An overview of key risks in Europe

7 Feb 2012 by Jim Fickett.

Bill Hester at Hussman Funds doesn't write very often but, when he does, it is always worth reading. In January he wrote an essay entitled, Five global risks to monitor in 2012. This does take a global viewpoint, but is mainly about the situation in Europe, and does a good job of pointing out the core risks. The whole piece is dense with useful information, and I won't try to summarize, but will just point out a couple points.

Hester graphs spreads of sovereign rates over the German rate for each of France, Spain, Italy, Portugal, and Ireland, all the way back to 1970. This shows that today's high spreads do not look at all unusual in that long-term context. It is a little hard to know how important this comparison is, given that (1) in the past the spread was at least partly about inflation expectations, but (2) as long as the euro holds together, inflation has no part in determining spreads (absolute rates, yes, but not spreads). However other risks are higher today than in the past, so probably Hester is right that this long-term comparison does suggest high spreads could be the new normal. If that is the case, it will be very negative for economic growth in the countries affected, and probably for stock markets as well.

Hester also presents a graph of Italy's economic growth compared with the OECD's leading indicator for Italy. The correlation is pretty good, suggesting we should pay attention to the leading indicator. That indicator is now almost as low as it was before the worst of the 2007-9 recession. Combine this with the facts that Italy (1) is probably already beginning a recession, and (2) has to roll over a large fraction of its debt this year, and it is clear that Italy remains a key concern in coming months.