Because of the EU’s lack of fiscal unity, a monetary and fiscal crisis was largely inevitable. The EU’s founding members hoped that somehow fiscal unity might emerge over time. Over the past 25 years, however, Europeans have been slow to address the issues that have prevented them from achieving a greater degree of fiscal unity.

But after two years, the Continent’s sovereign-debt crisis reached a critical stage that finally compelled leaders of member nations to take action.

During a meeting earlier this month, European heads of state struck a deal aimed at restoring order to the region’s economy and financial markets. The tentative fiscal compact would limit budget deficits by member states and create sanctions to enforce budget discipline.

Unfortunately, doubts abound as to the extent to which the deal can truly be implemented. The proposed fiscal rules aren’t going to be incorporated into a customary EU treaty, so each country will have to adopt the rules as they would any other law in their home jurisdictions. As a result, the rules are subject to each member nation’s political process, whether that involves parliamentary debate or ratification via referendum. As such, there is substantial political risk that the new rules may not survive this process in some countries.

The markets haven’t given the proposed deal a vote of confidence; the euro recently hit an 11-month low, equity prices in the region have continued to fall and yields on Italian bonds are rising once again.

This pessimistic reaction is understandable, but such pessimism is largely overblown.

The primary concern is that the EU will ultimately splinter as a result of this crisis, but that’s an unlikely outcome.

That’s because the consequences of a breakup–particularly if it’s not handled in an orderly fashion–would be dire. From an economic standpoint, the EU’s raison d’être is to facilitate trade within the region, which would collapse in the event of a breakup.

And dissolution of the currency union would require the reintroduction of former national currencies. As a result, citizens would be anxious to move their cash into the countries which have the strongest national currencies. That would spark bank runs which, in turn, would require nations to introduce capital controls and recapitalize their now isolated banking systems, as well as restrict the movement of both people and currency across their borders. In order to fund those efforts, private assets would have to be seized and hyperinflation would be a likely consequence. Naturally, social disorder would be rampant in the midst of this activity. That’s not an environment conducive to friendly trade.

There are orderly ways in which a dissolution could be handled, which largely sidestep many of the unpleasant consequences of a drastic change. But the temper of the European public is not favorably disposed to these changes.

So European governments are heavily incentivized to keep the currency union together and transform what was initially an experiment into a viable long-term societal evolution.

Germany stands to gain the most from a eurozone resolution even though it may be liable for financing the bulk of the deal.

Presently, the EU is tentatively committed to funneling EUR200 billion into the International Monetary Fund, about a quarter of which will likely be funded by Germany.

With Germany’s deep trade ties in the region, that’s a small investment to ensure markets remain open to its goods and services. On the other hand, Germany is better positioned to weather a collapse of the EU.

For one, Germany also has extensive trade relations outside of Europe: 6.7 percent of annual German exports are bound for the US with a further 4.7 percent going to China. So while a disintegration of the EU would be a shock for German exporters, they don’t rely solely on the EU for revenue.

And if the Deutsche Mark were to be revived, the former German national currency would be one of the strongest currencies in Europe due to the conservative monetary policy of the Bundesbank, Germany’s central bank.

Because of our relatively positive outlook, we’re maintaining our buy recommendation on iShares MSCI Germany Index (NYSE: EWG).

The exchange-traded fund (ETF) tracks the country’s 50 largest companies. The ETF’s portfolio has significant exposure to companies that derive a sizable percentage of their earnings outside the EU, including industrial companies involved in emerging-market infrastructure projects. We expect the gross domestic product (GDP) of emerging market nations to continue growing at a pace at least double that of the developed world, so that should cushion earnings for German blue chips.

Continue buying iShares MSCI Germany Index under 25.

Asian Connection

European progress toward a resolution to their debt crisis will also help China in its efforts to engineer a “soft landing” for the Middle Kingdom’s export-driven economy.

