Europe's critical turning point

Recent news gives hope the worst of Europe's crisis may be over, but with rising unemployment and negative growth there are still plenty of risks to keep investors on their toes.

Continuing the run of favourable economic news and views about the outlook for the global economy in 2013, various policy makers in the eurozone are expressing greater confidence that the depths of the crisis have passed. Without being irrationally optimistic about a sudden and sharp rebound in activity, a focus on returning the eurozone to economic growth is an unfolding theme.

Indeed, uber cynic, Germany’s Finance Minister Wolfgang Schaeuble judges Europe is "over the worst of the crisis”. European Central Bank President Mario Draghi continues to create optimism with comments about the tenacity with which the central bank will tackle any financial problems from any member government. This pledge is underpinning financial market optimism. Just last week Draghi was confident that the eurozone would emerge from recession during 2013, citing easy policy settings and stability in markets as key factors even though in December the ECB was forecasting eurozone GDP to contract by 0.3 per cent in 2013.

Such is the fading of the pessimism in the eurozone and move to relative optimism that short-term German government bond yields are no longer negative. The two-year German government bond had a yield of minus 0.10 per cent in the latter part of 2012 on the back of safe-haven investment flows, fears of a eurozone break up or a government debt default from one or other of the member countries. Now, the two-year yield is 0.14 per cent, a very sharp turnaround. The 10-year bond yield in Germany has risen 30 basis points to around 1.55 per cent from the 2012 lows as a further sign of less pessimism about the prospects for Europe.

Perhaps more compelling is the fall in government bond yields in the so-called vulnerable countries. The 10-year government bond yield in Spain, for example, is currently around 4.8 per cent, down quite massively from the crippling peak of over 7.6 per cent in July 2012. In Italy, it is a similar picture with the 10-year yield falling from a mid-2012 peak of 6.6 per cent to now be around 4.15 per cent.

The market rally in these bonds shows that investors are now putting an increasingly low probability on the risk of a eurozone break up and in turn, the governments in these previously vulnerable economies are benefiting from lower debt-servicing costs which in turn speeds up the path to more sustainable budget and fiscal settings. A nice self-reinforcing market trend.

The market optimism is also showing up very clearly in stock prices. Compared with the mid-2012 lows, share prices are up around 108 per cent in Greece; 48 per cent in Spain; 40 per cent in France; 30 per cent in Germany and 27 per cent in France.

These are big moves, albeit from levels market investors were judging to accord with the risk of Greece and Spain defaulting on their debt. Perhaps also the markets were oversold, but the change in momentum, market sentiment and hopes, if not optimism, for better times ahead in many European countries is starting to get compelling.

This clear and seemingly expanding market optimism is despite high – and rising – levels of unemployment, with the eurozone registering a record high 11.8 per cent unemployment rate in December. Overnight, eurozone industrial production also registered a surprise fall of 0.3 per cent in November which suggests GDP in the fourth quarter will again be negative and confirm that the eurozone ended 2012 in recession.

Even allowing for what is probably well-anticipated and accepted bad news, the whole dynamic is shifting to a better picture for eurozone economic activity in 2013. Draghi has even cited "positive contagion” from these latest trends, a nice turn of phrase to capture the change in mood.

Obviously, with GDP still printing negative growth and the unemployment rate rising, there are substantial risks in gearing up for sustained better news in the eurozone in 2013. That said, the market trends are as broad based as they are encouraging.

The true test of the market optimism will be in the months ahead and whether the eurozone will record a quarterly GDP growth rate much above 0.3 per cent and whether there will be a couple of months where the unemployment rate not only consolidates, but starts to fall. If this happens, the recent market moves will be justified and even built upon.