Macro, Policy

U.S. and Europe Update Back in the Soup

November 23rd, 2011 | By Nick Sargen


  • Equities have given ground this month on the heels of October’s big rally, amid spreading problems in the euro-zone and an impasse over long-term U.S. deficit-reduction.
  • While these developments are discouraging, I do not foresee a repeat of the crisis atmosphere in August, mainly because the risk of an imminent U.S. recession has diminished.
  • Meanwhile, investor attention is likely to shift to two policy issues: (1) Will extensions of the U.S. payroll tax cut and of unemployment compensation be affected by lack of a deal by the super committee? (2) What steps will European policymakers take to prevent further deterioration in the euro-zone?
  • Markets are likely to stay volatile until there is greater clarity on these issues. I continue to believe resolution of the U.S. budgetary problems will have to await the outcome of the 2012 elections. Problems in the euro-zone are more intractable and pose the biggest threat to global markets.

Renewed Market Worries

Following a huge rally in risk assets in October, market participants have turned cautious once again in the wake of recent developments in Europe and the United States. The catalysts this time were the failure of European policymakers to put forth a credible plan to resolve the crisis in the euro-zone, and more recently the inability of the congressional “super committee” to reach agreement over long-term deficit reduction measures in the United State

When the so-called “European grand compromise” was unveiled in late October, the initial market reaction was favorable, mainly because European policymakers achieved a 50% haircut for Greek government debt without triggering a run on European banks. Nonetheless, there was still considerable skepticism about whether the actions to recapitalize European banks and to leverage the EFSF “bailout facility” were sufficient to stabilize the situation. Soon after, investors’ confidence crumbled when the Greek government called for a referendum on the support package and when the Italian government failed to convince investors about its austerity program. While Greece and Italy now have caretaker governments headed by competent technicians, there has been a further erosion of confidence in European leadership.

The growing concerns about the euro-zone are evident from a wide range of market signals. With the principal exception of Germany, government bond yields have risen significantly, including for core countries such as France, Austria, the Netherlands and Belgium. At the same time, funding for European banks has become more problematic.

Amid these developments, U.S. financial markets fared reasonably well until this past week, when news surfaced that the “super committee” was deadlocked on efforts to trim $1.2 trillion in deficits over the next ten years. This development contributed to a sell-off in U.S. equities. In contrast to Europe, however, U.S. treasury yields have declined recently, as they continue to be viewed as a safe haven by investors.

As a result of all of this, market participants are wondering whether there will be a replay of the August sell-off in risk assets. My own take is that equity markets may test the downside, but I do not expect as severe a sell-off as in August. One reason is that the U.S. economy has proved to be surprisingly resilient of late, with the pace of economic activity accelerating in the second half of the year. Another reason is that a possible downgrade of treasuries by either Moody’s or Fitch would probably have less of a market impact than the initial surprise announcement by Standard and Poors.

Uncertainty about Policy Responses

In the wake of these developments investors are now focusing on possible policy responses to stabilize markets. I am concerned that the inability of the super committee to reach agreement may reduce the odds of a deal being reached to extend the payroll tax cut and unemployment compensation benefits. In an ideal world, action to reduce the long-term budget deficit would have been combined with short-term measures to bolster the economy. Now, however, it is less clear that the two parties will be able to reach agreement on short-term stimulus measures. If so, there is a risk that the economy could lose momentum heading into 2012, as transfer payments have been critical to bolster disposable incomes and consumer spending. Therefore, fears about a “double dip” recession could ensue, even if the economy grows by 3% in the current quarter, as now seems possible.

My primary concern, however, is the ongoing deterioration in Europe, both on the economic and financial sides. As noted previously, funding problems in Greece, Portugal and Ireland have now spread to Italy and Spain and even to core countries in the euro-zone. In order to deal with funding problems for Italy and Spain, it is widely acknowledged that the purchasing power of the EFSF “bailout” facility will have to be augmented considerably. However, there is no sign of resolution on this issue.

Ultimately, the European Central Bank (ECB) will have to assume a role as the backstop for the euro-zone. This role will require it to provide necessary funding for commercial banks and also for European governments on a much larger scale than at present. The reluctance of the ECB to assume this role reflects traditional concerns that such action could be inflationary. However, with Europe on the cusp of recession and many countries confronting austerity budgets for the foreseeable future, the principal threat is deflation, not inflation.

Even if the ECB alters its stance at some point, the euro-zone confronts other notable challenges. They include transforming the euro-zone into a true fiscal and political union where the central government can oversee structural reforms in the member states. In this respect, there is no solution in sight.

Investment Implications

Amid the extraordinary volatility in financial markets in recent months, we have not made major changes to our investment strategy, because we believe there are too many moving parts and it is easy to get whip-sawed. With respect to U.S. treasuries, we expect 10-year yields to fluctuate in a broad range of 1.75% - 2.25% in the remainder of this year. We are continuing to maintain a moderate overweight position in investment grade and high yield corporate bonds.

We also look for the U.S. stock market to fluctuate in a broad range, and believe the market has posted both its highs and lows for this year. The broad market continues to be supported by reasonable valuations (in absolute terms and relative to bonds) and prospective future gains in corporate profits -- albeit more moderate than in the past two years.

The principal risk to the outlook is continued deterioration in the euro-zone. We believe the U.S. economy can withstand a moderate recession in Europe; however, we are also concerned that problems in the financial system are getting worse. As a result, we are reluctant to further add to risk assets at this time.