Negotiations in Europe continue.  European Leaders tell us a solution is just around the corner, but that has been the case for nearly two years.  This time, the market is relatively optimistic, but it appears that full details of a solution may again be delayed for another week or two.

The market is looking for a solution.  The definition of solution is a means of solving a problem or dealing with a difficult situation.  It is unlikely that the EU Leaders' solution will solve all of the problems, but the solution will certainly need to be a detailed blueprint to deal with the current difficult situation.

The solution needs to be a plan covering three main issues:

1.     What to do about Greece (cut its debt);

2.     What to do about Europe's banks (recapitalise), and

3.     How to operate the European Financial Stability Fund (to prevent further runs on other European bond markets, specifically Italy's).

Twenty-one months seems a long time to come up with a plan.  We have heard endless reports of German Chancellor Angela Merkel and French President Nicolas Sarkozy meeting to discuss how to resolve the crisis, but there are 27 countries that have to agree, not just two.

Another problem is politics.  The Prime Minister of Luxembourg, Jean-Claude Juncker summed up the situation when he said: "We all know what to do but we don't know how to get re-elected once we have done it."

When a comprehensive plan is finally announced it is likely that the market will respond positively and a rally will follow.  Whilst that rally may be real, it will be worth considering that the rally will be on the announcement of a plan to deal with a very difficult situation.  The solution will not be an immediate fix.

Once the immediate crisis in Europe passes, the real, long-term solution will be economic (GDP) growth.  A country's debt is typically measured against its GDP, therefore, if a country's GDP declines its debt relative to GDP increases.  In contrast, if a country's GDP grows, its debt becomes less of a problem.

Because the debt of some European countries (primarily Portugal, Italy, Greece and Spain) has now become unaffordable, these countries are being forced to implement austerity measures (spending cuts and increased taxes).  Achieving GDP growth in this environment will be difficult; therefore it is likely that the solution in Europe will be protracted.

In summary, once European leaders announce a plan, if the market believes that the plan will effectively contain the debt crisis, that is, prevent the problem from worsening and spreading, share markets should rally.  Even if the rally is significant, investors need to be mindful that any such rally will not mean the problems are completely over and volatility will remain.  As always, investors need to ensure their portfolios are appropriately allocated to take into account the ever-changing investment environment and, importantly, are appropriate to their needs.

Regards
Nick Rose

Rochdale Accounting & Financial Services Pty Ltd is a corporate authorised representative (303378) of Capstone Financial Planning Pty Ltd AFSL 223135. 
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