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Summer of Discontent?
New York: June 20, 2011
By John Stephenson

It's beginning to look like another bad week for stocks. With no major economic data releases scheduled for the U.S. economy, it will be broad macro themes that will drive the market in the weeks to come. Unfortunately for investors, none of these broad themes appear to have a happy ending. Inflation remains stubbornly high in China and the Euro Zone debt worries seem to be accelerating as American lawmakers bicker over raising the U.S. debt ceiling. For some, this is just the quiet before the storm.

Producer prices in China are up 6.8%, inflation is now running at 5.5% and wages are moving higher. In spite of the government's best efforts to tighten monetary policy to curb inflation and moderate growth, inflation in China remains stubbornly persistent. Growth continues at a brisk pace suggesting that further interest rate medicine will be administered to curb an overheating economy. Over the past twelve months, Chinese retail sales grew 17%, industrial production climbed 13% and non-rural capital spending surged 26%. The growth trajectory for the economy is likely to be more moderate in the years to come as inflation worries dominate and China 's economic base expands.

Dominating the economic news is the tattered state of the euro zone. Last week, Standard & Poor's, a rating agency, downgraded Greek debt to junk status, citing “a significantly higher likelihood of one or more defaults” based on the agency's definitions of default. That same sentiment is being echoed in the capital markets where credit default swaps indicate at least a 78 percent chance of default. Greece is in desperate need of a second bailout to prevent defaulting on its obligations, in spite of receiving a €110-billion bailout just 13 months ago.

Shock waves are likely to roll across Europe in the weeks to come, as an all-important confidence vote in the Greek parliament could serve as a major barrier to getting a second bailout package to Greece in time to avert a default. Not only is the government of Mr. Papandreou in crisis, but the whole euro zone remains deeply divided on the issue of bailouts and the conditions surrounding further financial aid to Europe's periphery. The Dutch and German governments want mandatory private-sector losses as a condition of restructuring a second Greek bailout, which is being negotiated by the IMF, EU and the ECB.

European leaders are worried that a Greek tragedy may quickly morph into a banking crisis in an eerie repeat of the financial collapse of 2008/2009. Holding the line at Greece will likely weigh on European officials since commercial banks hold some €90-billion of Greek public-sector debt, as well as holding €20-billion of Irish public debt, and €42-billion of Portuguese debt. A Greek sovereign debt default would cause the value of these bond holdings to plummet, triggering a global banking crisis with its epicentre in Europe.

Over the last week, a shot across the bow was heard when Moody's Investors Service, put France's largest three banks up for review for a possible credit downgrade for their exposure to Greek debt. German banks, along with French banks, have the biggest exposures to debt-plagued Greece , Portugal and Ireland , suggesting a compromise will likely materialize to prevent a European recessionary crisis.

In the U.S. , limited progress has been made toward the August 2 nd deadline to raise the federal debt limit. The limit must be raised so that the government can continue to meet its obligations without impairing the country's creditworthiness, or touching off another global financial crisis.

But other than agreeing to sell off more of the telecommunications spectrum as a way to boost revenues and trimming agricultural subsidies, U.S. lawmakers are at a stalemate on how to increase savings. Both sides agree that some $2 trillion or more of savings must be found to win a debt limit increase while, at the same time, putting the federal government on course to save $4 trillion over the next decade.

With the S&P500 one bad day away from negative territory for the year and with waves of selling washing over commodity markets, investors have resigned themselves to a summer of discontent. U.S. banks have not escaped the carnage as international banking regulations ( Basel rules) have upped the required percentage of regulatory capital that large international banks must hold against losses. Investors are in a bearish mood as weak U.S. factory sector reports coupled with Europe 's debt worries have stoked concerns that the 2-year old global recovery may have stalled.

And while there is no doubt that things seem less rosy than just six months earlier, there could still be a few lingering catalysts for improving global growth. With hedge funds liquidating about a third of their earlier record net long position in the most traded U.S. crude oil contract, oil and gasoline prices have tumbled. That might, in turn, open up room for a little additional consumer spending as the beleaguered consumer dusts off from the sticker shock of $4-plus-per gallon gasoline. Japan 's re-emergence as a leading manufacturer and a key part of the global value chain is almost assured as it rebounds from the tsunami disruptions.

A strong snap back in commodities is almost assured as the sell off over the last two months has been unrelenting and valuations of commodity producers are looking positively juicy. But while it may be tempting to rush in, investors are cautioned to wait for the storm to pass before wading back in. Firms levered to U.S. growth and solid dividend paying corporations are likely the best antidote for the summer doldrums. There will be plenty of investing excitement ahead, but for now, a cautious approach is probably best.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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