Sovereign debt problems depress stock market confidence and hold back GDP growth

Market Pulse: June 28, 2011

The Federal Open Market Committee (FOMC) at its meeting last week downgraded its GDP forecasts for 2011 to 2.7%-2.9% from April’s 3.1%-3.3% level and for 2012 to 3.3%-3.7% from April’s 3.5%-4.2%. Mr. Bernanke said he expects the current economic slowdown to be temporary, but he added the disconcerting statement that “We don’t have a precise read on why this slower rate of growth is persisting.”

One factor that is certainly behind the current economic slowdown is concern about U.S. and European sovereign debt problems. Regarding Europe, the market is worried that a Greek debt default could start a new Lehman-style chain reaction in the global financial markets. The markets are waiting to see if the Greek parliament will approve a new package of asset sales and austerity measures that the EU is requiring for more bailout money. If Greece approves the package, then EU finance ministers are likely to approve a new bailout package that will keep IMF funding alive and avert a default for at least another year.

However, another bailout package will do little to change the market consensus that a Greek default is inevitable within the next several years. The markets remain very worried that a Greek debt default could spark a run on European banks that hold Greek debt, and on U.S. money market funds that hold European bank debt, as well as spark big and uncertain losses through the credit default swap market. That possibility is causing stock market weakness and reduced confidence among U.S. and European businesses and consumers.

Meanwhile, the Biden talks on raising the U.S. debt ceiling are starting to hit a wall as the two sides hunker down to protect their core positions. The two sides are so far apart on tax increases and spending cuts that it appears inevitable to us that they will go right down to the wire to the Treasury’s August 2 drop-dead date, possibly causing the credit rating agencies to provide further warnings about a U.S. debt rating downgrade. The added concern is that at least a few Republicans do not believe the August 2 drop-dead date and appear willing to allow the battle to go beyond August 2. We believe a debt hike will get done by August 2, but not before investors take the stock market lower to account for the increased risks.

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