Tuesday, June 26, 2012

Why Would A Bad Situation in Europe Hurt the US?

Something that we really haven't touched on is why does the EU situation hurt the US?  After all -- they're over there, and we're over here.  Doesn't the Atlantic provide any kind of buffer for the situation?

No.  Here's why:

1.) One of the primary reasons for the formation of the EU was to create a common market for the European continent.  That is now the second largest economic region in the world, trailing only the US in terms of size.  And that block has now been in existence for the last 10+ years, meaning it has become part of the world-wide trading system.  Speaking from personal experience, when a company is looking to expand, we try to get them "into the EU," as opposed to "getting them into France."  Now that system is in danger of splitting up, meaning that a coherent economic region may now become fragmented.  That creates enormous uncertainty for businesses -- it essentially freezes most moves into that region until the situation is resolved.

2.) The inter-relationship of financial markets is now at an all time high.  When the German market falls, it creates a negative loop that feeds into the Asian markets and then the US.  When EU investors seek safety, they buy US treasury bonds across the ocean.  In short, money doesn't stay locked in the EU, especially when other, safer alternatives exist.  And that easy, cross-border flow of money ties the two economies together like never before.  Also remember that financial markets are leading indicators of economic activity.  The stock market and yield spread are both parts of the Conference Board's leading indicator index.

3.) All banks have portfolios of bonds.  Some of the larger banks own bonds issued by some of the countries that are weakening -- Spain, Greece, Portugal, and Italy.  Should these countries leave the EU, their bond prices will drop, which will in turn force the banks to take losses on their bond holdings.   This, in turn, makes it more difficult for banks to make loans, thereby slowing the recovery here.

4.) Overall sentiment and psychology.   While difficult to define and quantify, it's hard to ignore the overall negative impact on sentiment when we continually hear negative news from a significant part of the world.  Put another way, when was the last time you heard about good news coming from Europe?  It's been quite awhile.  Eventually, that starts to have an impact on your actions and decisions.  Magnify that several times over, and you'll start to see the ripple effect as it moves through the economy.