The U.S. economy is moving slowly at a 2.5% growth rate, but doing better than other economies around the developed world. The U.S. has been able to produce this growth in a period when the fiscal stimulus is diminishing and we’ve seen a steep increase in taxes in the first part of 2013. The real positive news, as far as the U.S. economy is concerned, is that the real estate market continues to improve.

The macroeconomic framework has not really changed in recent weeks, but what has impressed me is the bull market in financial assets. Equities have been very strong, with the S&P 500 Index breaking very important technical levels. According to some technical analysts, the target for the S&P 500 over the next 3-4 years is well over 2,000. If this occurs, it would break the consolidation trend that has been plaguing the market for the last 12 years. Along with the equity market, we are experiencing a rally in the credit markets and very low interest rates. While all three are very important to monitor, we are keeping a close eye on the behavior of Central Banks. They are currently buying almost $200 billion a month in assets from the global markets.  At some point that money will end up in the hands of investors who will put it back into the market.

We believe the slowdown occurring in the U.S. may get worse with the rest of the global economies in Q2 before improving in the second half of the year.  However, for the time being, we continue to enjoy very positive liquidity conditions in the market. This liquidity situation is helping to improve the balance sheets of both retail investors and the Federal Government. However, at some point the current liquidity rally needs to transition into an earnings driven rally. We believe this may start to happen in the second part of the year or the beginning of 2014.

Ten years ago when the GDP growth was at 2%, corporate earnings were contracting and that was the reason for equity markets to fall. Today we are seeing a different scenario, with GDP growing at 2%, corporations are able to defend their earnings and their margins. Eventually,  we expect to see acceleration in the cycle here in the U.S. and globally, which we think will result in very significant upside. If corporate earnings are at these current levels in a weak economy, I can’t wait to see what happens when the wind is finally at their back.

My full commentary is available to read on Pioneer’s web site, but I wanted to summarize a few of the key questions and discussions here for you now.

1. Is the world a less stable place since the start of the crisis?

I believe that the world is less stable now than it has been in the previous four decades, and perhaps since the 1930s. The primary cause of this instability is DEBT. There is now considerably more debt in the developed world and the efforts to reduce it (the so-called deleveraging process) have negatively impacted growth and economic prospects for many countries.

Debt reduction can happen in a number of ways – growth, default or inflation – the trilemma for developed economies and investors. But the accumulation of public debt over the last 20-30 years is just a symptom of a more profound malaise – the rupture of the “intergenerational pact.” Developed countries have accumulated enormous liabilities at the expense of future generations and the problem is not just debt – the extraordinary high level of youth unemployment in most developed countries is another dangerous source of instability.

The liberal printing of money by major central banks to prevent a deeper recession during this financial crisis has expanded their balance sheets, admittedly averting a depression in the U.S. and has likely prevented the breakup of the Euro. However, one of the unintended consequences is asset price inflation around the world in bonds, equities, commodities, etc. and how this flood of liquidity has been distributed. The inequality can be seen at the country level and at the individual level with an increasing concentration of wealth in few hands.

Another major source of instability is Europe and whether or not the political glue keeping the Eurozone together will hold. We think there are reasons to be optimistic, but there will be bumps down the road. Although a lot of political capital has been spent in the Eurozone in the past few decades, there are still two major issues: European nations cannot achieve much progress on policy without acting together and we need to see progress on projects of future integration that were announced last year.

2. Why consider risky assets in these more uncertain market conditions?

We need to consider which asset classes may help us capture the opportunities this environment presents us with. Therefore, we need to consider the merits of investing in risky assets in general – and in emerging markets in particular – for three key reasons:

• A combination of bank intervention and blind buying by fearful investors has led to unprecedented low yields on so-called safe government bonds. It is our view that these investors will increase their allocation to riskier assets in order to earn higher returns, starting a trend which has been named “the great rotation.” Equity dividends are outstripping bond yields, especially in Europe and, as such, equities should be considered a structural source of investor income as well as potential capital appreciation.

• Cyclical components of the economy are improving, suggesting that the U.S. economy is expanding. China’s rapid expansion is slowing, but still leading global growth and the Euro region, despite the weak economic outlook, is on the right track for structural reforms.

