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The domestic economic calendar in this holiday-shortened week has the potential to shift the market's attention from the unsettling developments in Europe. But an enduring shift in sentiment is unlikely as the week's data will at best provide reassurance only about the U.S. economic scene. Such reassurance is badly needed at present, particularly on the labor market front, following the recent run of mixed economic readings.
But the market still has to grapple with the uncertainties in Europe, where Greece appears on track to exit the union and doubts persist about Spain's ability to deal with its banking problems. Greece is going to the polls on June 17th and the outcome of that vote will have a direct bearing on whether the country stays in the Euro-zone or gets out. Either of those two alternatives has serious implications, not just for the Euro-zone, but also for the global economy.
As I explained in today's Roundtable Review, the combination of these variables will continue to put downward pressure on the stock market for some time. In fact, I have been arguing this thesis for over six weeks now and continue to see the likely course to the downside. In today's piece, I survey this macro backdrop to explain this near-term market outlook.
Sizing up the Growth Question
While Europe is no doubt the major dark cloud on the market's horizon, questions about economic growth, both in the U.S. as well as in China, have also been weighing on sentiment. This week's economic calendar has the potential to answer some of the questions, at least about the U.S. economy.
The Chinese debate is different in nature. All agree that China's economy is slowing down. The point of contention is with respect to the extent of that slowdown. And that's where the 'hard landing vs. soft landing' debate takes the spotlight. As I have argued in this space multiple times in the past, I remain reasonably confident that China has plenty of resources at its disposal to ensure a non-disruptive slowdown. I completely agree with the key takeaway from the cover story in this week's Economist magazine that "it is likely to prove more resilient than its detractors fear".
The more immediate growth concern is about the U.S. economy, which has been producing mixed results in the last two months, particularly on the labor market front. The economy produced solid monthly jobs numbers in the three months through February 2012, but appeared to lose steam in the following two months. Optimists (myself included) attributed the softness to giveback for the unusually warm winter this year, while others have been pointing to a repeat of the last two years where the economy would lose momentum at the onset of Spring.
The May non-farm payroll report coming out this Friday has the potential to settle this question. The disappointing April & March jobs reports appear to have brought down expectations for May, with the current consensus ranging from 170K (at MarketWatch) to 150K (at Bloomberg). A strong report of close to 200K this Friday will raise hopes that the labor market, which provides the fuel for so many critical sectors of the economy, is getting back to its solid growth trajectory. There are number of other top-tier economic reports on the docket this week as well, but it is Fridays jobs report that will set the tone for questions about the U.S. economy for the following four weeks.
Sizing up the European Question
Greece will vote in another election in June, hoping to get a clearer verdict following the splintered result of last month's election. A lot is riding on the outcome of that vote, as it could potentially decide the country's future within the Euro-zone.
Here is a direct quote from how I described the Greece situation two weeks back in this space; the comment is as relevant today as it was then.
"Greece is a small economy relative to the size of the Euro-zone economy. The Greek economy and financial system itself will be devastated by its exit, whether voluntary or otherwise, particularly in the short run. But that may not be of that much concern to the Euro-zone leaders than what its exit would mean for the remaining at-risk countries of Ireland, Portugal, and Spain. Financial markets will start betting on who will be next to follow Greece out of the union. The residents of those countries will start withdrawing money from the banks to forestall losing it all, ensuring a garden variety bank run, encompassing the entire banking system. Spain is already struggling with its banks and can ill-afford this type of scenario unfolding. It is the fear of this sort of financial contagion that has forced Euro-zone leaders, particularly Germany, to keep the country within the union thus far."
It is reasonable to expect that leaders on both sides of the Atlantic are making contingency plans for 'Grexit'. But either way, this outcome has the potential of being a significantly destabilizing force for the global economy. The U.S. economy is growing, albeit at a moderate pace, and is not particularly exposed to a major recession in Europe. But a significant shock to the European financial system, which the Greece exit from the union would be, will most likely have negative aftereffects on the U.S. financial system as well.
Putting It All Together
Notwithstanding the market's positive finish Tuesday, I expect the overall trend to be to the downside over the coming weeks. The focus this week will likely remain mostly on the home front, with the last two days of the week chock-full of market moving economic reports. The most important of these reports is the May jobs reading coming out on Friday.
In the best case scenario, the Friday jobs report washes away the disappointing readings of the last two months by coming out ahead of expectations. Europe will remain a dark cloud on the markets horizon even if recent questions about the domestic economic outlook get answered to its satisfaction this Friday. And that problem is not going away for some time.
Focus List Update
We made four changes to the Focus List last week, adding and deleting two stocks each. We deleted VeriFone Holdings (PAY - Analyst Report), the payment processor, and Copel (ELP - Analyst Report), the Brazilian utility. Replacing these two, we add T Rowe Price (TROW - Analyst Report) and Valspar (VAL - Analyst Report).
VeriFone came out with strong earnings last week, but guided lower. I have long been a fan of PAY, but the pick has not been playing out that well since the company's European acquisition last year. The deletion essentially gets us out of this name ahead of the negative earnings estimate revisions that are bound to follow the weak guidance.
The Copel deletion is primarily an acknowledgement of the difficulties in maintaining a position in a majority government-owned electric utility in Brazil. We will look for exposure to the utility sector by picking a domestic name in the coming days.
Of the additions, T Rowe Price (TROW - Analyst Report) is a pick for the long haul as this premier equity-centric investment management operator stands to benefit from the eventual return of money flows into the equity markets. Given the macro issues weighing on the market at present, it is not realistic to expect money flows into equity funds to improve in the near term. But as the current clouds lift, TROW will be a big beneficiary of that.
Valspar (VAL - Analyst Report) is the sixth largest paints and coatings manufacturer globally, with a strong position in the industrial end markets. Despite the challenging macroeconomic environment for all basic materials operators, Valspar is expected to fare better given its track record of best-in-class operating efficiencies that help it not only sustain margins, but also expand them.
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