Global stock markets moved between gains and losses throughout July, but ultimately finished lower for a third consecutive month as global debt concerns and disappointing U.S. economic growth outweighed positive corporate earnings reports.

The month of July started out strong, with 78% of S&P 500 companies surpassing profit expectations for the previous quarter.  However, profit growth is expected to slow during the rest of 2011 as to higher commodity costs squeeze margins and persistently high unemployment restrains consumer spending.

After a big rally in the first week of July, markets turned their attention to Europe where the debt issues that plague Greece, Ireland, and Portugal threatened to spread to Italy and Spain.  Complicating matters, the European Central Bank (ECB) raised interest rates for the second time this year to fight inflation that has stayed above their 2% target the past seven months – the policy move comes even as yields on Greek, Irish, and Portuguese two-year bonds exceed 15%.  Fears were temporarily calmed by a plan to address weak peripheral nations’ ability to meet debt payments as well as the €159 billion ($229 billion) bailout to Greece to avoid default, but European leaders still face a difficult balancing act of the varying risks among different nations.

The problem of elevated debt levels in the U.S. is sometimes compared to that of the Eurozone nations, but there are important differences.  Compared to the U.S., the distressed Eurozone countries have significantly smaller debt markets, much lower credit quality, and lack of control over their currency adjustments. The most important distinction is that the ability of distressed Eurozone countries to meet their debt obligations is in question, which is not the case with the U.S.  The issue frightening investors is the threat of a credit downgrade by one of the major credit rating agencies, the potential consequences of which are largely unknown.

Moody’s Investors Service said on July 29 that the U.S. could keep their top rating as long as the Treasury agrees to raise the debt ceiling.  Standard & Poor’s indicated in the final week of July that anything less than $4 trillion in deficit reduction would put the AAA rating in danger.  Congress appears to have reached an agreement that raises the debt ceiling in two installments – an immediate $900 billion increase in the debt limit along with $917 billion of spending cuts over the next decade, and another $1.2 trillion increase to the debt ceiling contingent on finding another $1.5 trillion in deficit savings by the end of 2011.

Despite the threat of a credit downgrade, the benchmark ten-year Treasury yield fell as low as 2.77% during the month, the lowest since November 30.  (Treasury yields decrease as prices increase.)  Even if the U.S. loses its AAA credit rating, Treasurys are still viewed as a safe haven and big investors can’t find alternatives that match the depth and liquidity of the Treasury market.  In addition, Treasurys are gaining as economic indicators are signaling trouble.

A shockingly bad June employment report showed U.S. employers added just 18,000 workers in June following a 25,000 gain in May and the U-6 unemployment rate – sometimes referred to as the “real unemployment rate” because it includes underemployed and discouraged workers – increased to 16.2% from 15.8%.  In addition, the four-week moving average of initial jobless claims remains above the 400,000 level. Adding to risk aversion, revisions to U.S. GDP figures showed that the economic recovery lost momentum throughout 2010 before stalling this year.  And although Ben Bernanke said this month that the Fed is willing to provide additional stimulus (QE3) if necessary, he squashed the idea that any stimulus should be expected in the near future.

Peter Lazaroff, Investment Analyst

St. Louis, MO

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