Conditions Remain Fragile, But Continue to Improve
by Bob Doll, Chief Equity Strategist, Fundamental Equities, Blackrock
November 14, 2011
Eurozone Crisis Evolves With Political Changes
Markets continue to be dominated by the eurozone sovereign 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. In our view, the crisis is moving to a point that will force leaders to make hard decisions, or the markets will simply drive Europe into recession. Notwithstanding this backdrop, risk assets were mostly up in a volatile week. The Dow Jones Industrial Average added 1.4% to close the week at 12,154, the S&P 500 Index rose 0.9% to 1,264 and the Nasdaq Composite slid 0.3% to 2,679.
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.
US Earnings and GDP Growth Continue
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. In addition, money and loan growth are strengthening in the United States, and there is no sign of a renewed credit crunch. That 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 reduce the unemployment rate significantly.
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 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.
The Eurozone Crisis Is Difficult, but Solvable
Returning to Europe, the real cause of the debt crisis there stems from a long period of fiscal profligacy, 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 United States. A financial crisis such as the eurozone debt debacle 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.
