May 29 2012 Markets Rebound Modestly Following a three-week slide, stocks managed to stage a minor comeback last week, with the Dow Jones Industrial Average climbing 0.7% to 12,454, the S&P 500 Index gaining 1.7% to 1,317 and the Nasdaq Composite rising 2.1% to 2,837. For some broader perspective, stocks are now down approximately 7% from their April highs, but are still up 23% from their October 2011 lows. What Next for Europe? The market decline that has occurred over the last couple of months has largely been attributed to escalating concerns over the European debt crisis and it is believed that Europe remains the chief variable in determining the future direction of the global economy. If Europe’s debt crisis remains reasonably well contained, the world should continue to grow at a modest pace with the United States doing relatively well; if debt contagion becomes chaotic and uncontrollable, it would be an entirely different story. At present, policymakers in Europe are employing a number of strategies to combat the crisis and the growing political uncertainty, including efforts to influence the Greek elections, reinforce firewalls should Greece exit the eurozone and promote pro-growth policies regardless of what happens with Greece. Additional measures such as developing a pan-European deposit insurance program or directly recapitalizing Europe’s banks do not appear to be likely at this point, but remain options should the situation deteriorate. For its part, the European Central Bank continues to actively promote liquidity and has been expanding its balance sheet. The ECB has come a long way from where it was a couple of years ago when it was focused almost exclusively on fighting inflation and seems committed to doing what is necessary to help stem the crisis. US Recovery Continues, but Debt Issues Loom In addition to ongoing issues in Europe, investors are also remaining focused on the state of the US economy. The data has been mixed in recent months, but continues to point to a modest recovery. The business sector remains a source of strength, consumer uncertainty appears to be fading somewhat and we are also seeing some improvements in the housing market. Additionally, liquidity and credit conditions continue to improve in the United States, with bank loans increasing in recent weeks. There are a number of questions over the future direction of monetary policy in the United States. Given that US Treasury yields are at their all-time lows and that we have seen a noticeable drop in stock prices in recent weeks, it might seem reasonable to expect further accommodative action from the Federal Reserve. One major uncertainty in the US outlook is the so-called “fiscal cliff.” Last week, the Congressional Budget Office warned that the US economy would likely fall into a recession if all of the tax increases and spending cuts set to take effect on January 1, 2013 actually come into effect.
Risk Assets Remain Compelling There remains a high degree of near-term risk and the possibility of short-term turmoil given the evolving crisis in Europe, fiscal issues in the United States and the uncertainty over China’s growth slowdown, but global economic growth should remain acceptable with conditions gradually improving in the second half of the year. Leading global economic indicators are rising, the US recovery has grown more firm and earnings momentum is positive. There is still quite a bit more that needs to be done on the part of policymakers around the world to take the necessary steps, but the trends are pointing in the right direction. The European debt crisis should remain reasonably well contained and the US recovery remains on track, the outlook for risk assets continues to be a positive one. The combination of the rising equity risk premium, falling stock prices, improving corporate earnings and lower Treasury yields means that stocks have become quite cheap relative to bonds. Assuming that the world is not headed for a renewed deflationary spiral, there is little doubt in our view that stocks are poised to provide superior long-term returns over bonds given their current levels. Currencies The continuing flight to safety saw the euro driven to its lowest level against the dollar for nearly two years. The €/$ rate fell briefly below the €1.25 level, before finishing the week at just over €1.25. Oil & gold Oil and gold prices fell over the week, the West Texas oil price ending just below $91 a barrel, having been below $90 earlier in the week. Gold finished the week down almost 2%, at $1,565 an ounce. Bonds Continuing uncertainly among investors drove ever-increasing demand for core government bonds, with Germany’s 10-year yield touching a record low of 1.35%, before finishing the week at 1.38%. On the other side of the coin, yields on Spanish bonds drifted lower for much of the week before jumping sharply on Friday on new worries about Bankia, the country’s second-largest domestic lender. Overall, the Merrill Lynch over 5 year government bond index ended the week 1.4% higher. Source: Zurich Investment Managers, Aviva, Blackrock, Bloomberg & FT.com