Troubles at a Portuguese bank sent shivers through global markets, underscoring the fragility of the stock rally and reawakening fears over the stability of Europe's banks and the prospects for economic recovery.
While those concerns subsided and North American stocks later pulled back from deeper losses, the ripple effects from Portugal put a sudden end to investor complacency and triggered a rush to traditional islands of safety such as U.S. Treasuries, German government bonds and gold.
At the end of the day, the hit to North American stocks merely sent major indexes back to where they were several days ago. But the selloff highlighted concerns not only about Europe but also about high stock valuations on this side of the Atlantic.
"While we don't think that this will morph into yet another new, nastier phase of the crisis, it is a reminder that there are still lots of potential aftershocks and hangovers from the massive buildup of public sector debt from the lengthy EU recession," said chief economist Douglas Porter of BMO Nesbitt Burns. "And markets have suddenly gone from euphoria to Europhobia."
The source of the initial flight was Banco Espirito Santo SA (BES), Portugal's largest publicly traded bank by assets, and its wobbly parent, Espirito Santo International SA, a conglomerate with major real estate and other holdings. After plummeting more than 50 per cent since the start of April, the bank's stock lost 17 per cent Thursday, prompting the country's regulator to halt trading in what has become a penny stock. Immediately there were fears in the market that the bank's problems would hit other lenders, triggering a new banking crisis in Europe.
"With Portugal looking to be in trouble once again, prudent analysis has been thrown out of the window in preference to a knee-jerk reaction," said IG market analyst Chris Beauchamp. "Portuguese bond yields aren't soaring [yet], and the contagion hasn't spread to Spain or Italy [yet], but the combination of the news from Lisbon and more data that confirms the weakness of the euro zone has provided the excuse to finally kick-start the summer volatility trade into life."
Portugal's benchmark stock market index fell 3.7 per cent amid a wider European retreat. Italian stocks fell 1.9 per cent, Spanish stocks fell 2 per cent and even German stocks fell 1.5 per cent.
In the bond market, spreads widened sharply between German bonds and comparable government bonds issued by Spain, Italy and Portugal. But even in Portugal's case, the 10-year bond rose only one-fifth of a percentage point to just under 4 per cent, a remarkably low level for a country supposedly on the brink of financial calamity.
"The Portuguese banking system has been able to endure the crisis without significant disruption, aided by substantial public capital support and extraordinary measures from the ECB," the International Monetary Fund said in a statement. But it added that "pockets of vulnerability remain, warranting corrective measures in some cases and intrusive supervision in others."
The IMF would not name names. But BES does have a slew of headaches ranging from its ultimate parent's financing woes to a large, problem-laden portfolio of Angolan loans.
Espirito Santo International (ESI) owns one-third of Espirito Santo Financial Group, which in turn is the main shareholder of BES.
Dating back to last December, ESI came under scrutiny for its accounting practices during the worst of the financial crisis. It appeared everything the company did was legal, but concerns were raised that the company sold preferred shares to retail investors and understated the risks of those investments.
The Portuguese central bank ordered an audit and determined that the parent company was in "serious financial condition." Those worries were exacerbated this week when ESI delayed payments on some short-term debt.
This could spell big trouble for the Portuguese economy, because ESI is a huge holding company whose problems could weigh on business confidence and further damage its bank, which lost €517-million ($749-million) last year, largely because of credit provisions.
But there's no evidence that the bank itself is in dire financial condition. It has survived stress tests and did not require a government bailout during the euro crisis. And with only €52-billion in loans outstanding, it could fail without causing huge ripples in European financial circles – or global markets.