To say that Europe dominated the 2011 financial headlines would be an understatement. One word or comment from a European politician or central banker sent stock markets tumbling. Conversely, the smallest hint of a resolution to the debt problems of the other “PIIGS” nations (Portugal, Ireland, Italy, Greece, and Spain) sent the markets soaring.
 
In the history of the S&P 500, there have been only eleven days where more than 98% of the stocks that comprise the index moved in the same direction. Six of these eleven days occurred in 2011. In addition, from August 5th to the 30th, the S&P 500 experienced an extraordinary average daily move (up or down) of about 2.5%. This average, to put it into perspective, is 3.5 times the daily volatility for the previous nineteen years.
 
As a result, 2011 will be recalled as a year in which most everyone “was waiting for the other shoe to drop”. Some of these “shoes” included a potential” PIIGS nation debt default; which countries might have to replace the Euro as their currency; whether or not the Chinese economy could be slowed down without causing a ‘hard landing’; inflation and its squeeze on the emerging markets; and a credit rating downgrade of the US—potentially leading to a double dip recession.
 
The only one of these “shoes” that has dropped so far is the US debt downgrade in August of last year. Not surprisingly, after the US debt downgrade US bonds enjoyed a stunning rise of over 3% for the month. The reason was that investors believed that US Treasury bonds and the US dollar were still by far the best house in a bad neighborhood. It was a reminder that once again – in tumultuous times, the safety of US dollar assets becomes apparent to the global financial markets.

 
One dominant theme of the last five years has been the macro-economic backdrop. Macro refers to “the big picture” with respect to the economy and the risks that are weighing on the global economy’s ability to expand. The curious aspect of the macro picture is how it has morphed at different stages, taking investors on a rollercoaster ride. What began with the collapse of U.S. real estate changed into the Lehman Brothers default which ushered in the liquidity crisis and the subsequent recession.  

 
After a seemingly all too brief lull, it has now morphed into a sovereign debt crisis engulfing Europe. Some observers are now casting a wary eye on Japan which after over twenty years of economic malaise is now possibly near the end of its Houdini-like ability to forego a debt crisis of its own. Japan has defied just about everyone who has ever tried to profit from such an event occurring over the last twenty years.

 
The economic data for the US has been better than expected for over two quarters with the economy having generated over 2 million jobs since summer 2011. Further, for twenty–three consecutive months, the economy has been able to create new jobs while the real estate sector is showing early signals that the bottoming process has begun. Key US real estate markets such as Miami and Phoenix are showing encouraging data. The surprise thus far is the resilience of the US economy despite headwinds at home and abroad. Domestically, the biggest source of headwinds likely comes from the lack of political resolve on both sides of the aisle “to get something done”. Politics seems to trump economics with the US Federal Reserve caught in the middle.
 
With the Fed having done all it prudently can and Treasury fiscal measures to cut the budget deficit ruled out until after the November 2012 Presidential elections, it has fallen to the American economic machine to revert to form and pull the global economy back on track.
 
The US economic recovery is being led by exports, while car sales and consumer spending are starting to regain a more solid footing. One caveat on consumer data recently is that the savings rate has started to decline once again. Whether this is because of increased confidence returning to US households or simply because wages have been stagnant is open to question. Consumers are having to loosen their purse strings after several quarters of belt tightening in which the focus was more on debt repayment.
 
Another key barometer of the US economy is provided by credit and banking data. As the chart on the prior page shows, in the last six months bank credit (i.e. lending) has begun increasing. This is a positive indicator for cyclical sectors such as retail, automotive sales and construction. The rise of credit creation from the banking sector has been a missing ingredient for the economy’s ability to gain traction. Despite all of the positive North American data, the economic momentum is still early in its acceleration and not yet felt widely on Main Street. It seems that the US mood is less “happy days are here again” and more “will it hold?”

 
While exports have been a source of strength for the US economy, Europe’s problems will provide headwinds to US exporters for the remainder of the year. As many are expecting Europe to either enter a recession or to already be in one, European demand for foreign goods should suffer. Europe remains a key global market for both US and Asian goods.
 
Perhaps one key piece of data from Europe is interest rates on European government bonds. In response to the measures taken by the European Central Bank (ECB) in December of last year, bond yields have eased lower. This is a sign of investor confidence and provides stability on interest costs while European leaders get their house in order.
 
The measures taken by the ECB included a $640 billion USD cash injection into the banking system. In doing so, the ECB parted with its traditional measured response to economic challenges because it feared that a liquidity crisis similar to that of 2008 was starting to entrench itself. In the 2008 financial crisis, banks around the world became afraid to lend to one another. Thus the global economy ground to a halt in relatively short order.

 
So far, the ECB’s measures seem to be helping as about half of this money has found its way into government debt markets. In other words, the liquidity that has been provided has been used to purchase government bonds. This has helped to rein in interest rates and made it easier for governments in Europe to borrow and roll over debt maturities.
 
The remainder of the ECB’s cash infusion was largely re-deposited back at the ECB – even though the ECB is only paying 0.25% on these deposits while charging the banks a borrowing rate of 1%. This is being done by financial institutions because they are not fully confident that they can avert a liquidity crunch and require access to funds for possible future use despite the borrowing costs.
 
The one drawback is that very little of this money has made its way into the banking system to allow consumers and businesses to borrow with easier credit terms. It could be said that governments are crowding out the private sector.
 
This experience is not all that different than that of the US over the last two or three years. If events follow a similar script to that of the thawing of the US liquidity freeze, credit should begin to ease for European borrowers very gradually.
 
Markets will be watching whether or not European governments make continued progress in getting firm commitments from the European Union member nations with respect to fiscal tightening measures. In short, spending must be reduced sharply and a new treaty that will require European nations’ ratification in April of this year will impose steep austerity measures. These spending cuts will curtail European GDP.
 
This is where the European plan differs from the US. In the US, fiscal policy remained largely accommodative – partly because the political process would not allow tax increases. In Europe, there is really no political constituency that argues for tax cuts as consistently as that in the US. Right or wrong, this has perhaps helped the US economy sidestep an even more gradual economic rebound – regardless of what the long term implications of more debt might be.