Sunday night the European Union announced government loan backed guarantees of €720 billion and commitment to purchasing European sovereign debt. Concomitantly, the European Central Bank indicated it would intervene in government bond markets. As a result, global stock markets soared in relief on Monday.
Like most observers, we are impressed with the magnitude of the European response to growing concerns about the difficulties with Greece and the potential for contagion spreading to other countries, such as Portugal and Spain. We believe the actions by the EU and ECB will buy some time to permit policy makers to come to grips with debt management and most importantly encouragement of renewed growth. Having said that, we worry that recovery of growth will be slow for Europe and concerns about sovereign debt may be renewed in the future. Even Germany may be affected because of Chancellor Merkel’s loss of control of the upper house of the German parliament. This political loss threatens the potential for expected tax cuts to foster growth.
Meanwhile, the situation in the U.S. continues to appear more promising than that of Europe. A cyclical recovery in the economy is in place. The jobs market is beginning to improve. Profits have been beating expectations, interest rates remain low, and valuations of equities are not excessive. The dramatic rise of the volatility index (VIX) to 40 from 16 underscores the change in attitudes about risk that we expressed concerns about over one week ago. Divergences within markets have lessened.
Nonetheless, we reiterate a point we have made in the past that substantial rebounds in the stock market, such as the 75%+ gain over the past year, have been followed by a correction of 10-20%. The recent setback in the market was 7-8%, similar to the corrections in January-February and last July.
We believe the global perception of reflation vs. deflation will continue to oscillate back and forth. European actions may deflect concerns about deflation for the moment, but a large burden is faced by Europe to show the world more growth than is now apparent. The burden is not likely to be relieved quickly or easily. Moreover, increased debt creation to deal with the recent crisis as well as enforced austerity measures will weigh on future growth. As we said in our previous commentary, the stock moves of the past year will be a tough act to follow.
A. Marshall Acuff, Jr., CFA
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC