Policymakers still have a great deal of work to do to avoid an even larger disaster than what is already being faced. They do have a number of options, including enacting short-term fiscal stimulus measures, further increasing the funding of the European Financial Stability Facility, moves to more aggressively recapitalize the banking industry and a lowering of interest rates by the European Central Bank. It is unlikely that all of these measures will be enacted, but some sort of combination could, at a minimum, buy some time.
Ultimately, we believe the ECB needs to make an open-ended commitment to purchase troubled debt from the region’s banks until spreads fall to a targeted range. This action would need to be done in conjunction with fiscal reforms in debt-laden countries to correct their broader structural problems. This is, of course, easier said than done, but as we have been suggesting for some time, the earlier policymakers act, the less expensive such actions will be in the long-term.
Stock valuations unclear
For the past couple of months, equity markets have been largely driven by the macro concerns of the European debt crisis and the weakness of the US economy. Stock fundamentals, however, have remained solid, particularly in terms of earnings. We are currently at the beginning of the third-quarter earnings season, and expectations are running high for yet another strong quarter.
Corporate earnings’ guidance for the future is likely to be mixed, but another good quarter of results would show yet again that companies have been able to manage well in the face of all of the macro uncertainty.
It is difficult to assess value in the current environment. If the European debt crisis were to suddenly disappear, stocks would appear very cheap (some would say dirt cheap), but of course the uncertainty over the debt crisis remains the critical wildcard.
