It’s a question of Greece! May 22 2012 Stocks Drop as Europe Takes Centre Stage Although US economic data was generally good last week, stocks sank sharply as investor fears over Europe’s debt problems intensified. For the week, the Dow Jones Industrial Average fell 3.5% to 12,369, the S&P 500 Index dropped 4.3% to 1,295 and the Nasdaq Composite declined 5.3% to 2,778. At present, the focus of the European debt crisis is on Greece, particularly on next month’s elections. The upcoming elections look to be turning into a referendum on whether or not Greece will remain part of the eurozone. Should the more extreme parties in Greece gain popularity, the greater the likelihood that the country exits the eurozone. The more traditional Greek political parties, as well as the powers that be in Europe as a whole, are pushing for Greece to remain part of the euro, but the outcome is far from clear and the uncertainty has rattled global financial markets. Of course, Greece is capturing most of the headlines, but perhaps more worrisome is the debt contagion that appears to be spreading to other countries such as Spain and Italy. It is important to note, however, that contagion is not spreading as widely or as deeply as it did last year. This resilience reflects the sounder position of both the global financial system and global economic indicators, although it is difficult to take too much comfort in this fact since a broader resolution of the eurozone crisis is not yet in sight. In some sense, the only hope for the eurozone is to lower monetary policy further, which would also push the value of the euro lower. Additionally, the European Central Bank would have to engage in larger-scale bond purchases to improve financial market liquidity. The alternative could be the disintegration of the euro over time. US Recovery Remains on Firm Ground Despite the mounting crisis in the eurozone, the US economic recovery continues to look stable. Retail sales growth has slowed recently, but the decline in oil prices could help reverse that trend and provide a boost to consumption. Additionally, business spending remains solid and seeing a pickup in residential construction. The labour market strength that was evident earlier in the year appears to have ebbed somewhat, but we need improved employment growth in the second half of the year. Market Positives Should Win Out While it is true that US stocks have taken a turn for the worse over the last month, other markets (particularly European stocks) have been hurt even more. On a year-to-date basis, European stocks are down roughly 3%, while US stocks are still up close to 6%. This divergence represents a continuation of the pattern that has been in place since the current bull market started in March
2009. Since that time, US stocks have appreciated by nearly 70%, while European equities have climbed by just a little more than 10%. So what is the likely outcome for US stocks given the prevailing backdrop? In the near term, it appears stocks will continue to face crosscurrents that have solid corporate earnings and economic growth pushing prices higher and uncertainty and fear over macro risks pushing them lower. Until these crosscurrents diminish, expect a volatile trading pattern we have seen over the last several weeks could continue. Currencies The euro fell for the third-successive week, leaving it at a four-month low versus the US dollar. The main influencing factor this was the risk of the debt crisis spreading further amongst the eurozone’s member nations as a result of the knockon effects from Greece’s failure to form a government. The €/$ rate ended the week at 1.27, 1.6% lower over the week. Oil & gold The oil price dropped to a six-month low on the concerns surrounding Greece, which may hurt Europe’s debt troubles further and curb fuel demand. The West Texas oil price ended just above $91 a barrel, 4.8% lower on the week. Gold finished the week unchanged overall. Bonds German bunds rose for a fifth consecutive week, pushing the 10-year yield to another record low, as fear that Greece would withdraw from the single currency boosted demand for the region’s safest asset. While core countries benefited from this, peripheral countries, most notably Spain, saw prices fall over concerns about rising banking losses. The Merrill Lynch over 5 year government bond index ended the week 0.4% lower.