Asset Management

Markets remain fixated on Europe and central bank policy

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

June 15, 2012

Gloom and optimism took turns dominating the equity markets during the past week, with Europe’s debt crisis and further signs of weakening in the U.S. economy keeping investors on edge. Later in the week, fear was trumped by hope that the Federal Reserve and other central banks around the world would take decisive action to boost growth and ensure liquidity in the markets. Month-to-date though June 14, the S&P 500 Index was up 1.52%, while foreign and developed markets returned 2.20% and 1.10%, respectively, based on MSCI indexes.

Most fixed-income markets were in a holding pattern. The 10-year U.S. Treasury yield, which has traded within a narrow range between 1.60% and 1.67% since June 6, closed at 1.64% on June 14. Performance has been flat across U.S. investment-grade bond sectors, as measured by the -0.09% month-to-date return of the Barclays U.S. Aggregate Bond Index through June 14. However, agency mortgage securities have benefited somewhat from the increasing likelihood that the Federal Reserve may begin to buy mortgages to help stimulate the economy. Fund flows remained broadly positive for investment-grade corporate bonds.

Article Highlights

  • Spanish and Italian bond yields spiked as Spain’s bank rescue failed to soothe markets.
  • Equities gained on reports that central banks were ready to boost liquidity in the event of a post-Greek election crisis.
  • Weak U.S. data fueled hopes of imminent Fed action to jumpstart the economy.
  • The 10-year U.S. Treasury yield traded in a narrow range for much of the week.
  • Technical factors imply that equity markets may be bottoming and could move back higher.

Spain and Greece share the spotlight in Europe’s long-running debt drama
Developments in Spain and Greece dominated market fears about Europe during the week:

  • Early euphoria over the announcement of a €100 billion ($126 billion) plan to recapitalize ailing Spanish banks evaporated quickly as markets deemed the incremental move insufficient to address the region’s deeper economic and fiscal problems.
  • Moody’s Investors Service cut Spain’s sovereign credit rating three notches, and Spanish government bond yields spiked to 7%, a record high for Spain in the euro era. Italy’s borrowing costs also rose sharply on concern over Italian government finances.
  • The June 17 election in Greece also loomed large for investors, who feared an outcome that could lead to a Greek exit from the euro or to further political stalemate that would drag out the uncertainty even longer.

Markets rise as policy responses seem inevitable
Given global stresses and collective angst, policymakers are under immense pressure to act—so much so that global equity markets began to rally on June 14 on the belief that some form of central bank intervention had become inevitable. Signs of potential policy moves included:

  • G20 central banks were reportedly poised to take collective action to stabilize markets in the wake of Greek election results. (The G20 is a group of central bank governors and finance ministers from 20 major economies, including the U.S., China, Japan and the European Union.)
  • Within Europe, rumors point to the increased likelihood that policymakers are working on a potential fix for the region’s problems. The details remain to be seen, but the European Central Bank (ECB) is expected to use all of its remaining policy levers for monetary easing. Action must be taken soon, or Europe risks even greater economic weakness in the second half of the year, which in turn could further suppress U.S. growth and lead to a synchronized global recession.
  • Meetings of the G20, the Fed and the EU during the final weeks of June may provide the best window for aggressive policy action to help minimize or reverse the current angst. Given overwhelmingly bearish equity market sentiment, such action could provide a platform for a dramatic market rebound.

Further weakening in the U.S. adds to pressure for Fed action
Within the U.S. in particular, worsening economic data during the past week made it clear that something needs to happen on the policy front.

  • First-time unemployment claims jumped by 6,000, and the four-week moving average also rose.
  • The leading index of the Economic Cycle Research Institute (ECRI) weakened for the third consecutive week.
  • Consumer sentiment fell to its lowest level since last December.
  • The New York Fed’s Empire State Index of manufacturing activity plunged in June, reflecting underlying weakness in new orders, employment and prices paid.
  • Retail sales surprised on the downside (-0.4% in May, versus a revised -0.1% in April), indicating that consumers may be pulling back from steadier levels of spending seen earlier in the year. Although declining oil prices trimmed inflation and provided a boost to consumer incomes, money saved at the gas pump was not spent on other goods.
  • Business sentiment has taken on a more cautious tone as well, evidenced in part by rising business inventories in May. Business owners are likely frustrated by an ongoing lack of pricing power in the U.S., as seen in the sharp decline in the Producer Price Index (-1.0% vs. -0.2% in April).

The lack of U.S. inflation should allow the Fed more room to engage in further easing operations. This could take the form of extending the "Operation Twist" program, outright purchases of Treasuries and mortgages, or both.

Some glimmers of economic optimism
Not all of the U.S. and global economic headlines represent gloom and doom.

  • U.S. housing continues to improve, helped by record-low mortgage rates and record-high affordability levels. Harvard’s annual status report on the U.S. housing market, released on June 14, confirmed a promising outlook, although headwinds remain.
  • In China, key infrastructure projects have been greenlighted by the government, and oil consumption rose in May.
  • Prices for commodities such as copper appear to be seeking a bottom, and all of the emerging-market BRIC nations (Brazil, Russia, India and China) are focused on adding stimulus to their economies through easier monetary policies.

Technical indicators suggest equity market may be bottoming, ready to rebound
The odds of an equity market upturn look favorable, given the prospects for global action by policymakers, combined with extremely bearish investor sentiment. Hedge funds’ net exposures to equities are back to their 2011 lows, while fund flows into less-risky mutual funds are at levels seen during periods of market stress in 2010 and 2011.

A number of technical factors suggest that equities are bottoming:

  • The percentage of U.S. stocks hitting new lows over a three-week moving average has faded from May peaks, indicating less selling pressure.
  • Defensive sectors (i.e., industries that tend to perform better when the economy is weak), such as healthcare, consumer staples and telecommunications, are losing upside momentum.
  • Extremely stressed equity markets, including Spain and Italy, are attempting to rally.
  • Although long-term bond yields have fallen sharply in non-euro, developed markets as investors seek perceived safety, further rallies in safe-haven sectors are meeting resistance.

On balance, equity markets appear coiled to spring and await only a trigger to do so. In light of prevailing sentiment and expectations for policy action on a global scale, we believe such a trigger may happen soon.