Chris Kuflik - ScotiaMcLeod Montreal

Since our commentary last month, global investors have witnessed volatile markets that resemble a high stakes tug of war. While we hope for continued economic expansion and earnings growth, these are being pitted against the threats stemming from sovereign debt problems in Europe and the U.S.

I usually do not engage in political commentary, with the exception of how it affects us as investors.  Politicians in the United States seem to be more concerned about their political futures than finding lasting solutions to the present economic crises. They have been holding global investors hostage.

There has been a great deal of news flow from Europe. A little over a week ago, another round of bank stress tests were conducted to little fanfare. Recall that after last years’ stress tests, we saw the Irish banks which had passed the tests, ultimately fail and required huge capital infusions. This round of stress tests were more vigorous and saw eight of ninety lenders fail while another sixteen lenders squeaked by. After the tests, the European Banking Authority (EBA) acknowledged that “no bank has an entirely clean bill of health.” It should be noted that these EBA tests were done in order to see each bank’s ability to withstand an “adverse, but plausible scenario.” It did not include any outcomes should there be a sovereign debt default from Greece, Portugal, Ireland, Italy or Spain.

Why does this matter? Last Thursday, global markets rallied as a proposal from the EU to rescue Greece was presented. Fitch, one of the bond rating agencies, classified the package as “restricted default” due to Greek bond holders having to accept some of the burden of the package. Will this “restricted default” trigger write downs of Greek debt and further problems for European banks? Could the American banks be forced to pay for the CDO’s that I discussed in the last commentary? We do not know yet.  Lastly, the proposed bailout fund to be created, while a positive step, would not be large enough should Spain or Italy require a bailout.

As of this writing Sunday night, the politicians in the United States have yet to come to an agreement to raise their debt ceiling. While this seemed to be a fait accompli last Tuesday afternoon when President Obama announced the “ the gang of six”  senators from both parties were close to an agreement to not only to raise the debt ceiling, but also to spending cuts in principle. Investors have now learned that this is not the case.

The strong performance in the equity markets last week was due in part to the EU proposal and what was perceived as a resolution to the US’s debt ceiling proposal. The latter could be in jeopardy this week. In addition to these macro economic announcements, strong earnings reports from the US companies that have reported thus far also contributed to the positive tone. Do we think that the US will default? The short answer is NO. Equity, bond and CDO markets are clearly not reflecting a default. Also, the President has the authority via the 14^th amendment to increase the debt ceiling to avoid default. The difficulty with Obama raising the ceiling without the senate or congress is that it could be very difficult for him politically in the future.

The greater threat to global markets lies in the warnings from the credit rating agencies. On Friday, Standard and Poor’s warned that there was a 50 – 50 chance that the United States would lose its AAA debt rating in the next ninety days – even if the debt ceiling was raised or there was no US default. Without spending cuts and a credible plan to reduce their deficit, the potential for the AAA rating loss would increase the costs of borrowing and cause greater shocks to the financial markets. You should note that the bond and CDO markets are currently not reflecting this scenario.

Even though deficit reduction plans in the U.S. and Europe will most likely slow near-term economic growth, we believe the financial markets would generally applaud moves that reduce uncertainty and increase economic stability, both of which would increase the odds for a sustained recovery and growth phase. We are hopeful some real progress can be made soon – it has to be – so that businesses, consumers and investors can get to work doing what they do best. In the meantime, we will continue to monitor the situation closely as it unfolds and focus on equities which are both sound financially and pay good dividends.

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Chris Kuflik

Associate Director, Wealth Management

Wealth Advisor

514-287-2931

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