-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

Earlier this week the S&P 500 was down 15 percent from its April 2010 high.   The ongoing debate on whether the U.S. economy is poised for a double dip recession can be linked with these falls.

At present there is insufficient evidence to conclude that the U.S. economy will fall back into recession, though there are signs that the recovery could be losing momentum.  A key question is whether the adjustment in asset prices seen since the end of April has been appropriate.

Proponents of double-dip imply that asset prices may have further to fall.  In contrast, die hard bulls suggest that equity valuations are looking cheap.  In the past few sessions, the bulls have been gaining the upper hand.

The reining in of government fiscal incentives and in many cases the implementation of austerity measures suggests that economic growth in most of the developed world will be constrained for the next few years.

The release a month ago of the much worse than expected May U.S. Labour report was followed by a bout of poor U.S. housing and confidence data  that had the effect of triggering a wide scale debate about the prospects for double dip recession in the U.S.

The guts of the June U.S. employment report did little to dissuade this speculation.  Average hours worked in June fell and 652,000 people gave up looking for work; during the early stages of an economic recovery the labour market usually expands.

That said the data were not bad enough to suggest that double dip is a done deal.  Private sector payrolls managed to expand by 83,000.  While this was less than expected an expansion in private sector payrolls tends to be a precursor to economic expansion.

Picture Credit: A person enters at a jobs center in San Francisco, California February 4, 2010. REUTERS/Robert Galbraith

The recovery in euro/dollar between June 7 and June 21 coincided with an improvement in the tone in equity markets. While both of these events have helped to massage investor confidence, Libor has remained elevated compared with its levels at the turn of the year and the cost of insuring bank debt has remained extremely high.

Suspicion and uncertainty about the level of bad debt in the banking sector, specifically in Europe, refuses to go away. In order to head off concerns about non-performing loans, the Bank of Spain recently agreed to publish the results of stress tests on its banks; a move which forced the ECB into promising that the stress tests on 26 of the Eurozone’s banks would be published.  Greater transparency had been demanded by the markets and is widely welcomed by investors. That said there is an obvious caveat to the publication of stress tests insofar as it does not guarantee that the news will be all good. The coming months could be a testing time for the European banking sector.

The President of the Banque de France, Christian Noyer, recently warned that some banks (in Europe) were already having difficulties raising capital. This was followed by reports suggesting that some banks in Greece, Ireland, Portugal and Spain were particularly reliant on the ECB for funding. Faced with the expiration at the end of June of the ECB’s 442 billion euros, 12 month loan, nervousness may soon rise some more.

To make matters worse, the Bank of England is claiming that if UK banks do not quickly raise 750-800 billion pounds in order to refinance their borrowings, the economic recovery may be at risk. Despite reports that the Spanish property  market may yet see prices fall by another 30 percent and related concerns about non-performing mortgage debt, the Spanish government has recently issued reassurances on the health of its banks.

The Irish regulator is expected to have completed stress tests on Ireland’s three nationalised banks by September; the Irish taxpayer having already paid a heavy price to avoid bank collapse. Given that sovereign balance sheets in general can ill afford to further support the banks, investors are likely to stay wary. It will be a brave investor that chooses to take on an aggressive long euro position in this environment.

What began at the start of the year with an acknowledgement from Greece that it had been living way beyond its means soon turned into a more universal re-appraisal of the risks of sovereign default.

After Greece, the bond markets of Spain and Portugal were next to be re-examined.  More recently even the yields spreads of French and Dutch bonds vs German Bunds widened. Investors have shown themselves less inclined to finance the debt of countries which are not prepared to exercise budgetary prudence and governments have been forced to sit up and listen.

The rhetoric of this month’s G-20 meeting made clear that expansionary fiscal policies are off the agenda and that fiscal consolidation has become the new watchword of the majority of G-20 governments. Fiscal austerity clearly has an impact on growth potential and consequently on the market’s attitude towards risky assets.

The program of fiscal consolidation in the UK has just been launched.

Now safely in office the new coalition has been quick to let voters know the awful truth that deep public sector spending cuts are inevitable and will be “felt for decades”.

The UK’s budget deficit/GDP ratio may the worst in the G7, but it is by no means the only sizable industrialised country that has budgetary woes.  Market forecasts suggest the U.S. deficit could be 9 percent of GDP this year, but at least it is likely to perform better in terms of growth.

The Federal Reserve last month revised higher its 2010 growth forecast for the U.S. to 3.2-3.7 percent, the Bloomberg survey indicates a market consensus for U.S. 2010 growth at 3.2 percent compared with 1.1 percent for the Eurozone in 2010 and 1.2 percent for the UK.