• Emerging markets are still the best opportunity for a higher growth path although many are in a transitory phase, shifting toward lower growth. That’s why we believe that looking at the specific investment and economic initiatives of individual countries within emerging markets is as essential as adopting a bottom-up approach to identify the most compelling investment opportunities.

3. How can investors manage risk in this type of strategy?

Exposure to assets such as equities and emerging markets, with the aim of earning higher returns, inevitably means taking risks. We concentrate on adopting an active management approach to explore opportunities and combine them with a strong risk management discipline. Research is another important pillar of our investment process. The in-depth experience of our analyst team ensures that they have a strong grasp of the potential risks associated with an investment while they are searching for opportunities.

Finally, as the Chinese proverb says, “in every crisis there is opportunity.” The crisis and resulting instability are a situation that can be exploited by alert investors. Despite some of these existing conditions, I have no doubt that great opportunities lie ahead of us.

As someone smarter than me once observed, history never repeats itself, but it does rhyme. Oftentimes those rhymes, like my family’s dinner bills, are simply ‘head fakes’ – curious coincidences with no residual meaning. Other times, however, they do carry meaningful implications. Consider, for example, what’s going on in the markets right now.

Just last week the S&P 500 Index touched another new high, closing at 1598 on 4/30/13. Yet many argue that this is a ‘head fake’ and that the economy is not rebounding fast enough to support such ascension in the popular indices. Coincidentally, the lead article in a recent issue of Barron’s (4/29/13) is titled “Here Come the Millennials,” which refers to the bulge in population represented by 18 to 37 year olds. This group of younger adults, mostly the offspring of the Baby Boomers, is often referred to as the “echo boom”.

The reason I juxtapose these two concepts is this: Back in the early 80s, when the markets were fighting their way out of the grinding economic malaise of the 70s, many pundits were also discounting the new highs of the time as ‘head fakes’. At the time, the Baby Boomers ranged in age from 18-37. This large population grew up with an appetite for consumption (from toys, to schooling, to autos, to homes to financial instruments), and an ability to impact demand – and thus prices – of everything in their wake.

Some say Boomers are largely the impetus for the market’s movement (as represented by the Dow Jones Industrial Average) from just below 800 in 1981 to over 14000 some 20+ years later. There is still active debate, since they have reached a median age of 60, about the impact of Boomers on health care, retirement offerings and income distribution.

This “Rhyme” Has Some Reason
My point is that there is currently a “bar-bell” in the population of the United States. Just as the Boomers at one point were poised to start spending on technology, housing, autos and banking, the echo-boom “Millennials” are now ready to create their own wake of spending and development. The Boomers, meanwhile, are still active at the later stages of their own lives.

When thinking about recent market activity, I believe it’s best not to get caught up in the wave of negative messages or dismiss these trends as trivial. Better to take this rhyme in context, appreciate the broader landscape and consider the opportunities that may lie ahead on the longer runway that most of us face. As I’ve stated before, a multi-asset approach, which includes vehicles for growth and vehicles that generate, grow and sustain income along a spectrum risk may be the best way to prepare for the future. Better to put money in buckets … of near-term needs, medium-term wants and long-term desires … and then invest accordingly.

Underlying this trend are strengthening fundamentals such as a declining U.S. equity risk premium (the risk of investing in equities), the possible start of a U.S. dollar (USD) bull market, and expectations of tighter Fed monetary policy.

Inflation vs. Deflation Hedge

For decades, investors have viewed gold as an inflation hedge. Gold prices surged during the late 1970′s and again during the mid-2000′s in an environment of accelerating inflation in the U.S. Gold lost its luster as inflation retreated during the 1990′s (chart below). However, I believe gold became a deflation hedge after the Great Financial Crisis (GFC) of 2008 when markets worried about deflationary pressures brought on by government and household deleveraging. This contributed to a rising U.S. equity risk premium, declining real interest rates, and the U.S. dollar bear market all instrumental to the gold bull market. In addition, the emergence of gold ETF’s provided an investment vehicle (particularly for retail investors) into which to pour money into the shiny yellow commodity.

Factors Supporting the Gold Rally Appear to be Reversing

• Declining U.S. equity risk premia. Not only U.S. Treasuries but also gold have benefited from a flight to quality. A flood of global liquidity, a rebound in world economic growth and a reduction in tail risks have bolstered risk appetite. We believe this is leading to a rotation from safe-haven assets, such as fixed income and gold, into equity markets.

