Back from the Brink in Europe, Again

07/03/12  Author: Charles Lieberman, CIO

It will dawn on investors at some point that European leaders will not permit the credit crisis to lead to a meltdown in European markets. Each time the crisis worsens, European governments take whatever steps are necessary, sacrifice some sovereignty when they must, accept some of the liabilities of others, to avoid a breakdown of the system. The debt problems of Europe haven’t been solved even yet, but worst case scenarios should be regarded as fairly remote. Thus, we expect attention to shift towards the performance of the domestic economy, which still requires attention.

Recession in Europe has only a modest effect of domestic growth. Exports account for about 13% of U.S. GDP, Europe accounts for just 20% of U.S. exports and a sharp recession in Europe might lower their GDP by maybe 3%. So the impact of a recession in Europe on domestic growth is 13% times 20% times 3% of GDP, a miniscule number. The real risk was that of a meltdown of their credit markets, which might also cause our credit markets to freeze up. This was considered a severe risk, since memories of the credit freeze of 2008 are sufficiently fresh. Still, such an event requires that European leaders would fail to address the problems and would allow them to fester until they explode. Such an outcome was possible, but not overly likely. Once again, European leaders have stepped up to relieve the pressures.

Concerns over domestic growth were always overly focused on this risk of a total collapse in Europe. This possibility was always remote, but the fear of such an outcome was sufficiently terrifying that it has been causing households and businesses to be spend more cautiously, just in case. Such caution contributed quite importantly to the periodic slowdowns in domestic growth and the inability of our economic expansion to gain any real momentum. Other factors add to the list of concerns. Our own politicians have failed to act responsibly with fiscal policy and deadlock seems to be the preferred outcome over compromise and good management. In this environment, it seems reasonable that firms and people would spend only when necessary. Thus, hiring gains are slow, as is economic growth.

Even so, companies have proven over the past several quarters that rapid growth is not necessary for firms to grow profits. Fear is sufficient to keep valuations cheap however and to encourage investors to buy bonds for their safety. Longer term, this is a mistake. But in the short-run, it buys piece of mind. Still, stocks are the place to be if investors want or need any kind of return.

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