euro building blocks

Some investors have argued that events in Europe are having a disproportionate impact on US stocks. Their logic: the US is in the midst of a recovery, albeit a fairly anemic one, that is unlikely to be derailed by Europe’s travails.

It’s true that the US economy is doing much better than Europe’s, and especially southern Europe’s. But from my perspective, the trajectory of the US economy and the US stock market are very much tied to eurozone events. Here are four reasons why US investors should not underestimate the potential impact of events in Europe.

1.) Europe Makes Up a Significant Portion of US Exports. The US economy is much more consumption driven, and therefore more domestically focused, than other economies. That said, exports still count, and the United States still sends a significant portion of its exports to Europe. While exact data is spotty, in 2010 (the last year for which we have comprehensive data), Europe represented roughly 30% of foreign sales of companies in the S&P 500 index. Were a European recession to degenerate into a full-blown crisis, exports to European countries would plummet. At the margin, this would detract from US growth.

2.) A Rising Dollar Would Make US Exports Less Competitive. Since its 2012 peak, the euro has already depreciated roughly 8% against the dollar. To the extent fears of a European crisis continue to push the dollar higher, not just against the euro but against other currencies as well, US exports would become less attractive to other countries. To be sure, a stronger dollar is ultimately positive for US purchasing power and inflation, but in the near term, it would act as a further headwind for US exports.

3.) Recent US stock performance could negatively impact US consumer spending. As of Monday, US stocks were down 10% from their spring peak. Last Friday’s market drop can mostly be blamed on the United States’ own economic malaise. But the escalating crisis in Europe has also been a major catalyst for the recent US market correction, which has already erased roughly $1.5 trillion dollars from the US stock market since earlier this year. To the extent this drop hammers consumer confidence, it could have a modestly negative impact on consumer spending.

4.) The European banking system crisis could impact credit creation in the United States. While US banks are in a much stronger position than their European counterparts — US bank capital looks adequate and there is little risk of a run on banks here — banking stress in Europe is being felt in the United States thanks to the interconnectedness of the global financial system. On Friday, the Bank of America Merrill Lynch Global Financial Stress Index climbed to its highest level since the first days of 2012. At the very least, stress in the US financial system may harm the nascent recovery in US bank lending.

Looking forward, I believe a worsening eurozone crisis can still be avoided if European politicians get more aggressive in addressing their region’s, and particularly Spain’s, banking problems. However, until we see more clarity from European policy makers, equity investors may want to consider maintaining a defensive posture as Europe remains a major risk for US stocks as well as for the US and global economies.

 

Bloomberg: