italy, for instance, to last "as long as two decades" until the government there gets its debt to GDP ratio below the 100 percent benchmark.

"Unless the rest of the euro-zone provides Italy with significant amount of assistance over a prolonged period, we think Italy will eventually default with catastrophic consequences for the wider region," May said in a note.

The inability to come to terms with how far the debt crisis will spread and the stop-gap policy measures it has produced are blamed most for how long it will take the situation to play out. The European dilemma, in fact, is being seen as an extension of the U.S.-centered financial crisis that began in 2008.

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"Central bankers and politicians kicked the debt can down the road longer than we thought possible three years ago," Charles Biderman, CEO at market research firm TrimTabs, said in an analysis. "Now the explosive acceleration may really be starting."

For investors, the time frame makes for a difficult choice: Do you try to ride the headline waves, which have produced remarkable market swings, including last Wednesday's 400-point Dow drop? Or do you stick with a longer-term perspective by taking positions that, over the course of time, will weather the numerous storms in the coming years?

While the former choice and its quick gains might seem sexier, the latter seems, at least anecdotally, to be gaining more traction. After all, the only other choice is pulling money out of the market entirely.

James Paulsen, the consistently optimistic chief market strategist at Wells Capital Management in Minneapolis, believes it's easy to be fooled into seeing a trader's market.

"Many investors with multi-year horizons, swayed by eye-catching daily price swings into believing stock market 'investor' risk has been significantly elevated, could be mistakenly lessening exposures to risk assets due to elevated short-term volatility which is not impacting longer-term investment risk," Paulsen said in a note to clients.

Short-term traders, Paulsen argues, ought to be cutting risk during this period of extreme swings. Longer-term investors, though, face a market that, when measured over the post-World War II time period, has performed in line with historical averages regarding price swings, according to Paulsen's research.

"For 'traders,' the world has certainly changed and the new higher risk environment needs to be recognized and trading strategies appropriately altered," he said. "For 'investors' however, perhaps less has changed than widely perceived. Maybe investors should simply change their strategy from 'buy and hold' to 'buy and hold your nose' against short-term price swings."

Similarly, Bank of America Merrill Lynch is counseling its clients away from a strategy that looks for stocks that have been beaten down to rebound, and instead to those "of higher quality and strong secular growth versus the overall market, as well as sustainable and growing yield."

Specifically, the firm now favors consumer staples and information technology and disfavors financials and materials.

The selections, again, come from the notion that those expecting a near-term resolution of the debt crisis are kidding themselves.

"Investors hoping for a respite from a volatile and correlated market may be disappointed," Savita Subramanian, BofAML's equity and quant strategist, said in a note. "Europe is expected to experience a mild recession in 2012, and the U.S. policy looms large, as we expect another credit downgrade, government spending cuts and continued tax uncertainty."

Indeed, expectations for a prolonged crisis are heightened not merely by Europe's inability to cope with its own problems, but also the likelihood of ineffective policy response from Washington.

"The world's largest central banks and governments are headed by people who believe their central planning can lead to better outcomes than the free actions of people in markets," said TrimTabs' Biderman, who recommends clients hold hard assets to brace against the wild market. "In our opinion, their interventions will be very harmful."