Asset Management

Amid Europe’s gloom, markets find little solace in U.S. bright spots

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

After a strong start to the week, equity markets grew increasingly volatile and approached the Memorial Day weekend on track to post a second consecutive month of negative returns. For the month to date through May 24, the S&P 500 Index was down 5.3%, while foreign developed and emerging-market equities were down 10.2% and 11.7%, respectively, based on MSCI indexes.

In fixed-income markets, higher-quality assets continued to outperform lower-rated sectors for the same month-to-date period: U.S. Treasuries returned 1.1%, while commercial mortgage-backed securities, high-yield corporate bonds and global emerging-market bonds returned -0.6%, -1.4% and -2.7%, respectively, based on Barclays indexes. The yield on the bellwether 10-year Treasury security, which hit a record low of 1.70% on May 17, fluctuated during the past week, but stayed below 1.8% through May 24.

Article Highlights

  • Equity markets remained volatile on Greek and EU fears.
  • Greece is less likely to exit the euro than investors fear, but volatility will likely persist as long as Greece’s status remains uncertain.
  • With sentiment extremely negative and stock positions appearing oversold, equity markets may be poised to rebound.

The prospect of Spanish bank failures weighed heavily after the European Central Bank (ECB) rejected the Spanish government’s plan to recapitalize the nation’s struggling banks using ECB funding. With Spain’s economy and financial system already under pressure, the latest developments triggered a further spike in Spanish sovereign debt yields and accelerated withdrawals from Spanish banks. Moreover, the lack of an EU-wide bank deposit insurance program has increased the risk of a run on banks in other, weaker eurozone nations.

Greece remains the epicenter of market tremors

Financial markets fear that a victory by a left-wing political party in Greece’s June 17 national election will trigger a government clash with the EU, the European Central Bank (ECB) and the International Monetary Fund (IMF) over previously negotiated austerity measures. Such a clash could trigger a Greek exit from the EU, deposit runs on Greek banks, and contagion effects that could spread to other economically weak EU members such as Ireland, Portugal and Spain. This could undermine those countries’ banking systems, prompt more exits from the euro and, in a worst-case scenario, lead to a full-scale break-up of the EU and a global recession.

The market’s fear of a Greek exit is obviously real, but it is interesting that the political party pushing back on austerity still wants Greece to remain in the EU (as do the majority of Greek voters). In our view, this means Greece will not willingly break with the euro, no matter who governs after June 17. Rather, Greece will leave only if it is forced out upon failing to hit fiscal targets to sustain its banks and meet its credit obligations. Because that outcome represents a political decision with far-reaching global consequences, we believe the odds of it happening remain low. However, as reflected in global equity market performance, the likelihood of such a scenario has increased.

EU summit disappoints markets hoping for a breakthrough

One reason for continued market pessimism regarding Europe was the lack of meaningful progress made at a May 23 summit of EU leaders. Markets had been hoping for a unified statement on new measures to stabilize markets, such as the issuance of eurobonds to support Greece and other weak eurozone countries, or a clear commitment to growth initiatives to prevent further economic contraction. With new French president François Hollande and German chancellor Angela Merkel taking opposing views, the prevailing mood was one of disunity, which is likely to keep debt markets on edge and the euro weak versus the dollar as the Greek election nears.

Germany’s economy weakens, while U.S. housing market continues to heal

Adding to the week’s unease was the release of economic data showing that Germany—the eurozone’s largest and typically most resilient economy—is beginning to feel the impact of economic weakness elsewhere in the region. In May, German manufacturing output contracted to a level of 45.9, as measured by the Purchasing Manufacturer’s Index (PMI). A PMI reading below 50 indicates declining activity. Meanwhile, the Ifo Institute’s Business Climate Index, a key gauge of German business sentiment, fell to a six-month low.

In contrast, the U.S. housing market continued to show signs of healing. Sales of both existing and new homes rose more than expected in April, as did median home prices. New home sales are being boosted by reduced inventory, record-low mortgage rates, and a stabilizing job market. A strengthening housing sector, coupled with falling gasoline prices, may bolster consumer spending and help keep the U.S. economy on its slow-but-steady growth trajectory.

Equity investors generally paid scant attention to this encouraging housing data during the week, remaining fixated on the troubling news out of Europe. However, with market sentiment extremely negative and positions appearing oversold, equities may be poised to rebound in the near term.