Will European Voters and Strikers Derail The New Treaty's Austerity Plans?

European leaders agreed last Friday to a new EU treaty aimed at solving the euro zone debt crisis.  A key aspect of the fiscal treaty was an agreement to pursue stricter budget rules.  However, it did not take Italian labor unions long to show their displeasure with the pact.  The three largest Italian public and private sector unions walked off their jobs yesterday.  The unions are planning strikes throughout this week in an attempt to force the Italian government to modify the austerity plan. These strikes raise the question of whether European voters and labor unions will support austerity measures required by stricter budget rules.

Nationalistic resentment about the austerity measures being imposed upon economies that are already in recession could lead to the fiscal treaty ultimately being rejected.  The EU's aim to have the fiscal treaty finalized by March and ratified by June may not be achievable.  In addition to British opposition to the fiscal treaty, several other non-euro zone countries, including Sweden, Hungary and the Czech Republic, require parliamentary approval before giving their full backing to the pact.

It seems appropriate to be skeptical about whether much progress was really made in solving the debt crisis at the meeting in Brussels.  Greece still teeters on the brink of default and the cost of funding debt in Italy, Portugal, and Spain is at unsustainable levels.  Further, the European banks lending will be constrained by need to a fill a capital shortfall of $150 billion to hit new minimum levels demanded by the European Banking Authority.  The next round of elections in Europe may also bring to office politicians that are opposed to the new EU treaty. In particular, France's President Sarkozy's will face a tough re-election battle against a Socialist Party candidate, Francois Hollande, that has announced he would renegotiate the treaty. 

There remains a great deal of optimism in the U.S. that: 1)  the problems in Europe will be solved or contained; or 2) that the U.S. economy will be able to muddle through even if Europe goes into a recession of a depression. Frankly, this complacency about the impact on the U.S. economy in 2012 of the European debt crisis may be misplaced. 

According to Goldman Sachs, "A small minority of investors expects a euro breakup and a deep recession in Europe. In this case our uncertainty-based P/E model suggests the S&P 500 could fall by roughly 25% to 900. Even if collapse is avoided, the continuation of “passive containment” and delay of resolution continues to raise the costs in both financial and economic terms, creating a poor condition for equity markets." 

Time will tell whether the small minority of Goldman's bearish investors are correct. However, all investors should prepare for the possibility that the bear case will come to pass.