The stock market just barely remains above its pre-European bailout close. Does this mean that the European problem has not budged, or that it has taken a new shape? And, what does that tell us about the outlook for the U.S. markets?
The Reign of Uncertainty & Risk Aversion
While the U.S. equity markets haven't done much in recent days, other asset classes have been quite clear in their movements. The euro, the common currency, has been on a downslide against the U.S. dollar, reaching its lowest level in four years. Discussions about its move towards parity with the greenback are no longer a novelty.
Yields on treasury instruments have fallen victim to the so-called flight-to-safety trades. Flying in the face of our not-so-long-ago concern about the 10-year yield getting above 4%, this benchmark rate currently remains comfortably under 3.5%. The same is true of commodity prices, with oil shedding almost a fifth of its value in two weeks.
We see this pattern unfolding in measures of volatility as well, with the VIX Index at elevated levels. In fact, the VIX reached its highest level in recent days since the last quarter of 2008. The Index has since come down, but still remains elevated by historical standards and appears to have an upward bias. The elevated level for VIX and gold's new highs are all indicative of risk aversion and uncertainty.
Should We Continue to Worry about Europe?
As I discuss in today's Roundtable Review: Where is the Market Headed Now?, while Europe remains a problem, the nature of the problem has changed following the bailout announcement. We no longer worry about whether Greece and the other Mediterranean countries can meet their scheduled debt-servicing obligations.
We are, however, concerned about whether these countries will be able to implement the extremely tough austerity measures needed to bring their fiscal houses in order. And a related worry is the impact that such deficit-reduction measures will have on European growth profile.
My sense is that these peripheral European countries (Greece, Spain, Portugal and Ireland) have no option but to implement the tough conditions that are part of the trillion-dollar package. There is simply no other way. There is no way the markets will assign any level of credibility to the common currency and the monetary union in the absence of a tough belt-tightening plan by the Europeans, particularly the Mediterranean countries.
Getting back to the question raised above, we are no longer concerned about liquidity issues in Greece spreading out into the global financial system and dragging down the incipient global economic recovery. The larger-than-expected European bailout package has addressed those fears adequately, in my view.
But European growth is expected to remain sub-par for a while, which remains a drag for the U.S. and global economy. Now concerns about Europe's growth outlook are no small matter, but they are by all means a far benign worry compared to contagion fears. The current euro weakness is not due to continued funding/liquidity concerns. It is reflective of a weak growth outlook for Europe, given their need for stringent austerity measures to tackle fiscal imbalances.
Impact of the European Slowdown on the U.S.
As a major trading partner, Europe is important to the U.S., though it is less so than 15-20 years ago. More than a third of U.S. exports to Europe are of capital goods, but Asia is a bigger market for U.S. capital goods than Europe. From another angle, export-centric European economies, such as Germany and France, should benefit from the euro weakness. Overall, though, Europe's growth outlook is expected to suffer as a result of its need to implement austerity measures.
While the European slowdown will have a bearing on U.S. economic growth and the earnings outlook for the S&P 500, it cannot by itself drag either of the two down significantly. The European earnings exposure for the S&P 500 is in the 15% to 20% range, with industrials and technology as the largest sectors with secular exposure. The negative foreign exchange exposure for these sectors (euro weakness weighing on U.S. dollar earnings) should be offset by secular cyclical strength. The same cannot, however, be expected for the non-cyclical sectors, such as Pharma, household products, and food, where we may see some FX-related earnings impact.
The bottom-line is that while Europe matters, it no longer qualifies as this over-riding concern for the market. Concerns about China's growth profile, given its need to engineer a soft-landing, is a bigger near-term deal, in our view. Importantly, as this benign view of the international scene takes hold, the markets will start paying greater attention to developments in the U.S. market, and the outlook for that remains favorable. As such, I see a moderation in volatility and a generally-positive upward drift in the market in the coming days.
We made three additions last week; two to the Focus List and one to the Growth & Income portfolio. There were changes to the Timely Buys list as well.
We added Starbucks Corp. (SBUX - Analyst Report) as a play on the coffee chain's new focus on store-level profitability. Starbuck's successful completion of its turnaround plan has positioned it for strong earnings growth over the next few quarters.
We added Smith Micro Software, Inc. (SMSI), a small-cap mobile software developer, to gain exposure to the company's high-growth niche market.
We added McDonald's (MCD - Analyst Report) to the Growth & Income portfolio given the companys impressive earnings growth profile, juicy dividend and still-attractive valuation.