Reality bites. Europe recently admitted a eurozone member could restructure debt. The US government would soon be downgraded. These are realities that took time to sink in. Markets are taking these gradually, though some asset classes react more than others. The key issue here is that so much policy uncertainty in G7 for so long can actually have a real effect on the medium-term scenario. Let us touch on the US debt ceiling negotiations first, then on the euro crisis.

Though we expected noisy last minute negotiations, events yesterday are a bit more worrisome than expected. The debt markets seem to be almost certain there will be no default (except for some risk management trading in CDS), while equity markets seem to be more concerned with the debate. We believe the probability of default is extremely low, while the probability of a downgrade of the US rating is much higher. The downgrade has far reaching implications for debt markets, as a large portion of bond funds have rules dependent on that rating. Moreover, debt markets have always been anchored by the “risk free” rate of the US government, relative to which almost everything is priced off. On the one hand, a downgrade is almost natural and long overdue, as it seems counter-intuitive that the US fiscal situation gets the same rating as that of Singapore. High-grade corporates and sovereigns are the most likely beneficiaries of a downgrade to the US. On the other hand, the US as the “risk free” rate (and AAA) is all we know in terms of debt markets. The best case scenario is one in which tradition and market perception over-ride any rating action (except for those with rules that force them to react to a downgrade), and markets continue to operate as before, confirming the relative irrelevance of rating agencies. We see this scenario as the most likely medium-term scenario, though short-term jitters are also very likely.

The politics of the debate is what has complicated matters in recent days. Raising the debt ceiling does not require a fiscal adjustment, nor a grand bargain, as it had been raised many times in the past without this kind of comprehensive debate. It is actually positive that the debt-ceiling vote is used as a mechanism to force work on the medium-term fiscal position of the US government. A year ago there was no real fiscal debate, no proposals, no work on how to improve medium-term solvency. Now, both parties have looked into the options, and produced proposals. Negotiations have brought them close at times. However, it does produce volatile markets in the short-term. From a big picture perspective, paradoxically, the US medium-term fiscal outlook is better now than a year ago.

It is not easy to navigate these events at high frequency (on a daily basis)[1]. But from a medium-term point of view these are relevant opportunities of inflexion points. We trust our cautious stance relative to our relatively optimistic medium-term outlook is the right approach, when judged through time.

In terms of inflexion points, last week’s announcements in Europe seem to have been just that. The EU has acknowledged that a member can be insolvent and require debt restructuring, at the same time that the steps to differentiate Italy and Spain amount to a serious step towards further fiscal integration (very much like we wrote before that meeting in “Euro fiscal union or euro break-up”). Details need to be worked out and announced. Much of what was announced can be qualified as insufficient: the haircut apparently discussed for Greek debt seems as insufficient debt relief, while the fund that would be used to protect Italy and Spain (EFSF) has not been augmented so it is clearly not big enough. But the steps taken are conceptually very important, and they change much of what has defined the EU and the euro before.

In sum, our base case scenario includes a favorable resolution of the US debt-ceiling saga (potentially with a repeat before the end of 2012), and continued pressure in some European countries, as the specifics of the measures last week are not yet enough. The direction in both issues is positive, though the underlying flaws of the euro are significantly more complicated than the required fiscal adjustment in the US. Navigating the short-term swings is obviously more complicated, which is why keeping our sight on the medium-term and fundamentals, as opposed to the politics and short-term swings, is key. Markets swing in the short-term, but the magnitudes imply that the big picture and medium-term views still dominate, as we have not seen a drastic downdraft though the rhetoric is somewhat incendiary.

Though the low growth patch that defined 2Q11 remains the norm, about half of the companies in the S&P500 have reported earnings, with a higher than average percentage of those beating. Not only earnings have been mostly better than expected, but total revenues and margins. The S&P500 seems on track to fulfill optimistic estimates for 2011 full year estimates. At the same time, due to the volatility of the last 2-3 months, valuations remain attractive, globally and in core markets, in absolute terms and relative to bonds.

[1] For practical purposes, we could even see the debt-ceiling negotiations get worse, go through August 2nd, but still avoid default. August 2nd was most likely an arbitrary date chosen a few months ago, and higher than expected tax revenues have led people to believe there is more time.

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