• Start of a USD bull market. Historically, there has been a negative correlation between gold and the U.S. dollar. The USD trade-weighted index, which measures the value of the dollar against other world currencies, bottomed in mid-2011 and has been trending gradually higher (chart below). We believe factors are emerging for a USD bull market rally as we discuss in our Pioneer Blue Paper The U.S. Dollar: Awaiting the Upcoming Bull Market.

• Expectations of tighter Fed policy and elimination of negative long-term rates. There is a tight relationship between real long-term interest rates and gold prices. As the Fed aggressively eased monetary policy, long-term real rates turned negative. The persistent downward trend in real rates increased the attractiveness of gold.

Gold began to roll over as the Fed began to debate the merits of QE and contemplated potential exit strategies. In recent minutes, debate has risen over the prospect of tapering purchases of fixed income securities later this year – a move the markets will rightly interpret as tightening policy. If the Fed exits QE, we would expect yields to climb much higher along with real long-term interest rates.

Size of Gold ETFs Could Highlight a Risk

Deutsche Bank Research believes one of gold’s distinctive characteristics is the high share of investor money and physical hoarding that occurs in the market. The emergence of gold ETFs led to a surge of retail buying. Inflows into Gold ETFs peaked in December 2012 and have begun to roll over. We would caution that if our view on gold materializes, we could see more liquidation occur.

According to BCA Research, the price for gold has averaged between $600-$800/oz since 1975 in today’s prices. Long-term calculations spanning 150 years of data arrive at a similar result. They conclude that at $1600/oz the level that prevailed early in April gold appeared to be severely overvalued. They make another compelling argument that at today’s price of $1425/oz, U.S. headline inflation would have to rise by 8% for a decade in order for gold to be fairly valued today.

The recent price action in gold has raised expectations of whether this is a short-term move or something more long term. We believe it is the latter. In fact, with potential for a rotation from fixed income into equities, a stronger USD, and expectations for tighter monetary policy, gold is likely to continue its weakening trend.

Treasury Yields Probably on Their Way Up

My last blog, Why U.S. Interest Rates Will Rise, reviewed how 10-year Treasury yields remain at historically low levels and don’t reflect current economic fundamentals. We believe rates will rise and numerous factors are helping support that case. But what about the sustainability of that trend?

In order to determine the future direction of long-term interest rates, we’ve looked at the following guideposts, taking to heart the Fed’s forward guidance:

• Employment: Weekly jobless claims have been consistently below 400k since Q4 2011 – a level that is in line with monthly nonfarm payroll gains of 160k/month or more. It’s what we have been averaging during the last 12 months. We believe if this trend continues and the employment-to-population ratio declines slightly, it would not be surprising to see the unemployment rate fall below 7% by Q4.

• Inflation: While there remains enough spare capacity in the economy to keep a lid on inflation, inflation expectations can be fairly arbitrary. Strong asset price performance like equity and house prices and better-than-expected economic growth could feed into inflation expectations.

Why this is Not 1994

The Fed tightened monetary policy in February 1994 that triggered one of the worst bear markets in recent history, and investor concerns are that this might occur again. While investors are becoming concerned of a repeat of 1994, especially the longer 10-year Treasuries remain at or below -2% real yields, there are 3 key factors why we do not see a repeat.

• Fed’s Forward Guidance – Unlike 1994, the Fed has emphasized more transparency and more communication, believing it makes monetary policy more effective.

• Key Stakeholders – The overwhelming majority of the U.S. Treasury market is held by non-market sensitive investors such as the Fed and global central banks. They are acutely aware that selling U.S. Treasuries could have broad consequences, including affecting their bottom line and overall foreign exchange reserve management. In December 1993, the Fed and foreign central banks owned 30% of the Treasury market, but that figure has now ballooned to 64% as of September 2012 (the following table). As long as the holdings by these key stakeholders remain large, this should help cushion any potential selling of Treasuries by market-sensitive investors.

• Regulation – The banking system came under immense pressure and scrutiny following the Great Financial Crises in 2008. Policymakers implemented regulation to de-lever the banking sector. Most of the regulations forced banks to hold higher quality assets, and that led to a growing share of their balance sheets in sovereign bonds. For many global banks, that led to Treasuries. According to a BiS survey (Bank for International Settlements), the Top 30 largest banks have increased their share of Treasuries as a % of overall exposure from 12% in 2008, to 19% in 2012. This regulatory environment is not likely to change for the foreseeable future.

