The oft-repeated phrase of "kicking the can down the road" may be coming to an end in the financial markets. Up to now, markets have been at least somewhat satiated by moves by US and European policymakers to temporarily avoid crisis blow-ups using short-term solutions. From a one-year extension of the payroll tax cut in the United States, to long-term refinancing operations (LTRO) in Europe, short-term fixes have to date prevented a calamity. However, it appears that time may be running short for those "solutions" to satisfy market participants. With each new "fix" the positive market bump appears to be getting shorter, with focus more quickly returning to the long-term challenges. So while we believe that the US economy will continue to muddle along, we are in the midst of the third consecutive mid-year slowdown in economic growth and it may be hard to get a reacceleration until we have some answers to these longer-term issues.

But that doesn't mean that investors should sit on their hands; action is required here as well. Elevated uncertainty can cause paralysis, but we believe it's important for investors to keep their longer-term financial goals in mind and rebalance portfolios as necessary. Judging by mutual fund flows, individual investors are quite hesitant to add to equity exposure, while continuing to shovel money into bonds. In the near-term that can be appropriate—to hunker down and wait, especially considering our view that the near-term looks challenging. However, equities remain reasonably valued in a longer-run context. In addition to low valuations, investor sentiment remains depressed (a good contrarian signal), earnings remain healthy, and corporate balance sheets look great. Conversely, bonds held for capital appreciation purposes rather than income look much less attractive to us. Yields on Treasuries remain at or near record lows and sentiment continues to be elevated. History has shown that markets revert to the mean at some point, which would favor equities over bonds after a decade during which fixed income took the crown.

We think the ride for the markets will remain volatile until there is more clarity on both the eurozone crisis and the fiscal cliff. We continue to recommend that investors underweight European equities, and look to add to high-quality US equity positions as needed on the inevitable pullbacks. And, for those investors that want to make more tactical tweaks to their portfolio given the current environment, we would point you to the recent changes in sector recommendations in Schwab Sector Views.

Expansion continues but confidence waning

The last couple of labor reports have added to consternation regarding the US economy and the sustainability of the expansion. And, with the first quarter gross domestic product (GDP) report showing anemic growth of 1.9%, it appears clear that we're starting to run dangerously close to "stall speed"—where the possibility of returning to a recession increases. We believe we'll avoid such a scenario, but risks have risen. Without more certainty on the tax, regulatory, and health care front, it's difficult to see businesses wanting to aggressively invest or hire.

Confidence still tepid

Source: FactSet, Natl. Federation of Independent Business. As of June 12, 2012.

Several key leading indicators haven't deteriorated to the same degree as some of the labor data. Jobless claims, although ticking up lately, remain below 400,000, while both Institute of Supply Management (ISM) surveys showed positive signs. Both remain in territory depicting expansion, with the Manufacturing Index slipping to 53.5 from 54.8; but encouragingly new orders rose to 60.1—a 13-month high. The Non-Manufacturing Index ticked slightly higher to 53.7; but again, here the new orders index, which tends to be forward looking, rose to 55.5 from 53.5. And, helping support demand going forward, we've seen oil and gasoline prices pull back, which should help to bolster discretionary income. Finally, confidence should also be buoyed at least modestly by trends in housing and the strength in domestic energy production.

Fed ready to act, government needs to act

Housing continues to be a primary focus of the Fed, and Operation Twist has helped drive mortgage rates to all-time lows. They are also focused on the labor market, believing that unemployment at 8.2% is too high, while the recent soft labor reports likely increased the chances of another round of stimulus. If the Fed opts for more easing, we think it will more likely come via an extension of Operation Twist versus a third round of quantitative easing (QE3). However, Fed chairman Bernanke admitted in his recent testimony before Congress that further action may have "diminishing returns."

Cash remains plentiful

Source: FactSet, Federal Reserve. As of June 11, 2012.

The potential for much more impact, as Chairman Bernanke readily admits, would come from a fiscally responsible and sustainable budget agreement that addressed both the looming "fiscal cliff" and longer term deficit challenges. Tax reform, entitlement reform and broad spending cuts could go a long ways toward really uncoiling some springs in the US economy, but unfortunately seems unlikely to be realized in 2012. 

Europe needs to find union

But before we get to November, we can focus on elections across the pond. The fallout from the Greek election will be felt for some time. A potential Greek exit, detailed in two articles at www.schwab.com/oninternational, created market concerns about contagion spreading to Spain in particular.

