The jump in volatility recently has caught the interest of many investors and prompted thoughtful questions about the economy. We have been tracking three primary subject areas on a daily basis through these unusual global financial events: (1) the health of the U.S. financial recovery; (2) the European debt crisis; and, to a lesser degree, (3) the health of China and other Asian economies. These first two issues are at the heart of the recent market volatility.
The European Union is in an unfortunate position of slow to declining growth combined with unmanageable levels of debt. In most economic downturns, the cycle to reverse the decline is a decrease in interest rates by the Central Bank, which puts more cash into the system and creates a declining currency value. As a result of low borrowing rates and attractive currency exchange rates, domestic and international spending slowly improves. The 17-member Euro zone does not have this luxury because, while they share a Central Bank lending rate and currency exchange rate, they pay their own sovereign debt at a borrowing rate set by the market. Countries that have very high levels of debt—like Greece, Spain, Ireland, Portugal and Italy—cannot muster the growth needed to raise revenue to pay their existing debt and cannot issue more debt at a cheap enough rate to make it financially viable for the long term. It is a vicious cycle that has been a decade in the making. While it seems to have been a slow-moving train wreck, we appear to be nearing the climax. Ultimately, that should be good news because it would create some clarity in an uncertain world. The hope is that the Euro zone will solve the current problems without an undue level of bank failures and defaulting loans, while also fixing the deficiencies in the system. There have finally been some meaningful ideas offered, such as a rescue fund that can borrow from the European Central Bank, thus ensuring enough resources to bail out even a large participant like Spain.
In addition to news from Europe, every day we see some chart that compares the current financial recovery in the United States to recoveries in the past. More often than not, the current recovery is shown to be very weak and fallible compared to others. A strong recovery creates jobs, increases our standard of living, and ultimately increases personal net worth. We want a strong recovery because we want all of the above, so it is disappointing when jobs growth or retail sales or home sales are reported to be unexpectedly weak. Although it has been frustratingly slow, and may continue to be for awhile, the good news is that our economy is making progress. The even better news is that when the rest of the world gets its act together, the United States seems poised for solid growth and a recovery. Recent earnings reports show a very lean corporate America with little fat to trim. A pickup in global sales should have a pronounced and immediate impact on the American economy.
The outcome of the European debt situation and the recovery path of the U.S. economic recovery will influence the financial models and the psyche of investors worldwide. While the volatility causes us to pay extra close attention to world events, our outlook for a slow and steady recovery in the United States has not changed. We have lived through many of these market “blips” over the past few years and will probably experience many more over time.