Europe: All Quiet on the Western Front

The European Central Bank announced that it injected €530 billion into the European banking system in February, slightly higher than the €500 billion expected by analysts. This second installment of the Longer-Term Refinancing Operation (LTRO) is larger than the €489 lent out in December and brings the running total to over €1 trillion. For readers unfamiliar with the program, the LTRO was the European Central Bank’s most aggressive move to stabilize the financial system to date. Fearing another “Lehman Brothers moment” in which the disorderly failure of a major financial institution causes a domino effect of bank runs that risked taking down the entire system, the ECB made virtually unlimited funds available to participating banks for as long as three years at just 1% interest. If, say, the Greek government defaults on its sovereign debts, LTRO ensures that banks holding Greek debt remain liquid, even if they are technically insolvent. It is by no means a long-term fix to Europe’s debt problems, but it is a very effective Band-Aid.

Perhaps the best indication that LTRO is working as planned was the reaction of world stock markets to the announcements—or perhaps I should say lack of reaction. The Dow and S&P 500 were virtually unchanged, and European markets declined only slightly. The lack of volatility, either downside or upside, is proof that investors have taken a step back from the edge. In 2011, investors would have hung on every word of the announcement, and it’s likely the Dow would have moved 400 points. The muted action today proves that, at least for now, Europe is no longer considered an existential threat to the world financial system.

What Does This Mean for Investors?

The easing of Europe’s crisis removes an enormous weight that had been keeping a lid on stock prices. Not shockingly, the best performing stocks of 2012 have been those in the most cyclical and volatile sectors.

But lack of crisis should not be confused with economic health. Europe’s economy is still on life support, and the LTRO program raises a few key points:

1. Europe’s banks cannot remain dependents of the ECB forever. What happens when the ECB decides to withdraw its support? Will the banks be able to stand on their own two feet? If not, what happens then?
2. While LTRO has been effective in halting the crisis, the cheap loans being made available to Europe’s banks are not making it into the real economy. The same was true of the Fed’s aggressive stimulus moves after the 2008 meltdown; the Fed roughly doubled its balance sheet overnight, and yet lending in the real economy actually shrank as old debts were paid down or written off.
3. Monetary stimulus by the ECB is being neutralized by fiscal tightening and austerity by Europe’s governments. While this is not necessarily a bad thing—I, for one, applaud the discipline of Europe’s leaders to demand spending cuts and revenue hikes—it does come at the cost of current growth.

Still, on balance, it makes sense to be cautiously bullish. I expect European stocks to perform well in 2012, but I recommend investors hedge their bets by buying only the highest quality dividend payers. As a rule of thumb, I recommend that investors look to companies that have been able to raise their dividends in the past five years. If a company can raise its dividend in the environment we’ve just lived through, it can frankly survive anything.

As a one-stop shop, I like the PowerShares International Dividend Achievers ETF (PID, Financial). It’s loaded with some of the highest-quality dividend payers outside the United States, and most are domiciled in Europe.