The U.S. fiscal repair process may not be fully implemented until next year, but fiscal consolidation in the Eurozone is thematic not just in the periphery but also in many of the core countries.

The process of fiscal repair will weigh on growth in the coming years.  Since the end of April it has been clear that markets have been taking on board the prospects of a prolonged period of relatively slow growth in the industrialised world.

The optimism that fuelled rallies in stocks and other risk assets through the better part of last year came to an abrupt halt in April.  The recovery in growth noted in most developed countries from the middle of 2009 was built around huge fiscal outlays.

The time has come for governments to repair their balance sheets; as Bank of England Governor Mervyn King recently noted the financial crisis is only half way through.

There is a clear logic behind the recent correction lower in stocks and other risk assets.  The obvious question to ask now is whether this correction has further to go or whether it is drawing to a close.

Many of the answers will be found in economic data.  Despite reassurances from Federal Reserve President Bernanke that the (U.S.) economic recovery remains intact, the market will be sceptical about the ability of U.S. growth to accelerate until labour data show a significant improvement.

The impact of May’s disappointing U.S. payrolls number will be difficult to shake off. That said German, Chinese and Japanese economic data recently have been strong suggesting the global recovery is firmly in place.

Clearly, the market has had to adjust lower its exuberant expectations of growth to more moderate levels but it currently seems likely that most countries will avoid double-dip recession and stay on the recovery track.  This suggests that most risk assets should avoid a further sharp collapse from current levels.

The better tone in stock indices and oil prices that has appeared this week begs the question as to whether the bout of re-pricing is complete.

The correction lower was arguably necessary to allow for the fact that the fiscal repair process which has started in parts of the Eurozone and will soon spread to the UK and then to the US next year will cap growth prospects for the industrialised world.

The likelihood that most countries in the industrialised world will see growth in the region of 1 percent and 3 percent this year did not sit comfortably with the exuberance of the recent rallies in assets such as oil and stocks.

The rally in the WTI oil contract took it from $33.98 /b in February last year to a high of $86.84 /b in April 2010.  While a re-pricing was probably unavoidable, it must be said that the economic news, particularly in the US, is not too bad.  Recent US economic data has been sufficiently robust to allow some forecasters to draw the conclusion that the US recovery is now self-sustaining.

The Federal Reserve recently increased its growth forecast for this year to 3.45 percent.  Stronger growth should undermine fears of contagion from the Eurozone debt crisis and will likely allow for a relaxation in some of the market’s indicators of risk and bring further bargain hunters into stock markets and into oil.

This may bring a little support into the near-term outlook for commodities.  That said the reprieve from bad news on the European debt crisis may be short-lived.  On top of that, it is likely that a strong USD will continue to weigh on the prices of dollar denominated commodities.

The relatively better US economic outlook will likely help strengthen the dollar’s relative position in the second half of this year particularly given the fact that in Europe there is still the risk that further bad news will emerge.

Fears that the European banking sector is sitting on bad debts will likely be sufficient for the market to remain nervous and for the euro to remain under pressure medium-term.

The recent failure of the small Spanish savings bank Cajasur has drawn attention to the fact that the Spanish property crash may yet bring bigger causalities.  News from the Spanish regulator that it has tightened its rules for banks’ provisions against bad loans will help shore up confidence in Spain’s banking sector over the longer-term.

However, in the near term is may bring forward the shake out of the banks most heavily exposed to the Spain’s crumbling property market; suggesting more bad news is possible over the next couple of months.

On top of the risk that Greek debt may yet have to be re-structured, this is of particular concern.  Outstanding Greek debt is in the order of USD350 bln; to put this in perspective, the Russian debt default in 1998 was in the region of USD73 bln.

Pending economic data will help determine whether the stock market has seen a bottom or just a temporary base but with safe haven flows potentially further emphasising the strength of the USD, the near-term recovery in oil may prove shallow.  Potential remains for oil to fall back to $60 /b in the mths ahead.

It is generally agreed that if EU officials are to reinforce their commitment to the euro then the Eurozone’s fiscal Stability Pact will have to be strengthened.

The Greek crisis clearly illustrates why the maintenance of fiscal prudence is a prerequisite to a smooth running monetary union.

EU officials are no doubt currently chewing over a number of proposals as to how the Stability Pact may be tightened.

