The Sovereign Debt Crisis: Bad For Europe, Good For U.S. Stocks

For several months now, we've been talking about the post-financial-crisis "new world order" that's emerged from the speculative excesses, recessionary realities and regulatory breakdowns of recent years. This new world order has created a world of lucrative new profit opportunities – that are governed by a new set of profit rules.

In terms of that whole new rules/new profit opportunities paradigm, here's one that may surprise you: The ongoing European crisis could end up as a net positive for U.S. stocks.

Let me explain…

A Revealing Prediction

We've talked a lot about the debt and corporate growth troubles in Europe and the developed economies of Asia, and I've shown you a lot of reasons why the companies in those regions should suffer. Yet shares in those regions of the world have actually risen.

For some additional insight on the forces at play, I checked in with the folks at the New York-based Craig Drill Capital – a great, under-the-radar hedge fund that employs some of the best analysts and money managers in the world. Steven H. Reynolds , the firm's chief investment officer, has a sanguine view of Europe. And he believes that the European debt crisis could end up looking like a net positive for American shareholders.

"For U.S. equity investors, a return to the 'Goldilocks' environment will evolve," Reynolds said. "Moderate economic growth, subdued inflation, strong corporate profits, low interest rates and ample liquidity argue for higher asset prices" – including U.S. stocks.

Eurozone Blues

For investors who insist on keeping informed, there's no shortage of news about the European debt situation. Trouble is, most of that news is bad. And, in typical knee-jerk fashion, with each announcement, investors in each of the world's major markets react by whipsawing security prices for the following day or two, which causes additional worry – and uncertainty.

For instance, Bloomberg News just reported that European banks at risk of write-downs from the sovereign debt crisis face a funding squeeze that may depress earnings, curb lending and imperil the region's economic recovery.

Bloomberg said investors are shunning bank securities on concerns that Greek, Portuguese and Spanish bonds held by the lenders will plunge in value. Bank bond sales slowed in May to the lowest level since the Lehman Brothers Holdings (OTC: LEHMQ) failure in 2008, as the extra yield buyers demand to hold the securities over government debt soared to the highest this year. Firms are wary of lending to each other, depositing record funds with the European Central Bank. (ECB).

"There is a lot of mistrust," said Christoph Rieger, a bond analyst at Commerzbank AG (PINK ADR: CRZBY) in Frankfurt, told Bloomberg. "Banks are trading with the ECB rather than with each other."

Reynolds, the Craig Drill Capital analyst, says the situation isn't nearly as alarming as it seems.

He basically believes that while pu blic and private debt levels and interest payments relative to gross domestic product (GDP) are at dangerous levels in Europe, the problems are more manageable than the ones that sparked the global financial crisis in 2008:

• The banks are sounder.
• There is more transparency.
• Most of the problems are out in the open.
• And – most important of all – the "financial engineers" at the European Union (EU) and ECB are now experienced in crisis management.

Those financial engineers, "honed on the Panic of 2008 … are capable of developing creative remedies to the current liquidity crisis," Reynolds said. "For a reasonable period of time, a relatively stable – yet fragile – financial system will result."

A Buoyant U.S. Outlook?

There's no denying that bearish investors have made their case in recent weeks. They are legitimately afraid that the economies of the United States and Europe will fade so much in the months to come that they will sink back into recessions punctuated by credit blowups and a resumption of a bear market for U.S. stocks.

Still, the simple fact that there are a few economic boogey-men lurking behind each piece of data (many of which are actually quite suspect) doesn't mean that investors should run screaming away from stocks.

In fact, if you take the time to listen to the opposite point of view before you make up your mind about the direction the economy is headed, you might be pleasantly surprised.

Just consider these most-recent developments and revelations.

Capital Economics, a crack London-based macroeconomic research team, reported four positive developments for the U.S. recovery. CapEcon said that:

• U.S. household net worth rose for the fourth straight quarter.
• Manufacturing output will rise by 1% in June.
• Gasoline prices are expected to drop 4.5% this month from last month, keeping inflation at bay.
• And a weather-related jump in energy generation is expected to add 0.6% to industrial production

Analyst Richard Berner – the co-head of global economics and chief U.S. economist at Morgan Stanley (NYSE: MS), recently said that his economic models suggest that the pace of economic growth will actually quicken in the months to come.

According to Berner, "incoming data portray a robust economy, an acceleration from a 3% pace of growth in Q1 to a 4% annual clip in Q2 even as consumer spending decelerates … and we continue to expect 3.5% overall growth in the second half of this year."

The U.S. recovery will benefit from a bit of a tailwind created by the European debt situation, says Craig Drill Capital's Reynolds.

"For the European economy, restrictive policies should be moderately deflationary with slower growth, a competitive euro for trade, and stable interest rates. For the U.S., the impact should be minimal with a weak euro/U.S. dollar, moderately lower exports, continued low levels of interest rates and positive foreign capital inflows."

Plus, don't forget that the whole European mess will provide two big tailwinds to American consumers: A continuation of the afore-mentioned drop in gasoline prices – thanks to a stronger dollar – and lower mortgages rates – thanks to a rise in demand for U.S. Treasury bonds spawned by the lack of faith in the European financial system.

Europe is troubled. But the region's leaders are on the case, and the lower euro and interest rates will prove to be palliative – at least for awhile, Reynolds says.

Just how long the "perfect storm" fallout from an imperfect Europe will continue to aid the U.S. rebound and support U.S. stocks remains to be seen.

The bottom line for U.S. investors : Overall economic and corporate growth may be set to slow, but not to levels that are disastrous, or even likely to imperil U.S. stocks – at least not yet.

Investors should continue to trade the pessimism while it persists. But they should also be watchful for an overabundance of optimism if we get to the top of the range at the 1,150 level of the Standard & Poor's 500 Index, or if bears get the upper hand and manage to push the benchmark U.S. stocks index back down under 1,040. That would represent a decline of about 5% from yesterday's (Wednesday's) close of 1,092,04.

[Editor's Note: As this market analysis demonstrates, Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.

Subscribe to Strategic Advantage and hire Markman to be your guide. For more information, please click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Stock Market Strategies for the Post-Financial-Crisis 'New World Order.'
• European Central Bank:
  Official Website
  
• Bloomberg News:
  Europe's Banks Face Second Funding Squeeze on Sovereign Crisis
• Capital Economics:
  Official Website
• Richard Berner:
  Official Bio
• Money Morning News Archive:
  U.S. Stocks
  
• Money Morning Special Report:
  Don't Give Up on U.S. Stocks Just Yet

Join the conversation. Click here to jump to comments…