European Crisis: Take It In Stride
"Putting lipstick on a pig" is an expression used to describe an attempt to disguise something's less-than-flattering true nature. For investors a question of great importance is whether the European Union is currently trying to put lipstick on the "PIIGS," as in Portugal, Ireland, Italy, Greece and Spain.

Another important question is how much it really matters. I think the naysayers that liken today's European financial crises to the subprime mortgage and derivatives meltdown of the past









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few years are overstating the current problems by an order of magnitude.



There is no doubt that the PIIGS have been living on borrowed time or, more accurately, borrowed money, for the past decade. Having benefited from a real estate bubble until a few years ago, they are now suffering amid a worldwide recession and fairly weak fundamentals.

The main issue for the PIIGS is that they are, to a greater degree than they'd care to admit, farms with theme parks. By that I mean agriculture or tourism are extremely important to the PIIGS, although neither sector dominates in what are otherwise unremarkable industrial economies.

What is remarkable is that these countries are part of the EU. That leaves the member states as a group facing a conundrum: on the one hand, they must ensure these countries don't default on their sovereign debts; on the other, they lack the leverage to force the PIIGS to impose the sort of austerity measures on their citizens that would get their fiscal houses in order. In fact, the sort of forced belt-tightening these countries desperately need could result in civil disobedience amid their Old World labor systems.




Instead of fomenting riots, major EU powers like Germany and France are likely to see it in their own best interests to forge solutions short of outright bailouts but that still manage to stabilize their weaker neighbors. European banks are exposed to these countries and will need to participate in any workout.





As important as the EU's troubles are to the world financial system, calling this a crisis on the scale of the subprime mess is misleading. Financial markets are signaling that investors don't believe the situation will result in a similar domino effect.


The 6% to 7% yields on Greek government 10-year bonds hardly imply panic. What's more, if investors expected major EU countries to have to provide massive bailouts, German 10-year bonds wouldn't be trading at yields that are only 0.25% to 0.5% above those on 10-year U.S. Treasuries.

None of this is to deny that Europe is facing a financial crisis. But in the end it is likely to be remembered primarily as bricks in a wall of worry. We believe the world economy is in the early stages of a self-sustaining recovery. Leading the way is China, where inflation and interest rate pressures are already forcing the central bank to act. Financial officials there seem likely to allow the renminbi to appreciate rather than clamp down on the availability of domestic credit.

The U.S. is also showing signs of recovery. Soon, pressure is likely to appear for the Federal Reserve to raise interest rates modestly. The market already foresees this, which helps explain why the stock market is coping with a correction. This is normal, and we will be back in a bull market mode later this year.

The wall of worry is built out of many types of bricks. This month's flavor is Europe's credit woes and China's credit tightening. Later, investors will worry about higher interest rates, inflation and eventually the challenge of setting new records as year-over-year comparisons become more challenging. Bull markets climb walls of worry. They have in past cycles and will in this one. It is precisely when market sentiment indicates there is nothing to worry about that investors should be very scared.





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