This, however, is another case of locking the stable door long after the horse has bolted.  To make up for the lack of budgetary prudence exercised by some EMU members in recent years, others are now being required to guarantee their debt.  This may work in a federal system but in Europe it is running up against that critical issue of sovereignty.

Germany is faced with having to contribute a whopping EUR123 bln to the EU/IMF EUR750 bln European Monetary Fund.   German tabloids have not held back from venting their dismay.

The results of the May 9 regional election in North Rhine Westphalia also captured the doubts of many Germans towards what has been termed by the press as a ‘transfer fund’.

Granted the Greek PM is still promising to pay back the loans; but clearly scepticism on this point is widespread.   Many Germans blame their government’s announcement that previously promised tax cuts will not be forthcoming with the fact that money will now be sent to help Greece.

The lack of desire in Germany to bail out Greece sums up the fact that the Eurozone is very much a cluster of sovereign states.  The Monetary Union that was accepted by Eurozone member countries brought promises of monetary stability but breathed nothing about fiscal union.

Eleven years into EMU most Eurozone members still have no wish to give up their autonomy over fiscal policy and step closer to federalism.  This factor may mean that the EU will eventually have to recognise that the Greece will have to be allowed to default on its debt and potentially be allowed to exit EMU for the greater good of the system.

This would means heavy losses for some investors but it would remove a lot of uncertainty from the market.  For the first time this week an EU official hinted that a process for debt restructuring should be built into the EMU framework; Chancellor Merkel suggested that “orderly insolvencies of states will have to be studied”.

She also indicated that Germany would not be prepared to keep on funding less prudent EU nations. The sharp fall in this month release of Germany’s ZEW survey (to 45.8 in May from 53.0 in April) is a reminder that the uncertainties surrounding the fiscal crisis is having a detrimental impact on investor confidence.

If the doubts as to the future stability of the Eurozone continue they will almost inevitably have a detrimental impact on growth of the economy of the Eurozone and possibly beyond.

This supports the view that EU ministers should act quickly to restructure Greek debt.  For now selling pressure on the euro can still be considered relatively orderly.  What could force the EU to take action would be an increase of disorderly conduct in the movements of the euro.

If a gauge is needed to measure how concerned investors are at about sovereign default risk, we need look no further than the price of gold which has made fresh all time highs this week.

Assets with intrinsic value are in demand.

U.S. Treasury debt has also fared well on the back of safe haven buying over recent weeks; it is possible that the dollar could be entering into a renewed period of broad based strength as a consequence of risk aversion.

However, the solid demand for U.S. debt has not prevented the US authorities being wary about the risk of contagion from the European fiscal crisis;  after all the US budget deficit may hit 11 percent of GDP this year which is not too far behind that of Greece (at 13.6 percent).

President of the Federal Reserve Bank of St Louise James Bullard warned this month that Greece’s sovereign debt crisis was spreading and posing risks to the US economic outlook.

Clearly the Greek crisis has shaken both investors and governments across the board.

The EU’s huge EUR750 bln support package was designed to overwhelm the risk of default within the EMU.

That said there is still the possibility that Greece could be driven to debt restructuring of some kind eventually.  EUR440 bln of the EU’s package will have to be drawn from the Eurozone’s sovereign states and in Germany there appears to be significant popular resistance to the notion of huge fiscal transfers.

If Germany refuses to continue bank rolling the EMU support fund and if Greece cannot stomach the internal devaluation that would bring its competitiveness in line with Germany’s then default in the Eurozone’s periphery may yet happen.

In general, however, risk of sovereign default remains low, but it is higher than it has been for some years.

Bank of England Governor Mervyn King remarked this month that the financial crisis is still only halfway through.  The huge fiscal deficits presently carried by many governments were created as a consequence of the financial crisis.

The next phase will be the repair of sovereigns’ financial positions.  The Greek economic crisis has driven home the costs of delaying fiscal prudence and has injected a new urgency into the need for budget reform.

Looking ahead, the reigning in of government budgets will weigh on economic growth potential and worsen the trading environment for the corporate sector.

The rest of the year may thus be characterised by a continuation of the paring back of risky positions in the market which will support the US dollar and could make the going tough for assets such as equities and oil.

The Greek fiscal crisis has forced investors to weigh up the risks of sovereign default very carefully.

Funds have moved out of peripheral European bond markets and into U.S. treasuries, JGBs and even (prior to the election result) the UK gilts market. The crisis has also forced investors to reign in their overall appetite for risk.

This is clearly evident across asset classes. Even before the dive in U.S. stock markets on Thursday, the majority of European stock market indices and a large portion of Asian had already given up their gains for the year and oil prices had moved well below their recent highs.

