European Stock Markets and the Flight from Reality

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The economic news is going from bad to worse, so obviously this is a good time to stage a stock-market rally. That’s the contorted message coming out of Europe this week, on the heels of an E.U. crisis summit that was declared a success by most of the 27 government heads in attendance.

After tough talks, they appeared to reach an agreement on Friday that would allow governments easier access to the $875 billion pool of credit that has been set up as an emergency fund. They also approved a push by Spain for bailout money in principle to flow directly into banks, rather than going first to governments and thus pushing sovereign-debt levels up ever higher. (Spain is seeking $125 billion for its banks.)

The Finnish and Dutch governments on Monday sowed some confusion as to what had actually been agreed at the summit, but no matter. Stock markets in Britain, France, Germany and other European nations rose robustly, and the euro was also basking in the summit’s warm afterglow, although it dropped back a bit after a big bounce on Friday. The primary reason was a sense of relief that a worst-case scenario had been averted, but there was a very important secondary reason too: growing weakness in the already feeble European economy, which is raising market expectations for a cut in interest rates by the European Central Bank (ECB).

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Two sets of statistics issued on Monday show how fragile the E.U. economy has become. The first was the latest set of unemployment figures. They showed that the number of jobless in the 17-nation euro zone increased by 88,000 in May to 17.56 million, or a rate of 11.1%. That’s 1.8 million more than in May 2011, when the rate was 10%. In the 27-nation E.U. as a whole, almost 25 million people are now registered as unemployed, almost 2 million more than a year ago. Greece and Spain are the hardest hit, but the jobless rate rose in 18 of the 27 member states in the past month, according to Eurostat, the European statistics office.

The second piece of bad news was an index that gauges the expectations of purchasing managers in 3,000 companies around the euro zone. The latest report, by the research firm Markit Economics, showed a continuing deterioration in conditions, with significant declines in output and new orders being reported in a range of countries. Most troubling were the findings in Germany, easily the biggest economy in Europe, where purchasing managers reported the fourth monthly decline in succession, the steepest in three years. Commenting on the findings, Chris Williamson, Markit’s chief economist, said he expected the decline to accelerate further in the second half of the year. “Companies are clearly preparing for worse to come, cutting back on both staff numbers and stocks of raw materials at the fastest rates for 2½ years,” he said.

As if more bad news were needed, a highly anticipated report on the state of France’s public finances was published by the Cour des comptes, France’s equivalent of the U.S. Government Accountability Office. Its verdict: if the government is to reduce the budget deficit to 3% of gross domestic product next year, as scheduled, it will need to find additional savings of $41 billion. And that’s based on an optimistic scenario of 1% growth in 2013, which under current conditions seems anything but assured. “The situation remains manifestly troubling,” Didier Migaud, the president of the court, told Le Monde. “France is not out of the dangerous situation into which it entered several years ago.”

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None of this sounds particularly optimistic, yet traders have found some justification to buy — or at least they did so on Monday. The new element was growing speculation about the ECB, which is now widely seen as trimming interest rates in the near future. Deutsche Bank, for one, is expecting the ECB will “reward” the summit results by cutting its main interest rate, currently 1%, to 0.75%.

Whether that will make any difference to the real economy is a moot point. Interest rates, after all, are at historic lows in the main developed countries, including the U.S., but that hasn’t helped to pull them out of their deep economic woes. But then, when did stock markets ever let reality get in the way of a good rally?

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