- Editorial Market Commentary -

June 16, 2010 (FinancialWire) (Investrend Forums Syndicate) (By Steven H. Reynolds) (Go to http://www.financialwire.net/?s=cmmtry for all of today’s commentaries.) — The U.S. stock market, sensitized by its historic bear experience, has been reacting with a high level of volatility, both up and down, to the recent events in Europe.  Fears of default, contagion, and another global banking crisis, culminated in a steep 1,000 point downdraft in stocks.  This has been followed by strong relief rallies and re-tests.  Do these violent reactions signal that the bull game is over?

The 2008 financial collapse evidenced the enormous size of the credit bubble and its weak underpinnings.  The credibility of our modern financial system was called into question.  A profound loss of confidence proved to be nearly fatal to the global economy.

In the aftermath, the financial system, from households to multinational banks, has been going through a process of deleveraging and re-pricing of credits.  Lenders and rating agencies alike are getting to know better their counterparties.

This cathartic process, which started with sub-prime mortgages, has progressed to its final stage:  the re-evaluation of the size and quality of the debt of sovereign nations.  Their credit ratings and guarantees are under intense scrutiny.

In Europe today, markets are roiling from the results of this greater transparency.  In the countries under stress, public and private debt levels and interest payments relative to GDP are at dangerous levels.  The duration of the debt is relatively short, making roll-overs challenging.  The economic competitiveness of the individual countries is poor and relief through accelerated economic growth will be difficult.

These problems are exacerbated by an additional factor.  The extreme weakness and more importantly the volatility of the euro are sending shock waves though the world’s currency, stock and bond markets.  What was looming in January of 2009 as expressed in my piece “This Time Is Different” is now more apparent.

“In the global arena, an interesting development is arising:  concern over the euro.  If one thinks of the euro as an AAA-rated CDO where the AAA-rated tranche is Germany and the Baa-rated is Greece, it is the same construction as the instrument that wrecked havoc on the global financial markets.  With the gulf between the strongest and the weakest economies widening, will the euro merely weaken or unravel?  Will the euro just be another bad CDO?”

At the onset of the financial crisis in the U.S., the Federal Reserve and Treasury faced major hurdles.  Because of the size, complexity, and opacity of the problems, they had no real idea what corrective policies would be effective.  In addition, the political atmosphere was unfriendly, making a timely and targeted response difficult.  While not a pretty process, our leaders are to be commended for avoiding Armageddon.

Fortunately, the situation in Europe today is more manageable.  The “less” onerous conditions include; far more transparency, simpler financial instruments, and limited interconnectivity.  The problem is regional not global, the banks are sounder, and moderate economic growth exists.  Most importantly, the “financial engineers” at the EU, ECB and IMF are experienced in crisis management.  Honed on the “Panic of 2008,” they are capable of developing creative stop-gap remedies to the current liquidity crisis.

Pressured by heightened instability in the financial markets and with some prodding from their U.S. counterparts, the European authorities overcame political hurdles and announced an initial one trillion dollar stabilization plan with indications of additional measures if needed.  Like the U.S. “rescue” plan, it will have numerous implementation and compliance challenges.  The political differences within Europe cannot be dismissed.  The anticipated flare-ups in the financial markets will keep volatility at a heightened level.  In the end, authorities will be driven to address problems with creative and fine-tuned measures.  For a reasonable period of time, a relatively stable, yet fragile financial system will result.

For the European economy, restrictive policies should be moderately deflationary with slower growth, a competitive euro for trade, and stable interest rates.  For the U.S., the impact should be minimal with a weak euro/U.S. dollar, moderately lower exports, continued low levels of interest rates and positive foreign capital inflows.

For U.S. equity investors, a return to the “Goldilocks” environment will evolve.  Moderate economic growth, subdued inflation, strong corporate profits, low interest rates and ample liquidity argue for higher asset prices.  However, given the reality that the current U.S and European financial fixes are at best temporary patches and not permanent cures, the longevity of the favorable investment climate may not be long lasting.

So, in the meantime, relax.  Grab a beer and a dog.  The bull game goes on.

Source: Steven H. Reynolds, Chief Investment Officer, Craig Drill Capital.  Go to http://www.financialwire.net/2010/04/30/craigdrill-capital/ for important disclosure/disclaimer information and more about Craig Drill Capital.

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