In the FX market safe haven demand tends to boost both the dollar and the Japanese yen.  Currently the dollar’s gains are, unsurprisingly, most marked vs the Euro.  The massive demand for the Japanese yen on the back of the rout on U.S. stocks is reminiscent of previous crisis.

Unless the mood improves noticeably in the next few weeks, risk aversion amongst investors could be sufficient to undermine the pace of the global economic recovery.  Some of the impact of last year’s simulative government and central bank policies could in effect be negated.

U.S. fundamentals are far from perfect. The recent correction lower in the U.S. savings rate suggests that the U.S. will continue to carry a huge current account deficit in the foreseeable future. The budget deficit, which could be above 11 percent of GDP this year, is also potentially a huge problem.

Fiscal repair is unlikely to take a strong hold in the US until next year, but when it does this could be a significant restraint on growth potential.

That said, the crisis in the Eurozone reflects kindly on the U.S.  The U.S. has its share of fiscal issues but the fact that the U.S. operates as a federal system and not as a cluster of sovereigns with no real fiscal controls means that policy responses are far clearer cut.

The EMU is yet to prove whether it is possible to run a monetary union without close fiscal ties.  The current crisis in Greece could yet end with a Greece default.

It could also undermine the integrity and even the sustainability of EMU.  The U.S., unlike some countries within the EMU periphery, has no meaningful history of default.

For the time being, the crisis in the Eurozone is likely to put an end to all speculation that global central banks will diversify away from dollars in favour of the Euro.

Given that Japan’s huge debt, aging population and declining savings ratio implies a huge fiscal problem for the next generation, the yen is no real contender for reserve currency.

In balance, U.S. treasury debt is likely to remain favoured markets assets and this suggests that a period of broad-based dollar strength could be approaching.

Next month’s UK general election is not the only one of significance in Europe. There is the possibility that the German regional elections in North Rhine-Westphalia on May 9 could result in the end of the CDU/FDP government’s majority in the upper house of parliament.

While this would not alter Angela Merkel’s status as Chancellor, lessened support would make it more difficult for her to implement planned tax cuts and health services reforms. Fear that she may lose support in NRW is currently delaying the transfer of a German loan to Greece. In turn this means the markets are bracing themselves for a possible default in Greece; an event which could change the present composition of the Economic and Monetary Union of the European Union.

German popular opinion is firmly set against the notion of providing loans to Greece; although Germany as the largest EU economy is obliged to lend around 8.4 billion euros to Greece very soon to help the latter avoid default. While the election in NRW will not be fought on the subject of Greece it does give an added edge to concerns about lack of fiscal manoeuvrability in the region.

NRW has had to issue a record 27 billion euros this year. Over the past 10 years or so the amount of debt per capita has soared. This increase in debt and the possibility that the level of local services will have to be cut to meet fiscal consolidation targets does not sit happily with the notion that German taxpayers may have to make funds available to Greece.

Andreas Pinkwart, the Deputy Leader of the government’s junior coalition partner the FDP has described the prospect of a German loan to Greece as a “slap in the face of German employees”. It is unlikely that sentiment within the cash strapped economies of Spain, Ireland and Portugal has warmed to the topic of a bailout for Greece either.

Germany’s unwillingness to put its hands in its pockets to prevent a Greece default opens EMU to yet further criticism that it is a deeply flawed system. It has been clear for some time that the Stability Pact provides inadequate fiscal controls but if German pockets prove to have limited depth, then the ability of EMU to muddle its way through this crisis is significantly lessened.

To meet its May funding requirement, Greece needs to borrow around 10 billion euros from somewhere. The IMF will probably make the funds available even if Germany delays. However, Greece’s funding problems will not end until it can prove it can live within its means. Even if Germany lends money soon, more demands from Greece or from another peripheral country could follow.

At the heart of the imbalances within EMU is that many countries need to make huge leaps in competitiveness in order to keep pace with Germany. Without the ability to devalue their currencies workers will have to see the relative level of their wages drop instead. The alternative is that Germany stimulates domestic demand to absorb the exports of its EMU neighbours.

Returning to NRW, however, there is little appetite for additional spending. If relative wage cuts prove too big for Greece to tolerate (and for other EMU countries struggling under large deficits) and if Germany has no appetite either to boost its domestic demand or send bailout payments, then EMU could be approaching a stalemate situation. Devaluation (exiting EMU) or default starting with Greece remains a possibility. The alternative is that Germany could remove itself from the system; a move which would almost certainly result in the collapse of EMU.

