A perfect storm of uncertainty continues to impact global financial markets, contributing to sharp swings.

The European Union (EU) debt drama is quickly reaching a boiling point as larger euro economies are now getting sucked into the crisis. Meanwhile, in the US, investors face additional fears, including slower economic growth and the partisan budget battle going on in Washington.

We remain cautiously optimistic, however, because we expect many of these unknowns to be resolved in the weeks and months ahead, which should pave the way for a rebound in the economy and renewed strength in the markets.

Why the EU Can’t Play Kick the Can with Italy and Spain

This week, Italy and Spain became the focus of Europe’s debt drama, wrestling the headlines away from Greece and Portugal.

Italian and Spanish government bond yields exploded higher this week. Italy’s 10-year bond yields surged above 6 percent yesterday, while Spain’s reached a record 6.26 percent. By contrast, the yield on 10-year German government bonds is just 2.7 percent.¹

The one-off bailouts engineered by the European Central Bank (ECB) for Greece, Ireland and Portugal were no sweat to pull off, but Spain is twice the size of these three economies … combined! Spain is continental Europe’s fourth largest economy, and Italy is the EU’s second-largest borrower, with debt at 119 percent of GDP.²

But there could be a silver lining in this.

The ECB simply doesn’t have the financial firepower to bail out Spain and Italy on its own. We believe the EU can’t afford to kick the can down the road any longer. Instead, the only choice left may be to bite the bullet and come up with a permanent solution. Otherwise, the EU’s very existence is at risk.

The good news is that several options are on the table. EU finance ministers seem more open to large scale debt restructuring that may involve a Brady-bond type solution, which helped solve a debt crisis in Latin America during the 1980s. The plan would involve rolling over maturing debt into new bonds backed by the eurozone.³

If admitting the full extent of Europe’s debt problems is indeed the first step on the road to recovery, then perhaps investors already recognize this as a step in the right direction.

It’s interesting to note, in spite of the dramatic headlines of escalating default risk, European stocks have been among the world’s best-performing markets year-to-date. The MSCI EMU Index gained nearly 10 percent during the first half of 2011. Spain’s stock market was up 12.7 percent, and Italy’s 8.3 percent through the six months ended June.⁴

Perhaps investors have already priced in the worst-case scenario and they are now looking past the short-term pain and focusing instead on the benefit of getting the crisis resolved once and for all.

Europe’s Woes Not Spreading to the US

Despite what you may see on the news, we find little sign that Europe’s debt problems are spreading to this side of the Atlantic.

While interbank lending rates have gone up in Europe — reminiscent of what happened during the credit crunch in 2008 — 3-month LIBOR rates in the US have been steadily declining all year, indicating no credit stress here.

Also, rock solid readings from the Bloomberg US Financial Conditions Index show us that US credit markets are unfazed by the sovereign debt crisis over there. The index is well above levels during the 2008 credit crunch … and is even higher than at this time last year when the eurozone debt drama first grabbed headlines.⁵

That’s not to say that all is well here at home. After all, we’re facing a debt problem of our own in the US.

Politicians in Washington are doing their best to undercut investor confidence with dysfunctional partisan squabbling over the US debt ceiling. Congress seems dead set on playing a game of chicken … flirting with a possible debt default if no agreement is reached over the next few weeks.

Politicians of both parties should be ashamed of their bad behavior. They seem more interested in playing brinksmanship for short-term political gain than in tackling deficits in an honest way. It certainly doesn’t inspire much pride, much less confidence, in the American political system.

Then again, an impasse in budget negotiations resulting in even a technical default is a no-win situation for all. That’s why it’s more likely that a deal will be made at some point, even if it’s at the eleventh hour.

At precisely the same time this drama is going on, the US economy is coincidentally working through a mid-cycle slowdown in growth. We detailed the case for why we believe this soft patch should prove temporary in the Banyan Letter recently (Issue 22 • June 22, 2011). Suffice it to say, the current slump in growth appears to be a case of bad timing, but nothing more serious, in our view.

Last month’s unemployment report is a perfect example. There’s simply no way to sugarcoat it … the June job report was terrible in several ways.

Our economy created just 18,000 new jobs last month when forecasts called for over 100,000. The unemployment rate ticked up to 9.2 percent while the broader U-6 measure of under-employment is now up to 16.2 percent and has been rising for four straight months.⁶

Still, it’s important to remember that individual data points like the monthly jobs report or quarterly gross domestic product (GDP) numbers can be extremely volatile and are often heavily revised after the fact.

That’s why it’s important for long-term investors to focus on the big picture trends, rather than the month-to-month noise.

That’s not enough to make up for all the lost jobs during the last recession, but we’re trending in the right direction, with private sector job growth averaging 160,000 per month in the first half of 2011, in spite of June’s poor showing.⁷

The overall economy isn’t as bad off as the financial press likes to paint either.

No question GDP growth was disappointing at just 1.9 percent in the first quarter, but once again, the overall trend shows the US economy expanding at a healthier 2.3 percent over the past year. Meanwhile, there are a number of positive factors at work that tell us the growth slowdown is only temporary⁸:

Retail sales remain strong, expanding 6.2 percent year-over-year — a good indication US consumers are alive and well.⁹

Corporate profits are expected to expand another 15 percent or so in the second quarter, with positive surprises likely in the weeks ahead as companies report results.¹⁰

Bank lending growth is picking up steam too as US businesses invest for the future with capital goods orders expanding 17 percent annually.¹¹

This is strong evidence to us that the big picture trend of solid growth in the economy remains intact. Keep in mind that we could see more near-term softness in the economic data, which could certainly trigger more short-term market volatility in the weeks ahead. This is particularly true if debt ceiling negotiations go down to the wire, but we see this as only a temporary issue.

Politics and investment markets are closely intertwined and a perfect storm of uncertainty magnified by the political process is creating turbulence in the markets. But once some of these uncertainties are resolved, markets should be free to move higher once again.

Good investing,


Mike Burnick

Director of Client Communications

Banyan Partners, LLC

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The opinions expressed in this publication are subject to change without notice. This newsletter is not a complete analysis of every material fact with respect to subject matter discussed and has been prepared solely for information purposes and is not a solicitation or an offer to buy a security or instrument or to participate in any trading strategy.

The technical analysis in this publication is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future.

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¹ Bloomberg: EU Revives Buyback Idea as Crisis Hits Italy, 7/12/11

² Ibid.

³ Seeking Alpha: Brady Bonds Won’t Save Eurozone in Short Run, 7/12/11

⁴ MSCI Index data, as of 6/30/11

⁵ Bloomberg market data, 7/13/11

⁶ Bureau of Labor Statistics, 7/8/11

⁷ Ibid.

⁸ Decision Economics, Global Economic Developments, 6/24/11

⁹ Deutsche Bank US Equity Strategy, 7/6/11

¹⁰ Bloomberg data as of 6/30/11

¹¹ Deutsche Bank US Equity Strategy, 7/6/11