A Decoupling? The United States and Europe Going Their Separate Ways.

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The equity market’s performance since the end of 2011 proved particularly strong, resilient and broad-based. Stock prices defied the late 2011 forecasts and recommendations of many investment banks that suggested a cautious approach to 2012, and in some cases an allocation away from equities. In January, many of these bearish views were revised and now reflect a more positive outlook. Another element that continues to dominate the investment landscape is the daily preoccupation with trading and trading strategies. Recent events suggest the notion that such an approach results in financial success is proving elusive.

Despite the ongoing crisis in Europe as central bankers, government entities, and politicians attempt to stabilize the Euro and reach an agreement for the second Greek bailout, the U.S. equity market appears to have rationalized some of the European woes. The European difficulties now seem less onerous to U.S. markets.

Particularly telling is the behavior of overseas financial markets. Spanish and Italian bond yields have fallen and the ECB established itself as the “lender of last resort,” lending nearly 500 billion Euros/$650 billion dollars to European banks for a recently extended three years. This action was taken in an attempt to avoid a liquidity crisis among those international banks, and thus far it has worked. Although excruciatingly slow, progress on the Greek bailout has occurred. Bank recapitalization, state asset sales, and the terms of the newly issued long term debt have emerged. A 3.6% coupon and 70% of the short-term debt is to be replaced with 30 year paper.

The EFSF (European Financial Stability Facility), the temporary fund, and the ESM (European Stability Mechanism), the permanent financial mechanism, are essentially in place while the role of the IMF is yet to be fully determined. Additional funding for the IMF is being sought and is likely to be achieved. In reality, the alternative is unacceptable to member nations. An expansion of SDR’s (special drawing rights) and an increasing role for China are ultimate byproducts of the increasing role of the international organization. China, with $3.2 trillion of foreign exchange reserves has a vested interest in the stability of the international financial system. Chinese leadership has indicated a willingness to support the eurozone.

To a certain extent, the equity market has decoupled from Europe and is focusing increasingly on domestic economic events and policies. The successful progress evident in employment growth has provided the basis for a less pessimistic view. In 2011, the average monthly gain in employment was 160,000 and in January 2012, 243,000 jobs were added to non-farm payroll employment with unemployment falling to 8.3%. It is important to note that seasonal factors are notoriously difficult to adjust for this time of year when weather is such a dominant factor. Warm weather, which was experienced in January, could bias the data upward. Nevertheless, the improving trend has existed for some time. The ISM surveys for Manufacturing and Non-Manufacturing further confirm the positive developments. New orders, employment, new export orders all point toward continued expansion. Economic activity in the manufacturing sector has expanded for 30 consecutive months and for the overall economy for the 32nd consecutive month. For services, survey numbers have increased for 25 consecutive months.

These developments occurred against the backdrop of a very accommodative monetary policy. In fact, at the January FOMC meeting, the Fed laid out a path for short-term interest rates that extended the period of low rates from mid 2013 to the end of 2014, and provided greater clarity of the underlying economic forecast. This analytic framework reduces policy uncertainty and provides equity investors with a view of the potential return provided by a competing asset class, fixed income. Furthermore, the monetary authorities’ continued concern surrounding the anemic housing market assures easy money influenced by an “operation twist” and the mortgage backed market. Currently, the rate of monetary growth is very supportive of economic growth. Inflation-adjusted MZM and M2 are rising at 7-8% annual rates. Such a thrust of monetary expansion with a constraint on rates provides a favorable backdrop for stocks. With an earning yield of 8% on the S&P 500 and 1.94% yield on the 10 year Treasury, the risk adjusted valuation differential appears quite favorable.

By: Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer



If you have a question or need further information, please contact:

Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, Patrick.snell@mastrapasqua.com

Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, ckoontz@mastrapasqua.com


The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader's particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.