The uncertainty in Europe continues to dominate global market action, and it remains unclear whether Europe as a whole will move fiscally closer together or monetarily further apart in its efforts to solve its problems. The combination of fiscal rescue packages and increased austerity measures seems to be the clearest path to success, but investors are rightfully questioning whether, for example, Greece will be able to become austere enough for the markets to regain confidence. Within the US, the economy continues to show slow signs of improvement. First-quarter GDP growth was revised slightly lower (from 3.2% to 3%), but consumer confidence readings rose in May as the improving labour market overshadowed stock-market volatility. On the earnings front, both reported results and expectations have risen over the past couple of months as well.

 

The main issue currently plaguing investors is the degree to which fundamental uncertainty has inflicted damage on overall economic conditions. The most pessimistic view is that we are witnessing the start of a movement that will drag down the global economy; the most optimistic outlook is that what we are seeing is no more than mindless panic, which will be quickly overcome by fundamental strength.

 

We are not subscribing to either extreme, but our sympathies lie more with the latter than with the former. By our analysis, investors are beginning to move from panic mode to a wait-and-see approach, and while we do think fundamental strength will win out, we acknowledge that it will take some time.

 

As several observers have noted, the past month was the worst for US stocks since 1962, and there are some interesting comparisons between that time and the present. In the 1962 bear market, the S&P 500 fell nearly 30%, but US GDP continued to expand at a brisk pace. At the time, market sentiment was dragged down by the failed Bay of Pigs invasion and the Cuban Missile Crisis, but fundamental conditions remained strong. To some extent, we believe the current environment is similar, given that stock prices are being driven much more by sentiment than by fundamentals. In previous business cycles, when credit market pressures surfaced during a steep yield curve, the economy experienced brief slowdowns, but not recessions.

 

If that is also the case today, then what we are looking at should be a temporary slowdown in growth, but not a double dip recession. Our best guess at present is that nervous investors and slowly receding uncertainty levels will keep market volatility high over the coming month. However, should the US labour market recovery continue, as we expect it will, the backdrop of strengthening corporate profits and a recovering economy should push equity prices higher, although it will take some patience to get there.