Saft On Wealth: Europe's fall risks American winter

(Reuters) - It doesn't matter if you have zero foreign holdings, Europe's fall can easily turn into an American winter for the economy and financial markets.

The euro zone's debt crisis has reached a critical juncture, with markets losing faith in the bonds of even highly rated core countries, while economic behemoth Italy dangles in the wind.

Investors on Thursday were demanding a record amount of extra yield for holding 10-year French, Austrian, Belgian and Spanish bonds instead of benchmark German issues.

Even worse, those in charge, and with the strongest commitment to the project, are now apparently entertaining thoughts about what the world after this iteration of the euro would look like.

France and Germany, EU sources told Reuters, have held talks about a sort of semi-fracture of the euro, with a smaller and more highly integrated core supplemented by a looser outer circle.

It is impossible to know which way things will fall. Will the ECB oblige with a massive money printing exercise to protect the current arrangement? Will Germany and the core secede, or will Greece and others, perhaps Italy, be chucked unceremoniously out?

Whichever happens, portfolios everywhere will be hugely affected, from Asian shares which will find their largest export market in, at best, a recession, to the U.S., which is badly placed to fend off the waves of deflation coming out of Europe.

That is perhaps the first thing to understand: Europe's woes mean suppressed growth and inflation. Greece, Italy, Spain and Portugal have a competitiveness problem which must be resolved now that bond markets won't fund them anymore.

If they remain in the euro, living standards there will drop and the fall in demand that implies will put downward pressure on inflation.

If they leave that same force will be spread as -- newly competitive with a new drachma or new lira -- they compete on price with the rest of the world.

On the margins, that's all quite good for U.S. Treasuries, which will get a bid both because of the United States' relative stability and because the Fed's job of reigniting inflation and growth will be that much more difficult.

It is terrible, on the other hand, for equities. Profit margins should take a hit, and as we know from Japan, a very low growth and inflation environment is not good for long term stock returns.

If the ECB does a policy U-turn and prints money, bailing out Italy and others, it will probably be better for riskier assets but will add volatility, which tends to be bad for financial market valuations, and risk.

BANKING TRANSMISSION

The real nightmare scenario, and believe me that is not hyperbole, is a massive bank run in Europe, one which would end who-knows-where.

Any savvy Italian or Spaniard should realize that if their country leaves the euro not only might their banks fail, but their strong(ish) and stable (sort of) euros will be replaced by devalued new pesos or lira.

If they believe that is a realistic possibility, people will start to front run the process, pulling money out of home country banks and socking it away somewhere safe like Switzerland or Germany.

This process could easily turn into a bank run, one countries may wish to forestall by imposing controls on taking money out of the country. Fear of capital controls may simply serve as an accelerant.

As well, a euro exit by Italy, for example, will kill the solvency of many banks elsewhere.

That in turn can turn into a panic which hits even banks without any exposure to Italy or Spain. A wave of bank failures and recapitalizations, even if contained to the euro zone, will have important consequences for markets everywhere.

It will take credit out of the global system, making loans that much harder and expensive to get, even in the U.S.. Such an event would also massively hurt risk appetite, as investors burned by the euro zone debacle pare back on risk taking generally.

Thinking about this from a purely U.S. point of view, there are three main takeaways.

First, a recession in Europe, which is pretty much inevitable whatever the outcome, is a blow to global demand at a bad time for the U.S. economy. A disorderly break up of the euro almost certainly means a recession in the U.S., which will aggravate the unemployment and housing issues, crises the U.S. is barely coping with as it is.

Second, the chance of a transmission of failure through financial markets channels is real, but this time, unlike 2008, establishing consensus about how to rescue banks will be much more difficult.

Third, almost regardless of how it works out the woes of the euro zone will be exporting deflationary pressure globally, either all at once in a break up of the zone or little by little if the project hangs on.

All things being equal, which of course they rarely are, this should be good for Treasuries and bad for equities and other riskier instruments.

It may be a cold winter in financial markets, and a bitter one in parts of the real world.

(Editing by Walden Siew)