Over the past week the British electorate has taken a shine to Liberal Democrat leader Nick Clegg.

Based on just one television appearance the popularity of the leader of the UK’s third main political party has surged to such a degree that the press could not resist the opportunity to draw comparisons with the support attained by orator, statesman and former Prime Minister Winston Churchill.

Clegg’s rise from the political sidelines, while remarkable, does pose at least one problem.  Its speed suggests that the electorate may like the man, but is probably not too familiar with the policies of the Liberal Democrat party.

Among other things, the LibDems are committed to taking the UK into European and Monetary Union.

Not surprising, given the economic crisis in Greece, the party manifesto concedes the current time is not right for such a move.

That said, the party pledge remains that it is in Britain’s long-term interest to be part of the euro.  The UK currently runs a budget deficit/GDP ratio of similar proportions to that of Greece.

The UK economy is not directly comparable with that of Greece in many aspects.  That said, it is unavoidable that the UK, like Greece, will have to swallow a difficult period of austerity if it is to return its budget position to relative health over the next few years.

A shrinking of the public sector, wage freezes and cuts in public spending appear inevitable in both countries and this will be a drag on growth.

The UK, however, has a joker up its sleeve.  Aided by the 20 percent fall in the value of the pound vs the dollar and the euro since late 2007 the UK has seen a boost to its competitive which should soften the impact of this austerity on the economy and allow for a continued, albeit moderate, pace of recovery through 2010.

Faced with a continuation of recessionary conditions this year and a strong and fixed exchange rate Greece will find it difficult, and potentially impossible, to digest all of its prescribed austerity this year.

The issues currently facing Greece have made it widely apparent that EMU is still a nascent and flawed system.  The UK electorate have always been sceptical of a potential entry of the UK into EMU.

The current crisis in Greece vindicates that scepticism and is therefore inconsistent with the sudden rise in popularly of the Lib Dems.  Given the apparent disparity between British votes and the LibDems on the subject of Europe and also potentially on immigration, it could be that Clegg’s glory will fade fast.

Whether the financial markets will view the outcome of the UK general election as a positive or negative depends almost entirely on one issue: the budget deficit.

According to The Economist, the UK’s budget deficit will balloon to 13.5 percent of GDP in 2010. To give this some perspective, The Economist estimates that the Greek deficit will be a somewhat more moderate 9.5 percent of GDP this year.

Fuelled by recession, last year’s UK government borrowing was the largest ever in peace time.  The deterioration in the budget caused S&P to warn last May that the UK’s debt rating outlook has been revised to negative from stable.

The prospect of a sovereign downgrade would seriously increase the likelihood the UK would suffer a funding crisis.

In other words a lower debt rating would reduce investor interest in UK debt auctions and send yields higher and demand for sterling lower.  In turn higher yields would increase the cost of issuing bonds and divert more taxpayer money into servicing the debt and away from public services.

While there is probably no imminent risk of a credit rating downgrade in the UK, it is clear that budget reform is necessary to kick this threat into touch.

All political parties are aware of the need to rein in the deficit but the Labour party has taken the stance that tackling the budget deficit must be delayed to avert the risk that too much austerity too soon could tip the economy back into recession.  This has made the Conservative opposition the more market friendly political party.

The huge proportions of the UK budget deficit mean that the focus on spending cuts and taxes rises is more pronounced that usual in the build up to this year’s general election.  The combination of deficit worries and slow growth have been instrumental in driving sterling lower by 22% vs the USD and 22% vs the EUR since the end of 2007.

Bearing in mind that there is so much bad news already in the price and the market is positioned very short of sterling, there is the possibility that investors would cover these positions if the outlook for the budget deficit improves.

The first potential positive trigger for the pound would be if the Tory party were to win a outright majority on May 6.  While opinion polls continue to suggest this may be difficult for the Conservative party, interestingly the bookies odds point to a greater possibility of this outcome.

The other support for sterling would be better than expected economic growth which would increase the tax income into the treasury’s coffers and reduce the borrowing requirement.

While it is likely that growth will be fairly lacklustre this year, the outlook on the economy has been improving.  Purchasing manager’s surveys continue to indicate economic expansion, the housing market is maintaining a modest (if erratic) recovery and both February production and export data were better than expected.

The combination of improving growth coupled with a Tory election victory has the potential to push sterling sharply higher and strengthen the possibility that that sterling may have already seen its lows for the year vs both the dollar and the euro.