European officials have reportedly been courting the Chinese for months now, hoping to win a financial commitment from the growing global powerhouse. With nearly $3 trillion in currency reserves, China is one of the few entities with the financial strength to help stem Europe’s crisis. China also has a vested interest in seeing the eurozone stabilize because Europe consumes 25 percent of its annual exports.

Beyond exports, the Chinese government is also taking steps to boost its domestic economy. On November 30, the People’s Bank of China (PBOC), China’s central bank, announced that it had cut the reserve requirement for the nation’s largest banks by 50 basis points. That marks the PBOC’s first monetary easing in three years and it’s clearly aimed at shoring up the nation’s economy. We suspect that this was simply the first step in a broad program of monetary and fiscal easing which will likely run at least through the first quarter.

However, China’s policymakers aren’t in a position to pursue measures quite as economically stimulative as in years past; between 2008 and 2011 the PBOC grew its balance sheet by about $1.5 trillion while commercial bank credit expanded by more than $4 trillion. But a wide range of stimulative policy options remain available and with inflation in China currently running at a 14-month low–and expected to fall further in coming months–the central bank has a relatively free hand at this point.

Further reductions in bank reserve requirements are the most obvious blunt instrument in the PBOC’s toolbox, so we expect to see another cut in the coming months.

That would be a boon to China’s real estate developers, which rely on cheap credit to fund new construction, so reserve cuts should provide a boost to Guggenheim China Real Estate (NYSE: TAO).

China’s central government had been worried about the formation of a real estate bubble and the impact that it could have on domestic inflation. So over the past year and a half, Chinese authorities have been moving to cool the real estate market by requiring higher down payments or higher interest rates on home loans. These measures have achieved a slowdown, as evidenced by a decline in residential real estate transactions in 27 of China’s 35 largest cities.

With real estate prices down by double digits in many of its major markets, China is widely expected to begin loosening its stricter real estate policies, though the timing of these actions is in question. There’s also concern that the pace of Chinese construction over the past few years has left a huge overhang of unsold properties that will likely keep real estate prices depressed for at least another year.

But according to news reports, there is a healthy debate going on within the central government as to whether it should “reheat” the real estate market. One of the most common criticisms of the Chinese real estate market is that it’s too difficult for middle class Chinese to afford property. Officials on one side of the debate believe the government should do more to help middle class families buy homes, while other officials believe the real estate market should be further dampened. At the moment, it’s unclear which side’s arguments are likely to prevail.

While we remain sanguine about the overall Chinese economy, our concern about China’s real estate market has led us to cut Guggenheim China Real Estate to a hold.

Despite our more cautious stance toward Chinese real estate, we remain bullish on Chinese equities even though their recent performance has been weak.

Although economic growth has slowed in China–GDP growth this year should be somewhere around 9 percent versus more than 10 percent last year–it is still outpacing all of the developed nations. The current consensus forecast for 2012 Chinese GDP growth is 8.5 percent versus just 2.1 percent in the US and Japan, and what might be an overly optimistic forecast of 0.4 percent growth in the eurozone.

At the same time, inflation is expected to cool markedly from just over 5 percent this year to 3.1 percent in 2012.

With healthy growth and low inflation, the Chinese central government has plenty of room to take stimulative measures to keep GDP growth in the neighborhood of 8 percent for some time to come.

Due to the fact that China will remain a key driver of global economic growth, we remain bullish on Market Vectors China ETF (NYSE: PEK).

Weaker corporate earnings outlooks have been the most significant drag on Chinese equities; the slowing property market and the European debt crisis have shaken earnings forecasts. But as noted earlier, we expect progress to be made on both fronts in the coming year.

Market Vectors China ETF tracks the CSI 300 Index, a local market capitalization-weighted index designed to represent the 300 largest, most liquid shares traded on the Shanghai and Shenzhen bourses. It is also designed to exclude shares that exhibit higher-than-average volatility or suspicious signs of price manipulation. Market Vectors China ETF is the first US-based ETF offering exposure to this index, and allows American investors to tap into the broader Chinese markets.

Given our expectation of improvement in the Chinese markets, Market Vectors China ETF remains a buy below 55.