3 Indicators to Follow as Political Drama Returns to Europe

Last week, political drama returned to Europe, and resulted in most major European markets finishing the week solidly negative.

First, Spain’s political opposition leader called for Prime Minister Rajoy’s resignation after a slush fund scandal erupted. Popular Party political officials, including Rajoy himself, appear in a handwritten ledger as having received payments from contributions that violated regulations. Rajoy and others mentioned in the journal have maintained the document is a fraud. But concerns linger nonetheless.

In Italy, former Italian Prime Minister Silvio Berlusconi’s political coalition gained on favorite Pier Luigi Bersani’s center-left Democratic Party. This is worrisome for the markets because in the fall of 2011, then Prime Minister Berlusconi was removed from office after a no-confidence vote as Italy teetered on the brink of needing a bailout.

A win by Berlusconi in Italy could push the euro over the edge.

The economic and financial reforms that have helped bring Italy back from the brink since then were all implemented after Berlusconi was removed as PM. And the concern is that if he is elected, he will backtrack on the progress Italy has made.

Why This Is Important …

As of now, it looks like Rajoy is safe and Bersani should win. But, as we saw with Greek elections last year, anything is possible. Making things even more uncertain, last Friday was the last day official Italian polls could be published before the February 24th election.

All this is important because Spain’s and Italy’s leaders must continue to implement needed austerity and reforms to assure the rest of Europe remains willing to bail them out if needed. If leadership changes and new leaders decide they don’t like austerity, which is basically Berlusconi’s platform, a full-scale euro breakup is back on the table, and risk assets will drop.

Trying to decipher the dozens of headlines that have come since these two political dramas erupted is next to impossible. Luckily, we know that markets have a great way of instantly discounting and valuing lots of information.

So the most important thing you must know is …

Which indicators will help you determine if Europe is really deteriorating again, or if this is all just a “tempest in a teapot”

The three key indicators I suggest you watch over the next 2-3 weeks are:

• The yields on Spanish 10-year bonds,
• The yields on Italian 10-year bonds, and …
• The European banking index (SX7P), which has foreshadowed a decline in stocks over the past several years.

These three indicators have been the pulse of the European crisis since its outbreak nearly three years ago. And they often signal when things are seriously deteriorating, well ahead of a fall in stocks.

So, if Spanish and Italian bond yields continue to creep towards 6 percent and 5 percent respectively (currently around 5.5 percent and 4.6 percent), that is a sign things are getting stressed in Europe.

Additionally, if the SX7P — shown in the chart below — declines sharply, you can expect stocks to fall.

Click the chart for a larger view.

You don’t need to accurately decipher and interpret every piece of news coming from Europe. But it is essential that you know which indicators to follow to give you a true gauge of the markets. So I encourage you to watch these three over the coming weeks, and ignore the hysterical media headlines.

They will cut through the noise and give you the real analysis of the state of European markets, which could lead you to profitable opportunities on the downside as well as the upside.

Best,

Tom