Eclipse of monetary effect

Currently, the prime reason for the semblance of stability in Europe is the ECB, which - after the disastrous rate hikes of Jean-Claude Trichet - opted for US-style non-traditional monetary policies. Since fall 2011, an elusive calm has been sustained by Mario Draghi's pledge to defend the euro "at any cost," record-low interest rates and rounds of quantitative easing. Yet, realities are different, as evidenced by the euro's drastic 23% plunge from $1.45 in fall 2008 to $1.13.

Recently, the ECB launched a relatively large easing package, cutting all policy rates and further expanding QE to €80 billion per month. Yet, markets were no longer that impressed. Just as the Fed's Bernanke a while ago, Draghi has been forced to acknowledge that even non-traditional monetary policies cannot overcome structural challenges. That's the job of fiscal policy, which would require the kind of common institutions that Brussels lacks. As a result, economic uncertainty, political divisions, and strategic friction are likely to be reinforced by increasing market pessimism as the ECB has few alternatives but to continue to exhaust its policy tools.

Recently Eurozone banks have also been hit by a slate of shocks, while equity sell-off has sparked concerns about their profitability. In Italy, non-performing-loans (NPLs) have soared, which has resulted in efforts to "resolve" some local banks. French banks are suffering from the ECB's squeezed rates. In Germany, Deutsche Bank suffered a loss of €6.8 billion in 2015, after scandals and lawsuits, while the regional state-owned Landesbanken are coping with adverse markets. With heavy debt burden, Spanish banks' NPLs remain at elevated levels.

As the EZ banks grow more fragile, they are less likely to support the ECB's monetary easing in the real economy. By the same token, a systemic banking crisis, coupled with political repercussions, can no longer be excluded.

Changing sovereign risks

The erosion of Europe is not inevitable. Currently, financial and monetary conditions in the Eurozone actually reflect a slight improvement suggesting that the region is still on a rebound. However, economic indicators suggest that growth is slowing, as a result of the region's new threats and the weight of the old ones.

If the ECB's policy tools continue to soften, banking system remains fragile and Brussels cannot defuse the new threats, Europe's sovereign creditworthiness could face substantial downside risks - despite half a century of integration.

A Brexit alone could spark a downgrade to the UK, while providing another push for independence movements from Scotland to Catalonia. Such moves would shift spotlight on the fragile sovereigns in Western Europe's southern periphery, force new scrutiny of indebted core economies (France, Spain) and increase scrutiny of several EU members in Central and Eastern Europe (CEE), which currently benefit from the EU's enhanced creditworthiness. Of the 19 Eurozone sovereigns, 16 are investment grade today, while three remain speculative grade (Portugal, Greece, Cyprus) and two have negative outlooks (France, Finland). With a major shakeup, downside risks would increase significantly for those with speculative grade and negative outlooks, while investment grade positions would begin to soften.