Asset Management

Stocks decline, Treasuries shine as European fears intensify

William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets

With Greek government in limbo, uncertainty rules

The failure of Greek political parties to forge a governing coalition in the wake of recent national elections means that a second election will be held on June 17. A strong showing by anti-austerity parties in the first round of voting increases the likelihood that such a party could come into power next month, although the highly divisive political environment makes it difficult to predict the election results.

The probability that Greece will leave the European Union (EU) varies, with many putting the odds at higher than 50%. We continue to believe that the likelihood of an exit remains lower than that. In our view, the costs to both Greece and the EU are too great to envision a scenario in which both sides refuse to compromise toward a common resolution.

Financial markets fear such a scenario, because an exit from the euro and the EU could potentially lead to bank failures in Greece, with contagion effects spreading to Ireland, Italy, Portugal and Spain. Late in the week, Moody's Investors Service downgraded the credit ratings of 16 Spanish banks.

Global economic data: another mixed bag

Mixed readings on the U.S. and global economies did little to soothe market jitters during the week. Good news in the U.S. included:

  • Homebuilder confidence and housing starts that were better than expected
  • A rebound in the New York Federal Reserve's Empire State manufacturing index
  • A drop in the four-week moving average of first-time unemployment claims to its lowest level in five weeks.

Article Highlights

  • Equity markets extended their recent losing streak on fears that political chaos in Greece will lead to a Greek exit from the euro — an event that could undermine the broader European banking system and potentially threaten the global economy.
  • Fixed-income markets also grew increasingly nervous about developments in Europe, with investor anxiety fueling continued strong demand for the safety of U.S. Treasuries.
  • Global economic data releases were mixed: In the U.S., steady-to-improving housing and employment numbers were offset by weakness in some regional manufacturing data and a dip in the index of leading economic indicators.

However, this positive news was offset by a contraction in the Philadelphia Fed's manufacturing index and a drop in The Conference Board's index of leading economic indicators.

Outside of the U.S., German and Japanese GDP growth surprised on the upside, while India and China showed further signs of cooling.

Stocks slide and Treasuries gain

Amid the uncertainty, global stock markets continued to fall, eroding some of their gains from earlier in the year. For the month to date through May 17, the S&P 500 Index was down 6.5%, while foreign developed and emerging market equities were off 8.7% and 10.0%, respectively, based on MSCI indexes.

Fixed-income markets are also taking the risk of a potential Greek exit — and the unknowns that go with it — quite seriously. High-yield and investment-grade corporate bonds, which had traded within relatively narrow ranges earlier in May, saw their yields climb as investors' appetite for risk diminished.

Meanwhile, U.S. Treasuries benefited from a surge in demand for safe-haven assets. The yield on the bellwether 10-year Treasury security, which had topped 2% in late April, settled at a record-low 1.70% on May 17.

Outlook: still cloudy, but with some silver linings

Although Europe continues to pose genuine risks, we are not convinced that a major market shock similar to the 2008-2009 global financial crisis is the likeliest outcome. The European Central Bank and other government and financial institutions, informed by the lessons of the previous crisis, have had time to work toward appropriate responses as the long-running Greek drama has unfolded. We may be nearing a point at which concerted policy action in Europe is not only necessary but inevitable, as evidenced by somewhat softer rhetoric from German Chancellor Angela Merkel.

From an investment perspective, fear of the recent turmoil may now be largely reflected in equity market sentiment, which has turned quite pessimistic after reaching what we considered overly bullish levels in mid-March. European equities are trading at 30-year relative lows, and price/earnings (P/E) ratios in southern-tier markets have fallen to single-digit levels that historically have been associated with compelling long-term returns.

Meanwhile, slower growth in China and India has contributed to a steep drop in commodity prices, including crude oil prices, which are down 15% from their February peak of $110 per barrel. Lower fuel prices should bolster consumer confidence and spending globally.

The U.S. economy continues to expand at a rate of 2% to 2.5%. After hitting some speed bumps in April, employment indicators have improved again, supporting an optimistic outlook for growth in the near term. This confidence is tempered by the prospect of another round of U.S. debt limit negotiations and other fiscal policy debates, which could sap market and consumer confidence later this year, as they did in 2011.