But Beware of Duration Risk

If the economy continues to maintain its current recovery, and perhaps gain some momentum with unemployment maintaining its gradual descent, and inflation expectations remaining near 2%, we think 10-year yields can be expected to rise gradually over the next few years. Bloomberg consensus expects the 10-year yield to rise to 2.64% by Q2 2014 (see chart).

In a landmark speech on long-term rates, Fed Chairman Bernanke stated, “long-term interest rates are expected to rise gradually over the next few years, rising to around 3% at the end of 2014.” However, we do not expect a dramatic and destabilizing rise in long-term interest rates in 2013. As a result, we foresee continued strong performance in equities, high yield, and multi-sector bond funds.

While we don’t anticipate a bond bear market like 1994, we would caution investors to beware of duration risk. As we’ve described, we foresee the mis-evaluation of long-term interest rates and fundamentals are coming together to push yields higher. Interest rates do not have to back up much to create significant losses. My colleague Michael Temple will soon publish a piece with an examination of the exit strategy of the Fed and its potential impact on a broad range of fixed income strategies. In the piece, he will include a table and a description to show the danger of duration with this current economic backdrop.

• The European Central Bank’s stabilization programs have successfully reduced financial market and sovereign tail risk for banks.
• Global growth troughed in Q2 2012, but has been on an upward trend since.
• Market concerns over the U.S. debt situation are easing as the U.S. economy proved surprisingly resilient to many uncertainties.

As a result, investors are concerned that bond yields, which move inversely to prices, have bottomed for the U.S. 10-year Treasury and will surge, raising fears of a bond bear market along the lines of the Great Bond Bear Market of 1994.

Disconnect Between the 10-Year’s Current Yield and Fundamentals

We believe 10-year yields do not reflect current fundamentals and that the risk/reward ratio increasingly favors a gradual rising trend in yields. The key force behind a gradual pull higher in yields is the economy. Qualitatively, factors that drive long-term interest rate valuations include inflation expectations, growth expectations and the debt/fiscal outlook. Quantitatively, consider the results of a fairvalue model of the U.S. 10-year Treasury used by Citigroup’s fixed income research team, which covers fundamental variables in three key categories: growth, inflation and asset markets. Based on measurements of these, it projects the fair value for the 10-year U.S. Treasury yield to be 2.60%, compared to 1.99% currently (as of 3/15/13). Analyzing these key variables, it becomes clear that the 10-year yield is out of sync with current fundamentals. So let’s take a look at them.

Inflation Expectations and 10-year Yields

The Fed’s measure of inflation expectations the five-year forward breakeven inflation rate has been more or less stable between 2 and 3 percent since its inception in 1999. Following the Global Financial Crisis (GFC) beginning in 2007, there has been a convergence between inflation expectations and 10-year yields. Remarkably since 2012, 10-year yields have been trading “through” inflation expectations.

We think this condition is unsustainable. Investors will eventually demand higher yields to compensate for higher inflation expectations and not see the value of owning Treasuries. This risk could rise measurably the longer the Fed maintains its excessively easy monetary policy. 

Where Should 10-year Yields be Trading?

We sought to calculate a proxy measure of where 10-year yields should be trading in light of the current real GDP and inflation environment. Presently, both real GDP (GDP discounting inflation) and inflation (the Consumer Price Index, or CPI) are growing around 2% in the U.S., which would equate to 10-year yields intuitively yielding around 4% more than double current levels. 

Debt-to-GDP and 10-year Yields

There is a reasonably strong relationship between debt-to-GDP and 10-year yields. Since the mid-1990s, debt-to-GDP has been on a gradual rise while 10-year yields have moved in the other direction. Since the GFC, there has been a clear decoupling of these metrics. With debt-to-GDP skyrocketing from 36.3% in 2008 to 74.2% in 2013, and recent 10-year yields near their all-time lows, there appears to be little debt risk premia priced into the Treasury market. Yields have no place to go but up, unless you believe the status quo can persist. But the economy is growing, as I discuss below. 

The pressure on yields to rise comes from . . . the economy

Gathering momentum in the economy will put persistent pressure on 10-year yields to rise rather than decline. The Fed maintains a fairly cautious view of the U.S. economy. But we believe the economy is stronger than many believe.