Apparently, European policymakers shared the market concern, cobbling together a "bailout" for the Spanish banking system of up to 100 billion euros ($125 billion). While there are positives, the negatives seem to outweigh the positives. Among the concerns and questions:

• Loans typically come with conditions. What types of operational changes will be forced upon the banks? Who will supervise and enforce the conditions? Will insolvent banks be shut down and bad assets written down?
• The bailout only addresses one of Spain's problems. The economy is still contracting, the housing bubble continues to deflate, the fiscal deficit remains elevated and lack of control over local government budgets has not been addressed.
• Further credit ratings downgrades are likely for two reasons. The Spanish government is on the line to repay the loans, resulting in an immediate jump in Spain's debt-to-GDP level. Also, existing Spanish government bondholders could have junior status in the capital structure, as it appears the permanent bailout fund, the European Stability Mechanism (ESM) that begins in July, will be used and would be senior to existing holders.

If the aid comes from the ESM, it could scare investors away from Spanish government bonds. As a result, it only took hours for the market to shift from relief to concern, as the bank bailout may have accelerated the need for the Spanish sovereign to have a bailout of its own. This is a dangerous new phase of the crisis, as Spain's economy and debt are approximately four times larger than Greece. 

A broader Spanish bailout threatens the Union

Source: FactSet, Bloomberg. As of June 12, 2012.

If Spain needs a further bailout, the burden on the remaining non-bailout countries would increase. The credit default swap (CDS) chart illustrates that as the perception of a Spanish government default grows, the pressure on Germany also increases. At a 607 basis point spread, the CDS market is pricing in a 40% chance that Spain will default on its debt in the next five years.

Additionally, the link to Italy has not been severed, with Italian and Spanish government bond yields rising in near tandem. While Italy has stronger fundamentals than Spain by some measures, an elevated pubic debt level and unwillingness to change notoriously inflexible labor laws shackles growth. Fewer foreign investors at Italian bond auctions has resulted in increased reliance on Italian banks to buy government debt, a worrying trend that faced other peripheral countries in early crisis stages.

We believe we are accelerating toward the point where Europeans may need to make a bigger decision—either unite or break apart. Components of unity include both a banking and fiscal union. A banking union would likely need a European-wide deposit insurance program, common bank supervision and a way to resolve insolvent banks (a bank resolution mechanism). However, Germany is resisting a banking union without closer fiscal union. They seek a coordinated European approach to reforming labor markets, social security systems and tax policies, among other things.

In contrast to uniformity, protectionist measures are gaining traction. In addition to rolling back the retirement age to 60 from 62, the administration of France's new leader, Hollande, is slated to introduce legislation to increase the costs to fire workers and shift production to lower-cost locations. We typically try to find "what can go right" when sentiment is so negative, but find it difficult to imagine countries giving up sovereignty anytime soon.

As a result, the market remains vulnerable to swings in sentiment, a factor in our underweight bias toward Europe. The most resisted concept, joint euro bonds, is the solution that is likely needed to finally arrest the rollercoaster. We will be watching to see if Germany's Council of Economic Advisors proposal for a European Redemption Fund (ERF) garners acceptance as a first step toward joint debt.

Europe pressuring global growth

Economic growth in Europe has taken a hit from fiscal austerity, uncertainties about government bailouts and credit contraction. While competitive strength and ties to emerging markets have resulted in continued economic growth in Germany, the European Union (EU) comprises 58% of Germany's exports. As a result, recessions in many EU economies are weighing down even Germany.

Germany is not immune

Source: FactSet, German Federal Statistics Office, Eurostat. As of June 12, 2012.

We've remained concerned about the health of the European banking system and the impact on economic growth. Lending is likely to suffer more while banks continue to incur losses on both public and private sector debt, while also raising capital requirements and reducing leverage. Confidence in the banks could benefit from a deposit insurance program to stem capital flight, as well as recapitalization. We believe a longer-term banking union could result in substantial consolidation of the European banking system.

As a region, the eurozone's size is large enough to influence global growth. In particular, China's exports to the eurozone fell into negative territory on a yearly basis during March and April before rebounding to 3.4% growth in May. However, the focus on the importance of exports to the Chinese economy may be overstated. Gross exports are roughly 27% of China's GDP and the EU is 18% of exports, resulting in the EU having a 4.9% impact on China's economy. For comparison, the EU has a 2.0% impact on the US economy.

More important is investment spending, and here the Chinese government can influence growth. After a sharp fall, there are signs infrastructure spending is about to reaccelerate, which could partially offset the likely upcoming slowdown in property construction. Additionally, financial conditions have eased with better credit supply and an interest rate cut, and a stimulus program to incent the purchase of energy-saving home appliances and vehicles will likely add to future growth.

While emerging markets could be vulnerable during "risk-off" periods, we have a positive intermediate and long-term view. Within emerging markets, we like China because its stimulus programs are in an earlier stage than elsewhere, and because it has financial flexibility. Longer-term, market-based reforms could reduce the profits of state-owned companies that dominate the Chinese index.

Read more international research at www.schwab.com/oninternational.