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It's Europe, stupid (cont.)

This chart goes a long way to explaining the source of stock market angst in the past several months. The red line is the total return on the S&P 500 index, the green line the total return on the Euro Stoxx index, and the white line the total return on Bloomberg's Euro Banks and Financial Services index. Bottom line, Eurozone banks are getting crushed by fears that their holdings of PIIGS debt will wipe them out should a Greek restructuring prove contagious, and those fears are spreading to all markets around the world. By comparison, the U.S. is holding up far better than most.

Swap spreads confirm that there has been no material deterioration in the health of the U.S. banking system or financial markets, with spreads still at levels that reflect no unusual degree of systemic or counterparty risk. The problems are concentrated in Europe, where counterparty and systemic risk remain quite elevated.

So there are two key and related questions: Will a Greek default/restructuring bring down the Eurozone banking system? Will a collapse of the Eurozone banking system, bring down the U.S. and/or the global economy? Nobody has an answer to those questions, but to judge from market behavior, investors are becoming extremely concerned that a worst case scenario is in the offing.

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