11/21/11
Markets continue to be dominated by the European debt crisis, with Italy replacing Greece at the center of the crisis. How this crisis plays out is not predictable, and the upcoming days and weeks continue to be important to the outcome. Leadership changes in Greece and Italy have focused investors' concern on whether political leadership is splintering. The crisis seems to be moving to a point that will force leaders to make hard decisions, or the markets will simply drive Europe into recession. To US investors, the main issue has been, and continues to be, the issue of contagion. Although US banks have been steadily rebuilding their balance sheets since 2008, the European crisis poses a threat in terms of liquidity and counterparty risk. As always, the biggest concerns are the unknowns.
Recent economic data suggests gross domestic product (GDP) growth will remain at a trend-like pace in the fourth quarter. Meanwhile, S&P 500 earnings are up more than 15% over last year and have surpassed their 2007 peak, while price-to-earnings multiples remain fairly low. Additionally, money and loan growth are strengthening in the United States, and there is no sign of a renewed credit crunch. Which is a big change from the worries of the summer debt ceiling debacle and tightening in financial conditions. On the other hand, while it appears job growth has also improved enough to sustain the recovery, it has not been strong enough to significantly reduce the unemployment rate.
A big unknown for US investors is the outcome of deliberations by the Congressional Joint Select Committee on Deficit Reduction, the so-called "super committee." The group is charged with slashing the federal debt by $1.2 trillion over the next 10 years, though any resulting spending cuts or tax increases related to a long-term debt reduction will not be implemented until 2013. The consensus is that this committee will achieve approximately half of the deficit reduction goal, meaning a renewed sequestration process will begin January 2013 for the remaining $600 or so billion.
Returning to Europe, the real cause of the debt crisis there stems from a long period of fiscal indulgence, low productivity and excessive government spending, allowing the population to live beyond its means. These events are not all that dissimilar from those that have occurred in the US. A financial crisis such as the eurozone debt problem is a tough way to enforce fiscal discipline and restore some sort of equilibrium because the outcome of such a crisis is that living standards fall. Returning to equilibrium can be achieved by a sustained fall in wages and prices or by inflation and currency depreciation, which of course cuts into the real spending power of the countries and regions that are struck by the crisis. Some view that the eurozone debt crisis is a solvable one, and the solution probably lies in the European Central Bank (ECB) balance sheet expansion. To clamp down on the chaos and restore financial stability, the ECB needs to move beyond the current practice of piecemeal intervention and engage in full-fledged quantitative easing.
At this Thanksgiving time, I am honored and thankful to have had your support and friendship through all these years.
With warm regards,
Bob
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