The U.S. Economy Can Weather Euro Storm

Pretty much everything I read these days suggests much the same: "As the euro goes, so goes the world." I'm not so sure. Particularly for stock investors, maybe the euro and its zone are headed for more trouble, but the world can move on. Unfathomable?

The euro-end-all argument generally has three main points. One, if the eurozone goes into full scale recession as a result of severe austerity, hunkered-down banks, high debt burdens, and general political lollygagging, that combined they'll take down the rest of the world economy, right? Maybe.

It's no doubt true that the globe is highly interconnected, and Europe excluding the UK is 24% of global GDP. That's not insignificant. But don't forget the other 76%. Otherwise healthy regions, in this case that huge other 76%, can pull Europe forward better than most believe.

It's increasingly clear the summer malaise was more a typical mid-cycle slowdown, as opposed to a global recession harbinger. The world in aggregate is generally moving along - global GDP is at a new all-time high - including the much stronger than expected Asia ex-Japan, a recovering Japan, a decidedly non-recessing U.S., and still-popping Emerging Markets.

Many big European corporations are heavy exporters. Japan, smaller than Europe but still one of the world's largest economies, went into an earthquake-induced recession this year, and yet the world didn't recess despite a ton of claptrap about the global effects of their export-driven economy. Or consider the reverse: U.S. exports to Spain are less than 0.7% of the total, and 1% for Italy. Germany is a little less than 4% - still small, but it's ok because the German economy is doing better than others in Europe.

It's tough for the pessimistic-minded to contemplate, but it's precisely because the world is so interconnected that the eurozone is likely to do better economically than many believe; not worse as so many do believe.

The second euro-death-to-us-all contention is that stock markets are highly correlated (now far more than they have been historically), and since headlines globally are dominated by euro ills, euro health is all that matters for stock markets. Not so fast. High correlation doesn't necessarily mean low dispersion of returns. Note the S&P 500 this year is down about 3% (as I write), foreign stocks as measured by the MSCI EAFE are down about 15%, and PIIGs starlet Italy is down 24%. Simply, while it is true directional correlation is high, some divergence between the weak and the strong is evident.

Lastly, there's the "ghosts of panics past" piece of all this. If a major country defaults, and then the big global banks holding all that debt suddenly become insolvent, it's a 2008 liquidity squeeze all over again, Lehman style, on steroids. Scary stuff, but whatever beast euro-gate is, it's something different than ‘08. Banks in aggregate, particularly those outside the eurozone, are far better prepared today for such an event. 

Banks are wary right now, not flat-footed. Santander and SocGen, for instance, are increasing capital now, and U.S. banks started the balance sheet sandbagging process years ago (by their own volition or the government's). In fact, European bank leverage ratios sit below 15 today from a high of near 19 in 2008, and U.S. corporate cash balances are at all-time highs, near 7% of total assets.

Said differently, there's nary a corner of the globe not aware that the euro's in mortal danger, and that's a far cry from the low level of awareness that prevailed in 2008. Could a few more financial whales float to the surface? Sure. But by and large, the world's financial system has widely contemplated prolonged European ills. That's important because widely contemplated issues get reflected in stock prices.

In the short-term, the potential for large, unforeseeable shocks still exists. Of greatest concern is an event in the eurozone so big and unexpected it freezes liquidity and thus infects equity markets and the wider economy too. To my mind, that can only happen with a truly chaotic and sudden disbandment of the eurozone. Virtually everything else lacks the panic-punch to drag down stocks hugely.

Where to from here? Well, the eurozone could find funds from outside sources like the U.S. or China. (This is unlikely on the scale needed.) Or maybe troubled euro economies really do austere themselves toward continued solvency. (That'll be tough, especially if financing costs stay elevated.) Or the ECB can print to debase the currency and risk high inflation to keep everyone afloat. This is the most likely outcome, but at this point it's more a political issue than economic.  As we speak, ECB head Draghi and regional leaders are playing chicken with each other. We'll just have to wait and see.

Whatever the euro fate, no side has an incentive to force a hasty-and thus chaotic-disbandment. But what ought to be clear is that a continued euro PIIGs problem doesn't necessarily spell doom for the rest of the world. In the medium to longer run, this is a moment where global equities remain hugely cheap, sentiment is stuck in Halloween havoc rather than holiday cheer, and the global economy along with corporate earnings are moving ahead.