Europe Takes Action - You Heard Right!

European leaders appear to have achieved more in their two-day Brussels summit than many in the market expected and the results are showing up in markets across the board. Details on the Euro-zone deal are still sketchy, but they have generated enough optimism to offset the relatively soft consumer spending data for May on the home front.

Is it the end-point on the Euro-zone question that the market had been looking for all this while or we are seeing ‘irrational exuberance’ that will soon subside once investors realize that hardly anything has changed on the ground at this stage? My take is that the market’s optimism today is not misplaced, as the European leaders have announced their intention to pursue substantive changes.

This is by no means the end point that everyone has been hoping for, butit is nevertheless a good-enough start that puts the region on track for shared liabilities and a banking union down the road.

Markets are forward-looking pricing mechanisms; they look ahead in putting a price tag on assets. So we don’t need each and every broken piece of the Euro-zone framework fixed before asset prices will reflect the ‘fix’. A credible enough roadmap would suffice – and that’s what we are seeing in the market today.

Leaders agreed to break the ‘feedback loop’ between undercapitalized banks and their distressed sovereign regulators by letting the permanent bailout fund directly inject capital into the banks. They will do that after they set up a common Euro-zone-wide bank supervising institution.

They also agreed to let the bailout fund directly purchase government bonds of member countries without requiring them to go through onerous austerity programs like what Greece, Ireland and Portugal endured. With respect to the immediate needs of Spain, they agreed to not give priority to their loans over existing government debt and even let the currently agreed bank bailout loan eventually transferred to the common bailout fund.

There is also a growth-centric program through increased spending that had been agreed to in pre-summit meetings. All in all, they have set the process in motion to create a banking union, kind-of mutualize debt and agree on a sequencing of these measures.

This doesn’t mean there won’t be disappointments down the road; you can almost guarantee there will be. National politicians, who have thus far been behind the curve on everything, will need to sell to their citizens why they need to sign off on ceding their fiscal sovereignty to Germany. Many European nations don’t exactly have fond memories of the last time Germany was their overlord.

Bottom line: Europe is not fixed yet, it’s a very long journey. But they made a good start today.

(This article was originally published as Ahead of Wall Street - June 29, 2012.)

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