Asset Management

European debt relief collides with U.S. jobs anxiety

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

September 7, 2012

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Labor Day may have shortened the trading week in the U.S., but there was no shortage of headlines or economic releases to drive the markets. On September 6, the European Central Bank (ECB) announced a much anticipated—and hoped-for—bond purchase program to combat Europe’s sovereign debt crisis. The “relief rally” in stocks was immediate, with the S&P 500 Index surging 2.1% for the day and the MSCI Europe Index gaining 2.6%, led by Spain (+5.2%) and Italy (+4.5%).

However, a weaker-than-forecast U.S. jobs report for August, released on September 7, took some of the wind out of the markets’ sails.

Article Highlights

  • Equity markets surge on news of European Central Bank’s bond purchase program.
  • Mixed data on U.S. employment tempers relief over Europe.
  • U.S. Treasury yields tick higher but waver as markets digest August jobs report.
  • Fed reiterates commitment to further monetary stimulus if needed.
  • Prospect of a September stock market correction warrants caution.

In fixed-income markets, higher-yielding, non-U.S. government securities (“spread” products) were generally supported by the ECB announcement. Based on Barclays indexes, U.S. high-yield and global emerging-market bonds both returned 0.21% on September 6, while the broad, investment-grade aggregate index declined 0.28%, weighed down by U.S. Treasuries in general (-0.39%) and longer-term Treasuries in particular (-1.47%).

With Treasuries losing some of their safe-haven appeal, on September 6 the 10-year Treasury yield jumped eight basis points (0.08%), closing at 1.68%. The yield began drifting lower, however, in the wake of the August jobs report.

ECB delivers what the markets have been demanding
After much speculation, ECB president Mario Draghi confirmed that the ECB would move forward with a plan to purchase sovereign debt issued by fiscally strapped eurozone members that are otherwise unable to obtain financing at reasonable rates. The plan, known as “OMT” (outright monetary transactions):

  • Allows for unlimited ECB purchases of bonds with maturities of one to three years;
  • Effectively lowers borrowing costs for Spain and Italy, which have been the recent focus of sovereign debt fears;
  • Will use a "sterilized" approach, meaning that purchases will be offset by equivalent sales to avoid a potential increase in the money supply, which can have inflationary consequences;
  • Does not give the ECB seniority over other creditors, thereby alleviating concerns that private holders of eurozone debt would bear the brunt of any potential restructuring; and
  • Requires participating governments to abide by strict credit conditions.

The advent of OMT represents meaningful progress in resolving the European debt crisis. However, full resolution is a long process that will require significant steps toward actual fiscal integration among eurozone members.

The next milestone for Europe is the German Constitutional Court’s ruling on the legality of the European Stability Mechanism (ESM), the eurozone’s permanent bailout fund. The court is scheduled to announce its decision on September 12, although markets seem to view a favorable ruling as a foregone conclusion.

U.S. labor market conditions continue to confound
The employment situation remained in flux this week. Mixed data points underscored the recent lack of consistency and momentum in U.S. job creation:

  • On the positive side, weekly first-time jobless claims fell to 365,000—a drop of 12,000 and the biggest weekly decline in two months.
  • Private payroll gains in August, as measured by the ADP National Employment Report, came in at 201,000—well above consensus forecasts and a welcome surprise for the markets.
  • Total nonfarm payrolls, however, which are reported by the Bureau of Labor Statistics a day after the ADP release, were disappointing, showing only 96,000 jobs were created in August, versus an expected 125,000.
  • The national unemployment rate inched down to 8.1% from 8.3%, primarily because more people left the workforce. Unemployment has hovered stubbornly around 8% for the past eleven months.

The weak jobs report, while disappointing, could prompt the Federal Reserve to take action to help stimulate growth sooner rather than later. Heading into the Labor Day weekend, Fed chairman Ben Bernanke noted that "the stagnation of the labor market in particular is a grave concern" and pledged that the Fed "will provide additional policy accommodation as needed."

Outlook: Continued slow growth in U.S., recessionary track in Europe
On balance, U.S. economic data point to modest GDP growth of 1.5% to 2%, although some sectors of the economy—especially the housing market—have shown strong, steady improvement. Corporations remain in a wait-and-see mode with regard to hiring and investment, despite having record levels of cash. Fears that the U.S. will go over a "fiscal cliff" due to political gridlock have intensified and will likely continue to do so this election season, contributing to subdued or delayed business activity.

In Europe, recent policy actions have cheered investors, but underlying economic conditions remain weak. GDP growth in the eurozone has been flat or negative for three consecutive quarters, and the ECB has lowered its 2012 growth forecast to -0.4% from -0.1%, and its 2013 forecast to +0.5% from +1.0%. That said, the risk of a catastrophic shock—an outright depression, breakup of the euro, or collapse of Europe’s major banking institutions—now seems more remote than it did during some of the more volatile periods the markets have endured since the sovereign debt crisis began.

Cooling economic growth and non-performing loans in China also remain a concern. Ongoing weakness in construction-related commodities such as iron ore, for which spot prices have reached their lowest levels since 2009, suggest that China’s slowdown has yet to run its full course.

In the past week, the Chinese government announced new targeted infrastructure projects designed to stimulate growth. In response to those announcements, the Shanghai “A Share” Index moved sharply higher on heavy volume. This may signal the market’s belief that the government intends to finally reaccelerate growth. If so, that has positive implications for the global economy.

Sluggish U.S. and global growth prospects notwithstanding, equity markets have recently hit year-to-date highs. It has generally been a strong third quarter for stocks so far, and the S&P 500 Index is up 15.6% for the year to date through September 6. The MSCI Europe and small-cap Russell 2000 indexes have also posted double-digit gains (+10.6% and +14.1%, respectively) during this period.

At current levels, the market may be "overbought" in the short term. Short-term trading sentiment has become increasingly bullish, a contrarian indicator that could signal a potential pullback in September and warrants caution among investors. Long-term sentiment remains pessimistic and is a positive for those with a long-term focus.