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Markets May Need Another Major Retreat Before Europe Is Forced Into Action: Strategist

Europe will continue to hold stock markets hostage until the region’s debt crisis is resolved, and it could take a further correction of up to 40 percent before governments are forced into action, says Kelvin Tay, Chief Investment Strategist at UBS Wealth Management in Singapore.

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Global stocks have remained volatile since falling nearly 20 percent from early August to late September as news of Greece’s debt problems unnerved investors. Tay says the skittishness could continue well into next year as attention shifts towards an Italian debt crisis, a possible recession in the Euro zone and a potential breakup of the bloc.

"2012 is going to be very similar to 2011, where the markets are going to be in the stranglehold of what's happening in Europe. So you might actually need the markets to come off, 25, 30, 40 percent before the politicians get together and say 'Hey let's not muck around here, we need to get something seriously done'," Tay told CNBC on Tuesday.

A spike in 10 year Italian bond yields past 7 percent in the past week — a level widely seen as the trigger for a bailout — forced a change in the government in Italy and a push for much needed reforms. However, UBS thinks there is still substantial uncertainty over whether Italy and Greece would be able to implement austerity measures in a way that would be "convincing to the markets".

Tay expects Italian bond yields to go even higher, towards the low single-digits, before anything concrete gets underway. "That's going to be enough to force the whole situation," he said.

He doesn’t expect the alternative — a breakup of the Euro zone —to happen, as the consequences would be too devastating for politicians.

"The nations have to say: We want to step out of the Euro zone. The Euro zone can't say: Guys get out of the Euro zone. So it's very, very difficult. And of course you have the associated risks which runs with the banking system — the whole banking and financial system breaking down altogether. The political, social and economic costs are just far too adverse right now for the eurozone to actually consider that (a breakup) as an alternative," Tay said.

Others note that Europe, especially Italy, will require more than austerity to get back on track. Reforms promised by recently ousted Prime Minister Silvia Berlusconi a decade ago were never fully implemented, leaving the average Italian worse off today than in 2000, according to data from the IMF.

"Until Italy's growing again, and what you need there is the structural reforms of its labor markets, to allow the long-term growth to come back there... if Italy doesn't grow, it's very difficult to sustain that long-run debt of theirs," said Jay Bryson, global economist with Wells Fargo Securities.

"I want to see them...tearing down the associations, the professional associations in Europe, Italy, to make it easier for people to move into some of those service sector jobs, that's the sort of things that we really need to be able to see."