During the last few years, there has been a good deal of uncertainty over the U.S. economic outlook, especially public consumption, as the government focuses on cutting expenditures to reduce the fiscal deficit. If we strip out government consumption, the U.S. economy has been growing at a relatively robust rate between 3.0-3.5% year-over-year – similar to the mid-2000s. 

Nonfarm payrolls have been averaging around 160k/month, not too far from previous peaks over the last 40 years. The housing market has been on a nice upswing with housing starts up 86% from the trough in 2009. The external environment is contributing to U.S. growth, with net exports rising 8 out of the last 9 quarters. A relatively weak USD and a pickup in global growth are the main factors boosting net exports.

Despite the Fed’s dour view of the U.S. economy, the markets will increasingly look past government consumption and focus more on the other sectors of the economy. We do not believe the recent softening in U.S. economic data is sustainable and expect yields to move higher on stronger macro-economic data. In my next blog, I’ll review the factors we believe are gathered behind sustainability for a rise in long-term rates.

• Inventories are rebuilding. If you recall, there was quite a bit of hesitation in business and other types of spending in the fourth quarter of 2012 due to fears of the fiscal cliff and year-end tax hikes. Inventories ran down, but consumer demand didn’t really wane, so companies fell a little bit behind and have now started filling orders.
• The housing recovery has continued and I think it’s going to end up being a bright spot this year.
• There’s probably been some modest capital spending as well. I think the only drag really will end up being government spending. I’ve seen some reports that suggest private GDP is well over 4% at this point, with the government holding things back a little bit. That’s not a bad place to be.

U.S. GDP Should Slow Somewhat in Q2
I think we’re going to see a bit of a slowdown in the second quarter, although it won’t be like last year, when there were rumors of a possible recession in the second quarter or the middle part of the year. I think we may see GDP of something like 2% or a little less, due in part to:

• Some of that inventory building in the first quarter has helped companies feel more caught up, but we’re not seeing much of an acceleration in consumer spending. Auto sales are holding pretty steady and housing may be getting better, but not very rapidly.
• In addition to the ongoing slow growth in China, we’re seeing a more marked slowdown in Europe.
• The sequester should start to have an impact on the economy, as the furloughs will begin and hours worked in the government will be diminished. That in turn will have an effect on spending ability.

In my view, all of this should keep interest rates where they are – in a tight range. We’ve been treading the low range in U.S. Treasury yields, with the high being a little bit over 2%, on the 10-year. I don’t think U.S. interest rates are going to matter that much to performance this year. Job growth should continue to be pretty slow, so we won’t see the Fed materially change its behavior any time too soon.

Central Banks Turning up the Heat
Speaking of central bank activity, probably the most material shift we’ve seen has been with the Bank of Japan, which announced about $75 billion a month or so of debt monetization, which is really quite substantial given their balance sheet. Their balance sheet is going to double over the coming year or so.

And that move has caused quite a shift in certain asset classes recently. Despite what I think was a well-broadcasted move, the markets were still surprised because the debt monetization was of a more dramatic size and scope than people anticipated. Obviously the yen is much weaker because of that, and the dramatic change in Japan’s liquidity will only, in my mind, exacerbate volatility in the markets as well as make the search for yield on the part of investors even more challenging.

I would also note that the Bank of England has been at the forefront of the monetization, at a steady pace, but they may be changing as well. The only laggard has been the ECB – arguably the one who should be easing the most at this point. But even they are now stepping up, I think, for a little bit easier behavior than they’ve had in the recent month or two.

So I think the situation we’ve been in with the central banks, the U.S. stoking the flames, if you will, has just gotten more intense. The heat’s going to get hotter and I think it’s going to be more of the same, frankly, until no one can bear the yields.

The recent, seemingly terminal decline in interest rates has been difficult on many investors who have been planning their income needs for the future. Interestingly enough, a wise presenter at a meeting I attended in January* addressed this very point with a ‘wow’ factor of quite a different nature.

He began with a look back to July of 2005. If you were trying to derive $100,000 in income from a fairly low-risk investment – let’s say 2-year U.S. Treasuries – you would have needed to invest around $2.5 million to achieve your goal. By contrast, to achieve the same $100,000 in income in July of 2012, you would have had to invest some $45 million in 2-year U.S. Treasuries. Wow! While that kind of money may not be an issue for a $150 million Powerball winner, it certainly would be a problem for the ordinary Joe (pun intended).

