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One Step at a Time

Europe largely resolved its bank liquidity issues last week, although progress was far more limited in addressing bank solvency and sovereign financing issues.  This qualifies as progress, although their work is still incomplete.  Domestically, growth prospects continue to improve.  Incoming data clearly points to stronger growth, a healthier labor market and a fading risk of recession.  These positive developments should dominate market behavior, but not until the major uncertainties in Europe are resolved satisfactorily.


Europe still needs to recapitalize its banks and convince investors that the restructuring of Greek debt will not be permitted to spread defaults to the other sovereigns of Europe.  Convincingly large lending facilities to provide support for European sovereigns are being put into place too slowly to satisfy investors.  Banks will be required to boost their capital ratios, but no mechanism has been provided.  Their stock prices are too depressed for banks to accept so much dilution and there are insufficient buyers for them to raise capital ratios by selling off assets.  Government debt guarantees will cause their bank stock prices to rally, enabling bank to raise capital.  Or, governments should invest in preferred shares, as we did with TARP, to eliminate all uncertainty.  This would also curtail bank sales of sovereign debt, so sovereign bonds would rally, which would reduce investor concerns that the sovereigns will be unable to obtain market finance.  And all of this must be underwritten with policy action to reduce budget deficits over time.


Domestically, growth continues to improve, although the Fed may yet reinforce growth prospects with its creative approach to monetary policy.  Initial unemployment filings have resumed their downward trend.  Hopefully, this will translate into larger job gains, although much stronger job gains in the household survey hints precisely at this possibility.  It is also necessary that the payroll tax reductions be extended.  Corporate America is doing well, with Ford and G.E. raising dividends.


The equity market needs bad news to prevent the rally from continuing.  Rising profits and cheap valuations make stocks very attractive, but concerns over Europe will offset these solid domestic fundamentals, particularly when developments increase the risk of widespread credit defaults.  So, volatility should remain high, as investors respond these events.  Stock prices will move higher, but it will remain a roller coaster ride.  As Europe resolves its finances, risks of a meltdown should fade and volatility should decline, clearing the way for stocks prices to move meaningfully higher.