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I assign a very low probability to events in Europe causing a recession in the United States and see no reason to back off on my bullish view of the U.S. stock market. Europe buys 1/3 of our exports. Since exports are only about 10% of U.S. GDP, exports to Europe account for about 3.3 % of our GDP. If Europe sustains a severe recession, resulting in a relatively large decline of 10% in its GDP, the effect on our own GDP will be to reduce it roughly by 10% of 3.3%, which is only 0.33%. Not much of a threat.

The bigger threat lies in potential contagion from a banking collapse in Europe. It is not clear how deeply U.S. banks are intertwined with those in Europe (we certainly cannot rely on the reassuring statements by U.S. bankers or government officials), but we do know that U.S. financial institutions, especially money market funds, have pulled back investments in European banks. The financial disturbances and sovereign debt worries there have been going on for two years, so there has been plenty of time for our institutions to reduce exposure to Europe if they chose to do so.

Taking a page from Donald Rumsfeld, the effect of a European banking collapse on U.S. banks is a known unknown. We know it would hurt, but we don't know how much. We find solace in three mitigating possibilities: 1) Europe will muddle through. Italy is now the most prominent weak spot, but it currently runs a small deficit and is in the process of enacting major spending cuts, so there is some hope, here. 2) Germany may back off and support a U.S. - style bank rescue by the ECB, and 3) in the wake of a banking or currency collapse, contagion to U.S. banks may not occur, at all.

Current fears reflect widespread awareness and sensitivity to the financial panic of 2008, in the same way that every irregularity on an airplane right after 9/11 caused worries that a new terrorist attack was at hand. Another known unknown has been with us for several years, now: a possible air strike on Iran's nuclear capability, followed by the blockading of the Straits of Hormuz. Another known unknown is whether the U.S. can ever cut spending and/or raise taxes to close its budget deficit. One known unknown that has become known is whether the US would default on its debt. We did not. That one scared everybody but the bond market.

Not on the radar screen of worries, but probably more likely to occur at any point in time, are the unknown unknowns, like Japan's earthquake/tsunami/nuclear meltdown of this past year, the tragic events of 9/11/2001, or the financial crisis of 2008. Unknown risks like these are always possible. We entertain ourselves and delude ourselves into thinking we are being prudent by taking defensive financial steps in the face of known risks, but those rarely are the ones that nail us.

Source: Staying Bullish Through Troubles In Europe