Why Europe Debt Defaults Are About to Rattle Stocks

Though the crisis in Europe has been pushed aside in recent months, the new year is likely to bring new concerns that a slew of nations are in line for debt defaults.

Talk of a Euro Break Up Dangerous: Slovenian President

Citigroup released a fresh analysis Monday in which the firm estimates that at least five nations along the periphery of the euro zone will need to restructure their onerous debt burdens.

The worst of the bunch — Greece — likely will dump the currency completely before 2013 ends, while nations such as Spain and Italy that have ducked under the radar likely will find themselves back under pressure, Citi said.

"In Europe, we assume that in the near term, as recently, creditor nations will continue to do just enough — through official support — to prevent (European Monetary Union) disintegrating, but not enough to return the periphery countries to sustainable fiscal paths," Citi economist Michael Saunders said in a report.

"Eventually, we expect Grexit (the nickname for a Greek euro zone exit) and a series of sovereign debt restructurings, alongside moves towards tighter integration among EMU countries," he added. (Read More: The Euro Zone Is 'Shaping Up Quite Well': Think Tank)

The result, the team at Citi said, will be debt restructuring in Greece as well as bailouts for Italy and Spain.

Restructuring ultimately will take place in those nations plus Ireland, Portugal, Cyprus and Slovenia by 2017 after rounds of bailouts and austerity won't be enough to ameliorate the respective debt crises.

"In Greece, debt restructuring is unavoidable whether Greece exits the euro area (our base case, with a 60 percent probability in the next 12-18 months) or not," Citi said. "Banking sector deleveraging throughout the (European cooperation for Accreditation) — both core and periphery — will occur through consolidation and recapitalization, but also through resolution, debt restructuring and liquidation."

While the restructurings are ominous enough in terms of Europe's economic future, they also have broader implications.

U.S. financial markets spent two years at the mercy of the debt crisis, rising and falling with each headline. Bailouts and liquidity gestures sent stocks climbing, while the latest news of woes and social unrest over budget cutbacks sent markets reeling.

The stock market, though, has been on a fairly steady climb over the past six months as the European Central Bank and other authorities have shored up the debt problems at least for the moment.

At the same time, investors have placed sharply lower possibilities on debt defaults.

In Spain, for instance, the current probability of a default, judged by credit default swaps flows, is just 3 percent, down from 6.62 percent a year ago, according to Moody's Analytics. (Read More: Greece Debt Talks Likely to Result in 'Sticking Plaster' Solution)

"Market-based risk measures for most European sovereign issuers have actually improved a great deal over the past year or so," Jerry Tempelman, sovereign risk analyst at Moody's, said in an interview. "That's clearly due to actions by the European Central Bank that have improved liquidity a great deal over the past year."

But Tempelman said the confidence in European sovereign debt might be getting overdone.

"Investors could clearly be too optimistic at this point," he said. "You could argue that right now we're in the eye of the storm, if you will, that policy markets (should) take greater advantage of this opportunity to implement structural reforms measures. The ECB has improved liquidity, but that does not take care of long-term solvency."

Indeed, the market has been down this road before only to be let down either by the scope of the problem or an unwillingness by Europeans to adopt reforms necessary for further bailout funds.

Those roadblocks will be complicated by a European economy likely to begin, and possibly end, 2013 in recession.

Similar conditions in the past have not been kind to U.S. stocks.

"We continue to think that the economic assumptions on which the latest debt forecasts are based are too optimistic," Vicky Redwood, chief UK economist at Capital Economics, said in a note. "As a result, it may only be a matter of time before major doubts about the future of the bailout resurface and Greece moves back to the brink."