Asset Management

Market swings continue on global hopes, fears

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

June 8, 2012

After tumbling 2.5% in the first two days of June, the S&P 500 Index rallied at midweek, edging into positive territory (+0.4%) for the month to date as of June 7. International equity markets, led by Europe, also rebounded during this period, with the MSCI EAFE Index (+2.3%) and the MSCI Emerging Markets Index (+0.9%) benefiting as global growth fears diminished somewhat.

Through midweek, U.S. Treasuries gave back some of their recent gains and underperformed lower-rated, higher-yielding fixed-income sectors. Month-to-date through June 7, the Barclays U.S. Treasury Index returned -0.4%, while corporate high-yield bonds posted flat (0%) returns and global emerging markets gained 1.3%. The bellwether 10-year Treasury yield, which had hit a record low of 1.47% at the beginning of the month, rose to 1.66% by June 7.

Article Highlights

  • China cut interest rates, boosting global equity markets at midweek.
  • The rally lost steam after Fed statements disappointed the markets.
  • Treasury yields came off their record lows but remained volatile.
  • The odds of another U.S. summer slowdown have increased.
  • Some contrarian signals suggest equities could rally, but caution is warranted.

Relief over China’s rate cut gives way to disappointment in the Fed
On June 7, China’s central bank lowered its key lending rate for the first time since 2008. This action, along with speculation that European officials are working on a deal to recapitalize troubled Spanish banks, brought some relief to financial markets that have grown more fearful of synchronized global weakening and increasingly impatient for effective policy leadership to help avert a deeper crisis. Markets were encouraged—at least initially—by Federal Reserve chairman Ben Bernanke’s statement that the Fed is prepared to act to prevent a further slowdown in the U.S. However, without an explicit policy commitment, the positive impact of the Fed’s comments proved fleeting.

Relative quiet on the Greek front does not mean all is well
There has been a lull in market volatility associated with the political uncertainty in Greece, although that is likely to change as we approach the June 17 election. Currently, financial markets seem to be placing their bets on a ruling coalition between the conservative New Democracy party and the Pasok (Socialist) party—both of which support upholding previously agreed-upon austerity measures. The election outcome is far from certain, however, and the risk is that a victory by anti-austerity forces could send shock waves throughout European and global economies. Ultimately, genuine progress in Europe will require consensus on closer fiscal integration among EU members.

U.S. economic sentiment improves marginally
While U.S. economic data did not surprise on the upside during the past week, sentiment improved slightly and now assumes that the U.S. economy is not likely to contract unless the very worst fears of European debt contagion are realized. Within the U.S., factors supporting an optimistic view included:

  • The service sector of the economy continued to expand in May, based on the Institute for Supply Management's nonmanufacturing index.
  • The Federal Reserve’s latest "Beige Book" survey showed moderate improvement in the U.S. economy.
  • The housing market remains on track for recovery, with the inventory of unsold homes falling to less than a six-month supply, while prices are stabilizing.
  • First-time unemployment claims fell by 12,000 in the week ended June 2.
  • Consumer spending has remained solid and could strengthen further on the stimulus effect of sharply lower oil prices.

The risk of a self-fulfilling downturn is real
Despite these positive signs, the macro concerns dominating the headlines over the past few months—whether in Europe, the U.S. or China—appear to have offset the momentum that was developing in the first quarter. In our view, the odds that we will experience a third consecutive summer slowdown have increased, while our confidence that growth can reaccelerate in the second half of the year has diminished. Among the chief warning signs are:

  • Corporate earnings estimates have turned lower and bear close monitoring, as a similar drop led last year’s summer slowdown.
  • Many U.S. companies are reporting sharply lower sales in Europe, reflecting the weak eurozone economy and a stronger dollar that makes U.S. exports more expensive in euro-based markets.
  • Although surveys indicate a need for increased hiring, U.S. employers seem to be taking a wait-and-see attitude before committing to more jobs and capital expenditures. This reluctance can have a self-fulfilling negative impact on overall activity.

Caution remains the watchword for investors
Given these conditions, equity markets may be vulnerable to further losses, despite the extended nature of May’s correction and sentiment that is now extremely bearish. On the other hand, history suggests that conditions may favor a rebound:

  • Monthly stock market declines of more than 8% have most often been followed by sharp rallies. (Between May 1 and June 4, the S&P 500 was down 8.3%.)
  • As measured by a widely used contrarian indicator, Wall Street equity strategists are now allocating, on average, 50% to stocks—the lowest level since 1992 and one historically associated with strong equity market returns.
  • In Europe, stock valuations in Italy and Spain are at extremely low levels that in the past have been congruent with very healthy annual returns.

Fixed-income markets will remain unsettled over the next few weeks. However, investors in search of yield are likely to continue buying corporate bonds and higher-quality high-yield securities, given their attractive risk-adjusted return potential. While absolute yields remain low, there are few alternatives available.