The escalating debt crises on both sides of the Atlantic are complicating the process of investment decision making for the latter half of 2011 as sovereign default fears grow against the backdrop of a world economy still growing at a reasonable pace.
"Crisis? Take your pick" — as Bank of New York Mellon put it on Friday — perhaps best summarizes the mood among investors who face a crunch week for U.S. deficit reduction talks ahead of the White House's July 22 deadline on a deal to raise the $14.3 trillion debt ceiling.
The focus of the euro zone would be to assess potential damage to banks from any default of Greek sovereign debt and contagion to other peripheral countries, namely Italy. The early part of the trading in the coming week is likely to be dominated by reaction to European banking stress tests.
"The economic reality right now is investors and financial markets underestimate the impact on economic growth from the turn towards budget austerity. There's a risk of significant disappointment on the pace of growth in the United States and euro zone," said Didier Saint-Georges, member of the investment committee at private asset manager Carmignac Gestion in Paris.
"That's making us cautious on investment strategy. How to be cautious these days? Reduce your exposure."
One of the flagship funds at Carmignac has reduced equity exposure to 20 percent against a maximum limit of 50 percent and its exposure to government bonds focuses on German debt.
Reflecting increasing concerns surrounding U.S. debt, the five-year U.S. credit default swaps rose to their highest since February 2010. The CDS curve has been inverted in the past week as investors priced in greater risks over the short term than over a five year period.
"With the U.S. still debating the debt ceiling and EMU politicians divided on how to tackle the EMU debt crisis, it is time to 'Think the Unthinkable,' namely U.S. and EMU officials failing to find credible solutions," Morgan Stanley said in a note to clients.
"This is by no means our base case, but what would happen if both events were to hit markets simultaneously? We see high-yield and high-deficit currencies falling hard, with the Swiss franc and the yen outperforming in such a scenario."
What's complicating the investment strategy is that corporate news flows have been encouraging. Just on Thursday, Google results beat Wall Street's most bullish expectations, sending its shares up 12 percent.
Key earnings reports over the coming week includes Goldman Sachs, Bank of America Merrill Lynch, Apple, GE and IBM.
Analysts have consistently reduced second-quarter earnings growth forecasts for S&P 500 companies given slower economic momentum, but earnings are expected to rebound quickly towards the end of the year.
The Q2 quarterly earnings growth rate has nearly halved to 6.7 percent, from 13.3 percent in April. The Q3 rate is expected at 16.6 percent.
Next week's U.S. data including the Philadelphia Fed survey would provide a crucial update on the state of the world's biggest economy after a disappointing set of data in recent weeks, especially last week's monthly jobs report.
Analysts at Goldman Sachs say the upside risk is bigger than the downside in the near term — this could in turn provide support for risky assets into thin summer months.
"Even if risks to the longer-term growth outlook are skewed to the downside, forward growth expectations remained above the 'run rate' visible in the current data, which in turn had been more than fully reflected in markets," Goldman Sachs said in a note to clients.
"After a long string of weak and disappointing data... the hurdle for the data to surprise to the upside had become much lower and the likelihood of near-term improvements, particularly relative to the sharp weakening, had increased."
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