Cyprus, the Euro and You

First the “PIG” countries—Portugal, Ireland and Greece. Then Italy and Spain, and finally Cyprus.

In the four years since global stock markets bottomed and launched on an historic if somewhat unappreciated bull market, the euro zone has lurched from crisis to crisis. Country after country has been forced to take harsh austerity measures or risk being kicked out of the common currency.

This time around, all eyes are on Cyprus, the Mediterranean island country whose banks have become a haven for big Russian money. Euro zone officials have issued a deadline of Monday for the country to enact measures to shore up the finances of its banking system, and thereby “earn” a $20.5 billion bailout package. Should the government fail to do so, its fellow European nations have basically threatened to pull the plug and force it out of the euro.

Should that happen, economic consequences would be both swift and severe for Cyprus. The government’s 4.625 percent bonds due February 2020 have collapsed to about 64 percent of face value and a yield of 12.65 percent, already reflecting the strong possibility it will have to restructure its debt even if it does avert the immediate crisis.

On the other hand, it’s highly debatable whether there would be much impact on the broader euro zone. For one thing, Cyprus accounts for just 0.2 percent of the regional economy. Bailing it out would cost a fraction of the previous rescue packages for Greece, Portugal and Ireland and Spain. Rather, euro zone authorities this time around seem to be making a point that basic rules must be obeyed.

As for Cyprus itself, even with a deal the country’s economy is forecast to shrink by 3.5 percent in 2013 and by another 1.3 percent in 2014. Ending the euro would no doubt lead to a severely devalued local currency, making it far more difficult to import or raise capital abroad.

The result could be another shock to the economy in the near term, possibly a severe depression. On the other hand, a cheap currency would also make the country’s goods and services cheaper to foreigners, which eventually could be bullish for growth.

We’ll find out over the weekend whether or not the crisis in Cyprus blows up, or simply blows over like every other euro zone challenge has the past several years. If Cyprus is indeed left to twist in the wind, we can expect a negative reaction in global markets, as well as for the value of the euro.

Even if that does happen, however, it’s important to remember that Cyprus’ entire economy is scarcely more than 1 percent the size of Italy’s. Moreover, whatever happens there is likely to be a strong incentive for larger euro zone players to avoid sinking into a similar position.

The Euro

The upshot: More austerity in the euro zone, as countries continue to try meeting budget deficit targets as their economies stagnate. On the plus side for investors, that means a strong euro. On the negative side, it means we have to be very careful picking our stocks until growth does start to pick up. And it means more crises like Cyprus are likely.

In my view, the euro zone’s survival will only be assured when authorities heed the growing number of voices for ending austerity and returning to growth. This week, Fulvio Conti, CEO of giant Italian power company Enel SpA (IM: ENEL, OTC: ENLAY), went as far as to demand his country end austerity:

“The government has been able to generate a primary surplus,” Conti said. “Now it’s time to return some of that to the people. It’s about time we re-launch the economy with growth programs. Things like cutting taxes on business to restore consumption, restoring productivity, reducing the tax burden on labor.”

Conti joins a chorus that includes the CEO of Italy’s largest automobile company, as well as business leaders throughout Europe. The thrust is that the euro must be preserved, but not at the cost of a perpetual recession, even if that means operating at a lower level against other major currencies like the US dollar.

This sort of shift won’t happen overnight. In fact, any move to loosen the rules will certainly be met with opposition, particularly from the Germans who have consistently been the staunchest advocates of austerity, even at the price of growth.

And You

So what does all this mean for US investors? First, given the more than 200 point rally on the S&P 500 since mid-November 2012, a real blow-up in Cyprus is likely to exert a short-term negative impact on the market. The immediate worry reflected in stock prices will be that Cyprus’ woes will become a contagion, with Italy and its divided government a likely target of speculation for collapse.

A genuine crisis in Italy would pose a challenge to the stability of the euro. The country’s problems, however, are hardly news. For the most part, they can at least be assuaged with money as they have been in the past.
That means a negative near-term market reaction to developments in Cyprus would blow over. And while it lasted it would be a buying opportunity for stocks that have been bid up this year.

Second, as I pointed out in last week’s Mind Over Markets, in “The Dollar Rises Again,” the euro’s pain could very well be the US dollar’s gain. That’s another good reason not to abandon good US stocks, no matter how bearish you may be on the greenback over the long haul.

A move to a more accommodative monetary and fiscal policy in the euro zone would be good news for US companies operating in Europe as well as local companies, because it would spur both growth and competitiveness. Our model Personal Finance portfolios have plenty of both.

What happens if Cyprus really does set off a global contagion, as so many have feared other euro zone events would? If so, the best defense would be to diversify, ensure your portfolio is balanced and not over-weighted, and to focus on high quality companies.

We’ve only a few more weeks to wait before Personal Finance portfolio companies begin reporting their calendar first quarter 2013 earnings. At that point, we’ll see how our favorites are faring in an economy with many hopeful signs, but also facing the uncertain impact of higher taxes and reduced government spending.

Whether contagion worries percolate or not, earnings news will soon replace euro zone turmoil at the forefront of investors’ minds. That should be a comforting thought, as we head into a weekend with so many unanswered questions overseas.