Lost in all of the global action around Israel and Gaza, Russia and Ukraine and the slow-burning Iraqi civil war, investors have already forgotten about Banco Espirito Santo. This Portuguese bank spooked global markets a week ago on concerns that it may be heading for default. Indeed, the bank did in fact declare bankruptcy this past weekend.
For investors taking note of a seemingly endless bull market, that may have been a warning shot. After all, U.S. stocks stumbled on several occasions in the early years after the Great Recession of 2008, every time Europe began to wobble.
Judging by recent economic data, Europe may again start to dominate the headlines, and U.S. investors need to start paying close attention again. For that matter, if your portfolio has direct exposure to Europe, it may be time to trim your positions. European stocks have been marching ever higher, but it is increasingly apparent that it was too soon for celebration.
The entire basis for the rally in European stocks has been predicated on an expectation that a resumption of economic growth would help to bring massive debt burdens into check. Here in the U.S., a slowly improving U.S. economy has fueled a surge in tax receipts for the government, which is leading to sharply lower budget deficits.
Yet in Europe, economic activity remains sluggish and the expectations that growth will help to reduce both government and banking system debt is now an open question. (My colleague Adam Fischbaum recently found one European bank he's quite confident in, however.)
Although manufacturing appears to be contracting -- and business confidence weakening -- in Germany, the continent's largest economy isn't the main problem. Instead, it's France and Italy, Europe's second and third-largest economies, which are showing signs of stress. In Italy, for example, an economic slowdown recently led J.P. Morgan to lower its 2014 GDP growth forecast to zero. Weakness in France is expected to lead the International Monetary Fund (IMF) to lower its economic outlook for many of its trading partners.
As growth slows, the ability to reduce government debt burdens. And European economies will only face higher interest expenses once global interest rates start to rise. As it stands, leading European economies are among the most indebted in the world.
Yet it's not just European governmental debt burdens that should be of concern in a rising interest rate environment. European banks have also managed to buy time while the bond market has been friendly. But in coming months, the European Central Bank (ECB) is expected to issue a fresh round of stress tests for banks. And in light of weakening economic growth, these tests are likely to shine a light on the financial sector's remaining vulnerability.
Why does that matter to U.S. investors? Because U.S. banks are deeply enmeshed in counterparty transactions with their European peers.
As if government and banking system debts weren't enough of a concern, debt burdens at non-financial European corporations are also rising. According to the Financial Times, debt multiples are back above levels seen in 2008 and are above the 10-year average. All three of the entities (governments, banks and non-financials) have been able to maintain large debt loads because of low interest rates. But the era of low rates will gradually end in coming quarters, perhaps abruptly if bond vigilantes start to stir. And Europe's period of smooth sailing will head into choppier waters.
Risks to Consider: As an upside risk, the U.S. economy may start to accelerate in coming quarters, which would suck in a higher volume of exports from Europe.
Action to Take --> The key takeaway: The European economies never got better -- they just moved off of investors' radars for a few years. But governments, banks and companies now face a slowing economy, and an outright return to recession in places such as France can't be ruled out. If that happens, you'll need to scrub European exposure from your portfolio. You also need to assess how much exposure any U.S. companies or funds in your portfolio have to Europe. U.S. multinationals still count on Europe for a chunk of sales and would need to lower guidance of Europe's key economies slow further.