Asset Management

Markets want stronger policy responses to global challenges

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

June 22, 2012

After rising about 1% in the first three days of the week, U.S. equities gave back that gain and more on June 21, when the S&P 500 Index fell 2.2%—its second-largest one-day drop of the year. Month-to-date through June 21, the S&P 500 was up only 1.3%.

In non-U.S. equity markets, gains of more than 2.5% through midweek were trimmed by June 21 declines of 1.1% and 1.7%, respectively, in the MSCI EAFE and MSCI Emerging Markets indexes. Signs of economic weakening in the U.S., where job growth and manufacturing have slowed, weighed on equity markets, along with concerns over Europe’s ongoing debt crisis and China’s uncertain pace of recovery.

While equities were rattled by weak economic data, fixed-income markets remained relatively calm. The yield on the 10-year Treasury rose slightly during the week through June 21, but generally hovered around 1.6%.

Article Highlights

  • Fed extends “Operation Twist” and lowers economic forecast.
  • Anxiety over sluggish U.S. job growth trumps housing market optimism.
  • Greek election relief fades; Spanish bank fears intensify.
  • Equities give back some of June’s prior gains, while bonds hold up well.
  • Markets are vulnerable near-term if upcoming European summit disappoints.

Fed extends “Operation Twist” through year-end

On June 20, the Federal Reserve announced that it was extending its “Operation Twist” program through the end of 2012. Originally scheduled to expire at the end of this month, Operation Twist is the Fed’s effort to lower long-term interest rates and stimulate the economy by selling large quantities of short-term U.S. Treasury securities on its balance sheet and using the proceeds to purchase an equivalent amount of long-term securities.

Financial markets had anticipated policy action from the Fed, but some investors were disappointed that the June 20 statement did not include stronger monetary medicine in the form of a third round of quantitative easing (“QE3”). QE3 would involve the Fed’s purchase of mortgage-backed securities or other fixed-income assets without any offsetting asset sales, thereby increasing the money supply and stimulating growth. Two previous rounds of quantitative easing were initiated in 2008 and 2010. Although QE3 has not materialized yet, the Fed has indicated it is prepared to do more to stimulate the economy if conditions warrant. In its June 20 release, the Fed lowered its outlook for U.S. economic growth, forecasting continued high unemployment and benign inflation for the remainder of 2012.

Relief over Greek election proves short-lived as Europe remains in focus

With the formation of a pro-bailout coalition government in Greece following the June 17 election, the fear—and likelihood—of a Greek exit from the euro has greatly diminished, at least in the near term. Now the real work begins, as it appears the government will need promised EU funding by July in order to meet its obligations.

Meanwhile, Spain remained in the spotlight:

  • Stress tests released on June 21 indicated that Spanish banks will need up to €62 billion ($78.7 billion) in capital to withstand worst-case economic scenarios.
  • Despite a successful auction of medium-term debt at midweek, the Spanish government’s borrowing costs rose, with the yield on the 5-year bond eclipsing 6%—its highest level since the adoption of the euro. The 10-year Spanish government bond yield, however, retreated from the unsustainable 7% level, largely on hopes of policy action by EU institutions.

Adding to anxiety over the regional debt crisis were indications that the eurozone economy has begun to contract more rapidly, and that U.S. and European companies are starting to lower their earnings estimates in the face of deteriorating regional indicators. The Purchasing Manager’s Index (PMI) of manufacturing activity in the eurozone, for example, fell to 44.8 in June, from 45.1 in May. Levels below 50 indicate contraction.

U.S. economic indicators send mixed signals

The strength of the U.S. recovery remains in question, evidenced by mixed economic data releases during the past week. On the downside:

  • First-time unemployment claims, though down slightly in the most recent week, are on an uptrend over a four-week moving average—not an encouraging sign for the June payroll numbers to be released on July 6.
  • The Philadelphia Fed’s index of manufacturing activity plunged in June, versus expectations that it would improve from May’s negative reading.
  • The “flash” (preliminary) Purchasing Managers’ Index (PMI) of U.S. manufacturing activity fell to its slowest pace in 11 months.

In contrast, U.S. housing indicators provided some relative bright spots:

  • Homebuilder confidence inched higher, hitting its best reading since May 2007.
  • In May, building permits jumped to their highest level since October 2008.
  • Although housing starts were slightly lower in May versus April, April’s total was revised higher.

Other positive signs included:

  • A rebound in the Economic Cycle Research Institute’s (ECRI) leading indicator, which had fallen over the previous three weeks;
  • A better-than-expected increase in The Conference Board’s Index of Leading Economic Indicators for May; and
  • Gasoline prices that are down 66 cents per gallon from their recent peak, putting roughly $75 billion back into consumers’ pockets (about 2% of disposable personal income).

What to look for on the policy front

While speculation about policy responses in the U.S. and Europe was enough to fuel market rallies in mid-June, the heightened volatility of the past week suggests that something more tangible must be done to sustain investor confidence. Regarding Europe, markets are now looking to the June 28 and 29 summit of EU leaders for announcements of stronger measures to address the ongoing debt crisis. Among the policy responses rumored to be under consideration are:

  • An FDIC-style deposit insurance program to immunize the financial system from deposit runs. If implemented properly, such a program could alleviate stress and potentially help reduce broader systemic risks to global markets and economies.
  • Bond purchases by the ECB and the injection of more liquidity via a third Long-Term Refinancing Operation (LTRO).
  • Various proposals for closer fiscal union or coordinated growth initiatives among EU members.

With the exception of true fiscal integration, none of these policy actions would be a permanent fix for Europe’s problems. Nonetheless, they could represent a temporary solution that allows Europe to muddle through and provides sufficient impetus for an equity market rally.

In terms of U.S. policy, if June’s employment numbers are disappointing, we would expect the Fed to shift from Operation Twist to full-scale QE3, which could involve purchasing mortgage-backed securities or the use of other strategies, after its September meeting.

Nervous markets enter the final week of the second quarter

If no policy announcements of consequence emerge from the EU summit, equity markets and lower-rated, higher-yielding fixed-income markets will be vulnerable, while U.S. Treasuries could benefit from a further flight to safety. Technical trends that favored an upturn in the U.S. equity market have weakened: In particular, the S&P 500 has struggled to breach its 60-day moving average, a sign that further upward momentum may be constrained. In addition, despite volatility through the first three weeks of June, the VIX, or so-called “Fear Index,” failed to breach 30—a key threshold often associated with a drop in the S&P 500 that is severe enough to drive investors out of the market, setting the stage for a potential rebound.