Asset Management

Tiny Cyprus makes a big noise, while strong U.S. data vies for attention

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

March 22, 2013

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Equity markets were volatile during the past week, largely in response to developments in Cyprus, whose economy represents just 0.2% of total eurozone GDP but whose banking system has become the latest flashpoint in the euro crisis. A proposed €10 billion ($13 billion) EU bailout in exchange for a levy on Cypriot bank deposits not only angered depositors who would be “bailed in” to help pay for the rescue, but also fanned fears of potential bank runs in other weak eurozone nations. After the initial proposal was rejected by the Cypriot parliament, the European Central Bank (ECB) set a March 25 deadline for the government to come up with an alternative plan. As of this writing, it appears that some form of a deposit levy may still be imposed. U.S. equities, which had fallen on the Cyprus news, began to rebound on March 22.

Article Highlights

  • Equity markets oscillate as competing influences drive volatility.
  • Euro risk comes back in vogue with Cyprus banking crisis.
  • Weak manufacturing in Europe and mixed signals from China cloud the global picture.
  • U.S. housing continues to shine, providing a strong economic tailwind.
  • First-quarter GDP forecasts have risen, but short-term equity outlook is a harder call.

In fixed-income markets, U.S. Treasuries benefited from a more cautious tone, as Cyprus concerns reminded investors that the European financial crisis can still rear its ugly head. With Treasury prices rising and yields declining, the spread between Treasuries and investment-grade corporate bonds widened. The widening of spreads has been relatively contained so far, because the broader eurozone debt crisis has stabilized compared with late 2011 and early 2012. Meanwhile, net flows into fixed-income funds remain supportive, particularly for floating-rate leveraged loans. Year to date, the return of positive flows into equities has not come at the expense of dramatic outflows from bond funds.

Markets largely unmoved by continued strengthening of U.S. economy

With Cyprus dominating the headlines, markets paid little attention to a number of positive U.S. economic releases. The housing market in particular continued on its upward track: Housing starts, building permits, and existing home sales rose more than expected in February. Inventories of homes for sale are at decade lows, while construction labor crews are also in short supply—factors that we think will continue to drive home prices higher this year. The spillover effects of rising home values should provide an important boost to consumer spending as well.

In addition to housing strength, other favorable U.S. data included:

  • First-time unemployment claims. Although initial jobless claims were slightly higher for the most recent week, the four-week moving average declined. The steady drop in claims over the past several months correlates with improving stability in monthly job creation figures.
  • Leading indicators. The Conference Board’s Index of Leading Economic Indicators (LEI) rose 0.5% in February, more than consensus forecasts, indicating further expansion of the industrial sector, capital investment, and key financial metrics. Meanwhile, January’s LEI was revised upward.
  • Manufacturing. Two gauges of manufacturing activity — one national (the preliminary Purchasing Managers’ Index, or PMI, published by Markit) and one regional (the Philly Fed Index) — moved solidly higher.

Adding to the predominantly optimistic tone was the Rasmussen consumer sentiment survey, which surged after a decline in the first half of March, and improving levels of company activity based on ISI surveys. In addition, Federal Reserve Board Chairman Ben Bernanke reaffirmed continuing support of economic growth through the Fed’s low-interest-rate policy and bond purchases.

Europe still struggling

Aside from Cyprus, there was not much economic news out of Europe. In Germany, the Zew economic sentiment index rose in March, validating the strong rise seen so far this year. However, German manufacturing and service-sector activity sank, with the manufacturing Purchasing Managers Index (PMI) falling below the 50 threshold separating contraction from expansion. PMI readings were even lower in France.

Mixed signals in China, strong Japanese stock performance continue

While the Shanghai Stock Exchange “A” Share Index posted gains into mid-February, since then it has traded lower to finish below its December 2012 close. This drop has been accompanied by weaker data and inconsistent signals from policy makers. Chinese equity valuations, however, have reached attractive levels, and stocks lifted off their 200-day moving average on March 20, which may signal a better period ahead. This is important for emerging markets and the materials sectors. Also hopeful is China’s preliminary PMI reading, which increased to 51.7 in March from 50.4 in February, according to HSBC.

In Japan, consumer-oriented measures, including department store sales and imports, have improved modestly. This could be an early sign that the Japanese government’s efforts to push inflation expectations upward and drive consumer spending may be starting to take hold. The next central bank meeting is in early April and will signal whether Japan intends to maintain its newfound policy focus on aggressive monetary easing. Investors are counting on it: Japanese stocks are up 23.1% year-to-date in yen terms, based on the MSCI Japan Index.


Given recent gains in U.S. retail sales, industrial production and capacity utilization, we should expect to see an initial government estimate of first-quarter GDP growth in the 2.5% to 3% range. This is higher than originally thought and speaks to how much economic activity was pushed from the fourth quarter of 2012 into the first quarter of this year — primarily due to uncertainty surrounding the fiscal cliff, which delayed business and consumer decision-making.

In particular, accelerating trends in housing should provide a stronger tailwind this year, perhaps adding as much as 1% to growth (up from previous expectations of between 0.50% and 0.75%). Additionally, the passage of a continuing funding resolution to avoid a U.S. government shutdown (at least until September) has resolved some of the policy uncertainty in Washington, although budget and debt ceiling battles remain on the horizon.

On a cautionary note, while U.S. consumer spending has remained strong, it appears to be a product of a savings drawdown. This poses the risk of a slower rate of spending growth in the second quarter. Slower spending, combined with signs that business inventory levels may be high, could set the stage for another period of market weakness in May. However, unlike 2011 and 2012, when a similar pattern occurred during this time of year, we now have QE3 liquidity to support the markets’ potential move to higher levels.

The combination of these factors leaves us a bit conflicted about the short-term outlook for the U.S. equity market. The economic backdrop remains favorable with continued help from the Fed, but that positive outlook is reflected in short-term trading sentiment. As we have noted before, elevated levels of bullish sentiment can create the conditions for a correction. The fact that we have not seen one yet, despite macro “echoes” from Europe and a murky picture in China, reaffirms the powerful signal we saw in January’s U.S. market surge. It is possible that the market’s momentum could lead from a period of optimism into “euphoria” — a development that long-term investors should regard with vigilance and caution.

In fixed-income markets, we continue to find some value in a low-yield world, mostly in higher-quality high-yield instruments that offer a potential cushion against rising rates in the second half of 2013. Overall, we think the current environment is not one in which fixed-income investors should be looking to add significant risk, because they will not be compensated for doing so, given the compression in yield spreads versus higher-grade credits.