With 2-yr swap spreads as a proxy for systemic risk, we see that conditions in the Eurozone have been deteriorating for the past two years, and especially since last July, thanks primarily to the growing risk of sovereign debt defaults in the PIIGS countries. Meanwhile, investors have been terrified that defaults in the Eurozone could lead to another global banking crisis and a global economic collapse. Those fears have depressed equity prices and economies everywhere, even as corporate profits have been very strong. But markets can only worry so long about the end of the world being right around the corner.
Despite all the fears, the U.S. equity market has diverged significantly from Eurozone equities. The two charts above compare the S&P 500 index to the Euro Stoxx index, and here we see a significant divergence between the two starting in August of 2010. Since that time, U.S. equities have outperformed Eurozone equities by over 30%. This is a major difference between two huge players on the global stage. We've seen divergences of this magnitude before, but as the top chart shows, this is the first time that the Eurozone has underperformed the U.S. Whatever is happening in Europe is increasingly being contained in Europe.
I think this fits with my thesis that Eurozone sovereign debt defaults are not likely to be as destructive to the world as the market has feared. By staging a major divergence, equity markets are slowly coming to that realization. The impact of the Eurozone debt crisis has already hit the Eurozone economy: it doesn't take a default to cause a loss, because the market has already priced in defaults of $1 trillion, and because the money that the PIIGS borrowed was squandered long ago on unproductive activities that sapped the underlying strength of the Eurozone economy. All the losses are water under the bridge. Europe is foolishly trying to postpone the recognition of this reality, when it should instead be wiping the debt slate clean, recapitalizing its banks, and shrinking the size of its bureaucracy. While Europe dithers, the U.S. economy moves slowly ahead.
This is not to say that the U.S. is golden, of course. We have our own debt binge to worry about, with the federal government having borrowed $5 trillion in the past three years. That's an awful waste of money, but our debt/GDP ratio is still within the range of being payable, and we don't have the problem that Greece has of owing money in a currency we can't control. I believe the U.S. economy would be a lot stronger today if we had spent and borrowed less, because like the Greeks, much of what we have borrowed was spent on unproductive activities (e.g., transfer payments). At the same time, our federal debt was not concentrated in our banks, the way it was in the Eurozone.
Meanwhile, believe it or not, federal spending as a % of GDP has declined meaningfully in the past three years, thanks to a dramatic decline in the growth of spending. Amidst all the bad news there are some tidbits of good news to be found in the U.S.