A Wider Net May Make a Difference
As I’ve mentioned, perhaps ad nausea, investing is about exchanging current capital today, while accepting some level of risk in in the hope for greater returns on said capital in the future. The ideal is to build a portfolio allocated among diverse investments with the potential to both weather market volatility and generate income. While you would have needed to invest $45 million in 2-year Treasuries in July of 2012, today you may consider opting for other asset classes (see below) to pursue the same $100,000 at a more reasonable cost.

How Much Money Is Needed to Generate $100k in Yield?

Based on current yields for each asset class as of 3/31/13

Data represents past performance, which is no guarantee of future results. Source: Morningstar, Barclays, Bloomberg, Merrill Lynch. The 2-year Treasury is represented by the 2-year Treasury Rate. U.S Stocks are represented by the S&P 500 Index. Dividend Paying Stocks are represented by S&P 500 Dividend Aristocrat Index. Investment Grade Corporates are represented by BofA ML US Corporate Master Index. REITs are represented by MSCI US REIT Index. Emerging Market Debt (Sovereign) is represented by Barclays Emerging Market Local Currency Government Index. High Yield is represented by BofA Merrill Lynch US High Yield Master II Index. Indices are unmanaged and their returns assume reinvestment of dividends. It is not possible to invest directly in an index.

Looking Beyond “Safety” for Stronger Income Potential

The point of the above is that there are many ways to derive income. As you’ve heard me say before, the goal of investing is not only to generate income today, but for the future – to potentially grow this income and aim to sustain it over time. There are no guarantees in investing, of course – but there is hope. Either you can hope to win Powerball, or you can work intelligently, perhaps with a financial advisor, with the hope of building a diversified portfolio with the potential to weather the market’s – and life’s – little challenges (such as the disappointment of not winning Powerball in the first place).

*Thank you Burt White of LPL Financial.
Pioneer Investments is not affiliated with LPL Financial.

The bottom line is that European monetary authorities have decided to take Cyprus depositors to the woodshed. In the recent history of bank restructurings, all depositors have been sacrosanct while equity holders and some subordinated holders have received “haircuts.” This time around, European monetary authorities have decided to give almost every stakeholder in Cyprus’s financial system a taste of the harsh medicine.

This sent shudders throughout European risk asset markets and spilled over into other geographies, with the U.S. maintaining the most stability, as investors pondered whether we had entered a new paradigm of harsher treatment for financial stakeholders in Europe. For U.S. investors, the latest chapter in the European saga has had minimal impact as the Fed’s “monetary accommodation spigot” remains full-on.

Greater Liquidity in the U.S. Market
The ‘insurance’ that was taken out by the Fed late last year, in the form of QE3, is pumping about $85 billion of liquidity into the market on a monthly basis. So far, this obscures any monetary consequence from Cyprus. The U.S. Treasury has been enjoying a strong bid as a result of this and, given the uncertainty generated by Cyprus, may ironically be considered by global investors as a “safe haven,” despite the generally more upbeat economic data in the U.S. and greater resiliency of our domestic stock markets.

Meanwhile, the European Central Bank (ECB) has been passively draining liquidity from their marketplace as European financial institutions have been paying back funds from the Long-term Refinancing Operation, or LTRO (taken out last year). This, in combination with poorer than expected economic data (in part, we believe, a consequence of the less accomodative monetary environment), has led to increased European financial market volatility, a worsening of some financial indicators (such as Euro swap spreads and peripheral spreads) and a general “risk-off” tone to European markets.

The question on everyone’s mind now is: Can the U.S. equity and other risk market assets – and even the underlying economy – continue to do well as economic activity in Europe is anemic at best and may be on a path of continued deterioration?

My answer is: It depends. It depends on how much worse Europe gets and how long it takes the ECB to draw a line in the sand. It is clear to us that there is a potential for yet another “spring-summer” swoon if investors get spooked by the combination of European economic malaise, stalled policy response (what ever happened to the so-called banking union?), and some re-appearance of some “known unknowns” (North Korea anyone?). However, we don’t think it will happen this year.

