Over the last 10 years investors have certainly had many issues facing them as they make long term decisions regarding their investment strategy. The most recent issue impacting the markets is Europe (although the budget debate in the U.S. is a close second).
We see trends improving in the U.S. economy so why isn’t the U.S. stock market booming?
In a nutshell, investors are worried that a meltdown in Europe will create a worldwide financial contagion, impacting the global stock markets. If a credible solution emerges from the negotiations currently underway, it is expected that our stock market will show some attractive returns, as corporate earnings and balance sheets are quite strong and stock valuations, in terms of Price/Earnings ratios, are below historic averages.
Investors saw what happened in the U.S. in 2008 when the sub-prime mortgage crisis created a financial contagion, and they fear that Europe could be 2008 all over again. By way of some background – Europe is in a very difficult situation now for some basic reasons.
When the Euro was created, the idea was to unite the 17 nations economically so that they became united politically. Europe had been devastated by war over the previous 100 years and this was the basis of a solution. A common currency certainly united them from a monetary perspective, but there was no fiscal unity.
There are 300 million people in Europe and it was thought that having a united economy would give them an opportunity to better compete with the United States. It was expected that over time, the economies of each of the individual European countries would converge. However, this did not occur as each of the countries had widely diverging economic growth – Germany having enjoyed the strongest economy.
So, to keep up with their neighbors, some of the smaller countries, most notably Greece,resorted to government spending (read large government payroll) to stimulate their economies. Over time, Greece built up huge budget deficits which should have made holders of their sovereign debt quite nervous.
Greece and other smaller countries (Ireland, Portugal) required bailouts. When Italy (they have had the smallest economic growth of any country since the implementation of the Euro) surfaced, it became clear there was a need for a comprehensive plan for all of Europe.
The support of Germany and France, and probably the UK, is needed for this plan to work. The European Central Bank (ECB) is providing liquidity through long term repurchase operations (LTRO), which has helped alleviate pressure on European banks holding sovereign debt.
Ultimately, though, the long term viability of the EU rests on the ability of leaders to reach an agreement on fiscal restraint. Germany is the major player here and they are playing hard ball, indicating they won’t support bailouts unless other countries agree to spending cuts.
I think Germany will have no choice but to participate, especially after what happened in the U.S. in 2008 with Lehman Brothers’ failure. A “bazooka” is needed, similar to our TARP
program.
