Markets Buoyed by Debt Deal

Last week's announcement that European policymakers were able to come to an agreement to at least temporarily address that region's debt crisis helped stocks rally for a fourth consecutive week. Investors were also cheered by some solid US economic data that further reduced the odds that the United States would sink into a double-dip recession.

For the week, the Dow Jones Industrial Average climbed 3.6% to 12,231, the S&P 500 Index advanced 3.8% to 1,285 and the Nasdaq Composite rose 3.8% to 2,737.

European Agreement Represents Significant Progress

Last week's agreement (which includes an expansion of the European rescue fund and an agreement by Greek's debt holders to accept some losses) is still lacking in some details and certainly does not solve all of Europe's long-term debt issues. Nevertheless, the European debt deal is a significant milestone and helps remove some of the risk that had been weighing on the global economy and financial markets.

Despite some of the lingering uncertainty, to us, one of the most important takeaways from last week's news is that all of the parties were able to come together to make some hard decisions, to take some losses and to set up a new institutional structure that is powerful enough to take action while assuaging the concerns of many (chiefly Germany) over creating a more tightly intertwined fiscal union. It is important to remember that it was only a couple of years ago that the thought of any sort of bailout was a complete non-starter among most policymakers. Europe has been able to move from that point to an agreement in which countries will effectively guarantee each other's debt???a significant achievement.

There are still some significant long-term concerns about the fiscal stability of several European countries, particularly given that overall European economic growth is likely to remain weak. Italy and Spain, for example, still need to enact some significant fiscal reforms, which will be difficult to do given a charged political backdrop.

US Economy Continues to Grind Higher

On the other side of the Atlantic, recent data confirms that the US economy is continuing to grow. Perhaps not very quickly and certainly not fast enough to effect noticeable improvements on a persistently high unemployment rate, but it is growth nonetheless. Business investment levels and spending on equipment and software continue to improve and consumer spending levels have been ticking up. These trends were confirmed by last week's news that gross domestic product in the third quarter grew by an initial estimate of 2.5% (with final sales figures growing a healthy 3.6%). Corporate earnings have also remained solid. We are more than halfway through the third-quarter reporting season and companies have again been surpassing expectations for both revenues and earnings.

From a longer-term view, a retrospective look at the economy suggests that the United States is continuing to make some gradual headway against the lingering post-crisis headwind of high debt levels. Household debt levels are continuing to contract and banks are also continuing to improve their capital and liquidity levels. From a nearer-term perspective, we believe that the third-quarter GDP report shows that the economy has been moving past the negative effects of the Japanese earthquake and commodity price spike that hurt growth in the first half of 2011. One issue that remains a long-term concern is the federal deficit. The deadline for the so-called "super committee" to present a plan to reduce the deficit by $1.2 trillion is approaching and it is not clear at this point whether the committee will be successful in doing so. In any case, the deficit overhang looks to be an issue that will persist for at least the next couple of years.

Looking ahead, we expect this environment of sluggish and grinding growth should persist as the economy continues to heal from the credit crisis. As a result, we expect economic growth levels will remain modest through next year, suggesting that unemployment is likely to be stuck at an unfortunately high level.

Market Outlook Continues to Improve

Investor sentiment has certainly improved over the past several weeks, and while it is much too early to declare victory over the European debt crisis, last week's deal is certainly a positive step. The easing of the risks associated with Europe's issues, along with a brighter outlook for the US economy than was the case a couple of months ago, does create a more solid footing for risk assets. Given the sharp advance markets have seen over the past month, we may be in for a period in which markets need to "digest" these gains, but the longer-term outlook for stocks does appear to be improving.

 

 

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