We believe that, given where we are in the process of finally casting off the things that have weighed us down since the Great Financial Crisis of 2008 — the deleveraging consumer, hobbled banking system and dysfunctional political system (well, two out of three ain’t bad…) — the building momentum of the housing recovery and the re-surging investment in manufacturing and energy will allow the U.S. to finally reach the point of “economic escape velocity” from the quicksand that has been Europe over the past few years.

So, as we sit here today, recognizing that the path won’t always be straight upwards for risk markets in the U.S., we remain comfortable with our call that domestic risk assets and the dollar will perform well this year and may be one of the “safer havens” in 2013.

Why did Cyprus’s financial crisis spur the European Union into action?
There are a couple of reasons worth mentioning. The first is that these smaller countries have developed, at times, a banking industry whose assets under management outgrow GDP by several times: the ratio is above 7-to-1 for Cyprus. The second reason for watching Cyprus’s liquidity crisis closely is that it may provide the first severe test of the European Union’s (EU) ability to deal with the EMU debt crisis after the European Central Bank (ECB) pledged to save the euro from collapse.

What is the rationale behind the controversial levy on bank deposits?
Unlike previous cases, depositors in Cyprus’s banks are set to share the burden of this rescue. The earlier proposal, later rejected by Cyprus’s Parliament, called for deposits above the threshold of €100,000 to pay a hefty 9.9% one-time levy. This provision took aim at foreign depositors whose rescue would not have met the approval of EU and German taxpayers.

Even more incensed were local depositors holding money below the quoted threshold of €100,000. According to the plan, they would have received equity in the banks in exchange for a 6.5% bank levy and this burden looked excessive. Some argued that the Cypriot government wanted to spread the pain rather than hit only non-resident depositors and undermine its ambitions as an offshore tax haven for rich foreigners.

Is this the reason why Cyprus’s Parliament voted against the bailout?
I believe the Parliament rejected the first bailout package as unfair. Lawmakers could accept that Cypriot residents should not be exempt from burden-sharing, but opposed a plan that left senior bank bondholders untouched, while common people are being squeezed. They might have welcomed a “haircut” for investors who allegedly bought Cypriot government bonds at distressed prices and stand to gain handsomely when maturity comes (the first such tranche is scheduled for redemption in a few weeks’ time).

What is your assessment?
The main flaw in the plan is that it is barely consistent with the EU’s efforts to protect banks’ balance sheets from external shocks. Lenders drawing funds from retail depositors were said to be less at risk of a liquidity crunch compared to those raising money from wholesale inter-bank markets (which ground to a halt in the recession). It is hard for people to hold money in the bank if they feel their savings are less secure there than under the mattress.

So, is there any risk of a new contagion?
The euro crisis has been less frightening since last summer, amid the efforts of the European Central Bank to quell concerns about an EMU break-up. Political leaders have had plenty of time to follow up on the improved climate and solve the crisis on a structural basis, but that does not mean that any failed attempt to do so will spark a new crisis. The global economy is looking much healthier than at the height of the euro crisis and the amount of long-term emergency funds to the banking sector is declining. In this backdrop, the EU can afford to work on an alternative plan to sort out Cyprus’s specific problems.

What are the main features of the new deal?

The plan singled out the two main Cypriot banks, as if the banking sectors could be separated from the whole economy. This does not look feasible for a country whose bank assets are above seven times GDP. The second-largest (and least-solvent) will be stripped of its bad assets and eventually be folded into the biggest one, but not before being strengthened by a capital infusion funded by depositors above the €100,000 ceiling and, crucially, bondholders.  The new plan addresses the solvency issues of specific banks and did not touch on deposits below the conventional €100,000 ceiling. As a result it should not need parliamentary approval.

Where does the European Central Bank stand in this latest crisis?
It has talked tough on this issue and we believe the threat to freeze emergency funds to hardly-solvent Cypriot banks helped bring forth a new package. Some questioned the ECB’s tough stance, as if its pledge to save the euro by any means necessary was not dependent on political leaders’ firm commitment to solve the main issues. The German Executive Board said that the ECB could provide emergency liquidity to solvent banks, suggesting that Cyprus’s stricken lenders were barely in this group.

This latest crisis may provide an early opportunity for the ECB to increase its clout. The case for a selective bail-out of creditors (notably depositors) on bank resolutions was made by ECB board members since last year and the new deal of Cyprus meets that principle.