Asset Management

Markets rattled by European fears, U.S. disappointments

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

Equity markets ended the month of May sharply lower, buffeted by turbulence in the global macroeconomic environment. For the month, the S&P 500 Index lost 6%, its worst one-month performance since September 2011. Meanwhile, foreign developed and emerging market equities fell 11.5% and 11.2%, respectively, based on MSCI indexes.

In fixed-income markets, U.S. Treasuries continued to outperform. The Barclays U.S. Treasury Index gained 1.71% in May, while the broader investment-grade aggregate index rose 0.9%. Corporate high-yield and global emerging-market bonds posted negative returns, falling 1.3% and 3.2%, respectively. Investor demand for safety drove the bellwether 10-year Treasury yield to a new record low of 1.59% on May 31.

Spain eclipses Greece as a source of global market fears

The deepening sense of crisis in Europe was again a primary factor in market declines. Fear that a potential Greek exit from the European Union (EU) could spark a 2008-like global financial crisis dominated markets during most of May. Greek polls showing increased support for EU-oriented conservatives moved equity markets higher on May 29, but the rally was short-lived as investors quickly turned their attention to Spain.

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.

Article Highlights

  • Equity markets tumbled in the final week of May, capping a month of sharp losses.
  • Strong demand for safe-haven investments drove the 10-year U.S. Treasury yield to record lows.
  • European debt fears intensified as Spain’s troubled banking system came under renewed pressure.
  • U.S. growth has clearly slowed, but there is potential for the pace of recovery to pick up in the third quarter.
  • Bearish sentiment has reached extreme levels that could prompt equity market performance to defy consensus expectations.

U.S. recovery looking much more fragile

In past weeks, favorable U.S. economic reports — particularly in employment, housing and manufacturing activity — have often helped temper the negative market impact of the European debt crisis. That familiar pattern did not hold in the final week of May, as a spate of data releases pointed to a slowing U.S. recovery:

  • The economy added only 69,000 jobs in May, far fewer than expected.
  • National unemployment ticked up to 8.2%, from 8.1% in April.
  • First-time unemployment claims rose by 10,000 compared with the previous week.
  • First-quarter GDP growth was revised downward to 1.9%, from an initial estimate of 2.2%.
  • Pending home sales declined 5.5% in April.
  • Measures of consumer confidence were mixed.

The dismal employment headlines overshadowed the week’s positive data releases, which included surging auto sales and gains in consumer spending and personal incomes. Overall, the U.S. expansion has clearly downshifted.

Economic and political uncertainty will continue

We continue to believe that the pace of U.S. economic activity will reaccelerate in the third quarter of 2012, supported in part by higher disposable personal income that should result as overall inflation and energy prices move lower. At the same time, we acknowledge growing concerns about U.S. growth in light of the macro burdens facing the global economy. Of particular concern is the potential impact of automatic spending cuts and tax increases that will take effect in January 2013 if no political compromise is reached.

Outside the U.S., the odds that Greece will exit the euro have risen. The June 17 Greek election looms large in that regard. In Spain, we think the loss of bank deposits may force the government to seek external funding support from the European Commission, ECB, and International Monetary Fund (the “troika” of institutions that oversaw bailout loans to the governments of Ireland, Portugal and Greece). If Spain makes this request, it will most likely be before the next stress tests for Spanish banks are completed at the end of June.

The recapitalization of Spanish banks, while a necessary step, will not cure Europe’s ills. Eventually, EU leaders must find a credible, sustainable policy solution that involves some form of closer fiscal integration among member countries. Whether the current round of pain will be enough to compel that outcome remains to be seen, but there are small signs of movement in that direction, including a greater degree of willingness on the part of some leaders to consider a balance between austerity and growth.

More market volatility ahead

Current macroeconomic concerns are tempered by the now very bearish sentiment pervading the equity markets. In our experience, when negative expectations align as uniformly as they seem to be doing now, equity markets have a tendency to respond in a way that is opposite to what the consensus expects. In the fixed-income arena, the nervousness indicated by declining Treasury yields has so far not affected lower-rated, higher yielding “spread” credit markets as severely as in the fourth quarter of 2012, when Treasury yields were last in this low range. In fact, U.S. high-yield bonds could remain relatively insulated from events in Europe, as long as those events do not lead the U.S. back into recession.