No Escape From Europe's Rubble by Aaron Task

No Escape From Europe's Rubble

by Aaron Task
Friday, May 21, 2010

If the market hates uncertainty, as the saying goes, just about the only good news this week was that "uncertainty" over regulatory reform was removed.

But the reforms aren't necessarily positive, and major uncertainty remains about the euro and the outlook for the global economy -- among other small matters.

First, the grim tally: Thursday's washout left all major U.S. averages at least 10% below their 2010 highs. That the decline occurred less than a month after most averages hit those highs is at least as disturbing as the fact that the Dow and S&P entered official "correction" territory. (On Friday, the Dow dipped below 10,000 early on before rebounding to close higher.)

More from Yahoo! Finance: • Even $1 Trillion Can't Save the Euro • The End of a Global Free Market? • Homeowners, Economists "Overconfident" About Recovery

So there's a good reason why a lot of investors are feeling whipsawed --and maybe a little nauseous -- right now. The VIX, a.k.a. "the fear index," has jumped about 175% in the past month, while Treasuries, the dollar and gold have benefited from the "risk aversion" trade.

Inevitable Object Meets Irresistible Force

"The Euro-zone crisis has reminded the global financial community that despite all of the government liquidity and credit … the process of needed private and public sector deleveraging is going to be painful and -- to no small extent -- has been delayed/stunted by the government stimulus itself," says Daniel Alpert, managing partner at Westwood Capital. "It is, nevertheless, inevitable."

While many Americans rightly worry about the day of reckoning for our massive debts, the "inevitable" has already arrived in Europe.

As a result, expect the euro to remain the linchpin around which the global financial markets swing in the coming days and weeks. Reports of central bank interventions Thursday and Germany's vote to fund its portion of the $1 trillion rescue package Friday helped give the currency a boost heading into the weekend.

But the outlook for the euro remains in doubt.

Why the Euro Matters So Much

The euro's fall vs. the dollar raises concerns about the profit outlook for U.S. multinationals, which have benefited greatly from a weak dollar in recent years. Suddenly, the optimistic earning forecasts for S&P 500 stocks are being called into question. That's a big reason why mega-caps like GE (NYSE: GE - News), IBM (NYSE: IBM - News),Boeing (NYSE: BA - News) and Caterpillar (NYSE: CAT - News) have been so battered in recent weeks.

Beyond the stock market, a weak(er) euro has major ramifications for the global economy because it will make European exports more competitive against rivals from the U.S., Japan and China, most notably. (For more on this dynamic, see: Outlook for Global Economy Is "Bleak," Former IMF Chief Economist Says.)

Concern about the economic impact of the currency crisis is a big reason commodity prices have tumbled recently, most notably oil. Historically, currency crises lead to trade barriers and protectionism, which typically bring slower economic growth, if not deflation and depression.

The euro will be a major issue when U.S. Treasury Secretary Timothy Geithner and Chinese Vice Premier Wang Qishan meet next week for a strategic and economic dialogue.

Ahead of the gathering, Chinese officials said the euro's weakness means they are less likely to let their currency, the renminbi, rise in value, something U.S. policymakers have long agitated for. In sum, Europe's mess is further complicating an already highly sensitive sore spot between the world's largest and world's fastest-growing economies.

Meanwhile, in a world "intertwined by $500 trillion of derivatives," as Minyanville's Todd Harrison likes to say, Europe's crisis has also revived fears of "systemic risk" and financial contagion.

Fighting the Last War

The regulatory reform bill passed by the Senate on Thursday was designed expressly to address such an event, fear of which had diminished heading into the weekend. But whether the Dodd bill could prevent another "contagion" remains very much in doubt.

As The Wall Street Journal reports, key elements of the Senate bill include:

• Establish a new council of "systemic risk" regulators to monitor "too big to fail" firms and prevent bubbles from forming.

• Create a new consumer protection division within the Federal Reserve.

• Empower the Federal Reserve to supervise the largest, most complex financial companies.

• Resolution authority for the government to seize and liquidate failing financial firms without a taxpayer-funded bailouts.

• Give regulators new powers to oversee derivatives.

• Force banks to stop "proprietary trading," or making market bets with their own capital, and put limits on firms' ability to grow beyond a certain size of liabilities.

The WSJ labeled the Senate bill (which must be reconciled with a House version) "harder than expected" and said Wall Street is "bracing for seismic changes."

Considering prop trading and derivatives have become huge sources of income for Wall Street firms, maybe "certainty" over reg reform isn't such good news, after all.

No tears are being shed for the "fat cats," but if the reforms result in a contraction of credit, as opponents contend, the U.S. economy and our 401(k)s will feel the impact.

http://finance.yahoo.com/banking-budgeting/article/109622/no-escape-from-europes-rubble