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SORRY FRANÇOIS

The Street is not convinced that “the worst is over” for Europe

By Simone Foxman

A summit of European leaders that took place last week produced lots of talk but little in the way of tangible reforms. Leaders made the most compelling progress on the Single Supervisory Mechanism (SSM)—a banking regulator that would oversee all euro area banks—giving us yet another acronym to remember. They outlined the most basic plans for the bank supervisor, and implementation of those proposals will be phased in over the course of the next year.

European leaders have unsurprisingly gushed over the progress they made. French President François Hollande even told reporters after day one of the summit, “Tonight, I have confirmation that the worst is over.” (Reuters blogger Andy Bruce hilariously mocks this statement.)

But Wall Street doesn’t share Hollande’s enthusiasm. Regardless of investors’ perspectives about the immediate ramifications of the summit for markets, most still believe that a solution that will quell fears of a euro break-up is a long way off.

Moody’s Chief Credit Officer Alastair Wilson and Director of Sovereign Research Matt Robinson write (sign-in required, but the report is free) that banking reform doesn’t go far enough, and that EU leaders continue to move only when market pressure intensifies:

Policymakers’ continuing disagreements regarding collective responsibility for banks are symptomatic of the continuing absence of a common vision on greater integration of fiscal and economic policy. German and other officials’ conflicting statements about the possibility of a new fiscal commissioner with authority to veto domestic budgets highlight the disparate visions, suggesting to us that difficult political decisions will continue to be deferred.

European policymakers’ willingness and capacity to voluntarily implement pre-emptive crisis-fighting mechanisms and institutional reforms are proving extremely difficult, and are often correlated with their exposure to market stress. However, a reliance on market pressure to motivate change leaves the euro area in a precarious position, exacerbating the potential for shocks to undermine sovereign creditworthiness, which ultimately increases the cost of resolving the euro area crisis.

Laurence Boone, Bank of America Merrill Lynch argues that EU leaders’ “kick the can” approach to reform is creating a steep drag on the euro area economy:

Four main factors shape the euro area economic outlook: the fiscal adjustment, the credit contraction, the export capacity of each country and, above all, the uncertainty weighing on investment and consumption appetite. We have argued in previous pieces that the muddling-through approach of euro area governments to dealing with the crisis is creating unproductive uncertainty, although it is fair to say that governments have made concerted efforts to strengthen euro area institutional flows.

“Sorry François,” says Jamie Dannhauser of Lombard Street Research in a client note. EU leaders have made some progress, but it’s not likely to buoy markets for long:

Sorry François [Hollande], the worst may not be over. We suggest: positive sentiment towards [euro area] unlikely to last far into 2013. Severing the link between troubled sovereigns and troubled banks is essential if the [European Monetary Union] is to survive. [European Central Bank] bond buying is one part of the solution; the other is an effective supranational bank supervisor and resolution mechanism. The latest summit of European leaders took us a step closer; but it is a long and bumpy road to economic salvation.

Bill Blain of Mint Partners thinks that the best move right now might be to bet against Italy, predicting that a probable Spanish bailout will increase pressure on Italy:

The question is whether to join the rally?…[D]o you want to follow names like Pimco and others and buy Spain? If you buy the fundamentals the answer is a resounding no. If you are willing to [bet on] European politics it’s a simple timing question. Buy Spain, sell Bunds….and sell Italy?

I’ve long held the view Italy is a much bigger mess than the market’s are prepared to credit…A rough consensus is that the political situation is chronically unstable, the economy is contracting and the economic fundamentals are miserable…So what happens to Italy when Spain takes the OMT bailout? We suspect the market then focuses on forcing Italy along the same path. It might take time, but when folk realise Spain’s debt is effectively mutualised within the ECB, who would buy Italy unless it’s got the same attractions. Basically, it shows Italy flatlining and worse compared to Germany.

Wolfgang Munchau, columnist for the Financial Times, presents a dour view of the last summit, arguing that progress on banking union will do little to stem the immediate problems of the crisis:

While the combination of banking, fiscal and economic union, if done properly, would create a minimally sufficient institutional set-up for a sustainable monetary union, there is a big snag: the monetary union might blow up well before the new mechanisms kick in. The banking union, as currently constructed, will not help us in the current crisis.