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Eye on the Market, September 21, 2011
Topics: How bad can Europe get; How fast can China grow; How progressive can US tax policy be; and How independent can the Federal Reserve remain

Something notable happened over the last 2 months: the financial markets have finally priced in our dire view of the European Monetary Union. Call it "The European Reality Show". EU equities have underperformed the S&P 500 by 16% this year, following an additional 10% underperformance in 2010 . Debt markets price in 50%-60% probabilities of default for Portugal and Ireland and 100% for Greece, French bank credit default swap spreads have tripled as US money market funds reduce exposure, German equities trade at less than 10 times earnings, many European banks trade below 0.5 times book value and 70% of fund managers are underweight European banks. During the last 2 years, an aggressive underweight to Europe has been the right place to be, ignoring the wistful delusions of policymakers, analysts, economists, etc who believed the EMU could right itself through austerity-based lending and some structural reforms. However, now that this view has become consensus, we need to start thinking about whether a set-it-and-forget-it underweight to Europe will keep working from here. We address this topic in the attached note.

Other topics this week:

** A summary of a session we had with one of China's truest believers who walked through his arguments in favor of sustainable Chinese growth. We found this interesting at a time of intense skepticism within parts of the investment community
** A look at exactly who would pay more in taxes if the President's "Living Within Our Means and Investing in the Future" proposals were adopted. Answer: the implied Buffett suggestion of taxing capital at higher rates is mostly ignored in favor of higher taxes on ordinary income.
** Six charts showing why financial markets may never look at Italy the same way again
** A brief R-rated time capsule of Fed-badgering by US politicians
** No comment on today's Operation Twist, since a few basis points up or down at either end of the curve is not that meaningful. Treasury rates are not a binding constraint on the US economy right now.

Michael Cembalest
Chief Investment Officer


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