A good overview of perceived impacts of the EU situation to the US economy.

From the Investment Advisory Service I subscribe to. A good overview of the perceived impacts of the EU situation to the US economy.

Investment Comments

The generally benign market environment of the 1990s and low volatility experienced throughout much of the first decade of this century (until 2008) sometimes leaves investors unprepared for normal volatility that has characterized the market throughout history. As a result, investors panicked earlier this year when the Dow slipped over 900 points in three weeks. Over the next 2-1/2 months, the Dow moved up a strong 1500 points. The Dow has now given up about 1000 of those hard earned points in another three weeks. Volatility is the norm for investors, but it is still uncomfortable.

In the middle of what appears to be a market “correction” that happens in most years, even in a rising market, the Dow dropped over 500 points in ten minutes on May 6. Clearly this was not normal. It appears that “high-frequency traders” set off an avalanche. The term “high-frequency traders” refers to computerized techniques used by Wall Street firms and hedge funds to analyze short-term data and make trades faster than a human being could. It is said that over 70% of U.S. equity trades come from these traders. While such trading makes money for their sponsors, it also increases trading volume and is helpful to the market.

During a period of high market volatility the afternoon of May 6, it appears that many traders simply turned off their screens and stopped participating. The market for many ETFs (exchange-traded funds, which are unmanaged baskets of stocks) became quite thin, and there were far more sellers than buyers. Some of these supposedly safe index funds actually traded for a few pennies per share. This caused speculators to sell the underlying stocks that make up the ETF indexes because the index itself was much cheaper than the sum of its parts. The overall market dropped 5% in just ten minutes. This is the kind of traumatic drop that one might associate with a terrorist attack or assassination of a world leader. However, these were the actions of speculative traders and their computerized techniques, not of rational investors.

The broader trigger for the recent volatility is the growing concern over the status of the European Union (EU) and its currency, the euro. Market wags use the term PIGS to lump the troubled economies of Portugal, Italy, Greece and Spain into a convenient package. Greece accepted a massive bailout ($145 billion) from the EU as world markets were in turmoil. The EU and the International Monetary Fund (IMF) unveiled an even bigger rescue plan of $955 billion for any EU member country. Greece does have its problems, but Portugal is taking the responsible approach of cutting spending and raising taxes, rather than looking for a global bailout.

However, Greece and Portugal are a relatively small part of the global economy. To become a problem for the U.S., the problems would have to spread to Italy and Spain. Hopefully the size of the EU/IMF bailout will prevent this in the short-term, but longer term the presence of bailout money makes it easy for weak economies to avoid real reform.

The fundamental problem is that the euro is a flawed currency where 16 individual European countries devise economic policies under EU guidelines, but with little enforcement. European economies are simply too diverse for a single set of rules. Some countries, particularly the southern European ones, have historically taken on debt instead of paying their bills. The debt would keep piling up and the countries would experience currency weakness and devaluations as a way of inflating their way out of debt problems. This doesn’t jive with the stricter economies and stronger currencies that have historically come from countries like Germany.

So far the U.S. has been affected in three significant ways. The value of the dollar has skyrocketed, especially versus the euro. This can hurt U.S. exports as they become more expensive when denominated in euros, but it also helps keep inflation in check because import prices tend to fall. Second, global investors have flocked to U.S. Treasuries, helping our government fund its debt at much lower interest rates. Lastly, global oil prices have come down sharply, more than 20% in just a few weeks.

As scary as this volatility might be, it is fairly normal in a historical context. The global market reaction reminds us of the “Asian Contagion” in 1997-1998. Concern over Asian economies caused the value of their currencies to decline sharply, triggering a worldwide panic. Russia defaulted on its debts. There was also the bankruptcy of a large hedge fund that controlled 5% of the world’s bonds. Yet, economic growth continued, and the U.S. stock market was up by more than 20% in each year. While these types of events seem very significant at the time, the passage of time typically allows cooler heads to prevail.

U.S. economic statistics are starting to move from “encouraging” to “impressive.” An amazing 290,000 jobs were created in April, although the unemployment rate edged up as previously discouraged workers reentered the workforce and were now counted as unemployed. First quarter Gross Domestic Product grew at an annualized rate of 3.2% and consumer spending was even stronger. The factory sector is strong, although off of a weak base from early 2009. Factory orders were up in March for the eleventh time in the past twelve months. Consumer behavior is solid, with personal income rising in March for the ninth straight month. Personal spending grew even faster for the sixth straight month. Inflation remains well contained.

The recent events in Europe will likely have some impact on the U.S. economy, but we don’t expect it to be severe. Euro-zone economies make up only 14% of U.S. exports, and most companies indicated in their first quarter results and conference calls that Asia is booming. Hopefully, recovery in the U.S. and strong growth in Asia will be enough to offset continued weakness in Europe. We don’t see any reason at this point to believe this will turn into anything long lasting.