The headlines out of Greece are coming fast – deal, no deal, default, referendum, etc. It’s enough to make investors’ heads spin trying to keep up with the news flow. Markets have been volatile this week in reaction to the back and forth, and the rising possibility that Greece may leave the Eurozone. Investors are starting to fear that this could potentially be another “Lehman moment” that results in financial contagion across global markets.
Next Thursday (January 22), the European Central Bank will be hosting an important meeting. Last year, Europe experienced a setback in their recovery from the debt crisis as growth ground to a halt. As a result, the ECB took a series of actions over the past several months in an attempt to support the recovery. Their efforts thus far have been considered lackluster by financial markets, which has led to growing speculation that ECB President Mario Draghi will resort to a large-scale asset purchase program (otherwise known as quantitative easing) in hopes of achieving the desired impact. Indeed, he has stated on more than one occasion that the ECB intends to restore the balance sheet back to its 2012 level, which translates into an expansion of nearly one trillion euros from its current size.
Renewed signs of economic weakness in Europe have spooked investors and led to a significant correction in European stocks. In particular, there has been a spate of disappointing economic releases from Germany with industrial production, exports, and business confidence all coming in below expectations. This is concerning because Germany has been the backbone of the overall recovery with better growth relative to other European countries.
Over the past couple of weeks, we have executed several portfolio transactions in line with our belief that the second half of the year may be a good one for stock investors. Most of the trades have been relative in nature; for example, we’ve swapped defensive U.S. sector holdings for late cyclical sectors. We also traded “up” within our international holdings, by swapping a fairly conservative actively managed fund for an ETF targeting mainland Europe (the iShares MSCI EMU Index Fund; symbol EZU). In our two most aggressive policies, we purchased the iShares MSCI Italy Index Fund (symbol EWI).
As recently as this week Spanish bond yields had been roiling the markets as they crossed the 7% threshold that is considered the point of no return. With system risk rising anew, the onus was on policy makers to get moving in another attempt to bring down spreads and calm global markets. In the last few days, policy makers have not disappointed on the rhetoric front.
Some volatility has crept back into the markets in the past few days, largely driven by negative news flow out of Spain (the latest country to come under pressure as a result of the European debt crisis). This probably didn’t come as a surprise to most professional investors, but it might have to Europe’s esteemed leaders, one of whom declared just a few days ago that the crisis is “almost over,” while another described it as “ebbing.”
Tuesday served as quite a jolt to investors. The S&P 500 lost -1.5%, its biggest drop since last December. It seems that everyone had gotten quite used to the gentle drift higher that characterized the stock market so far this year, since there hadn’t been so much as a 1% correction in the S&P since the end of last year.
One of the things we’ve been defending against over the last few quarters is a rise in system risk. In particular the European banking system has been under fire, and for many months we’ve been watching sub surface risks rising in the credit markets. Bank lending is what moves world growth, so the idea that a banking crisis could lead to a seize up in world trade has been no small risk to defend against.
Santa Claus has come and gone, and so far seasonal tendencies have worked a little magic on domestic equity markets, which have been drifting up. But while U.S. equities appear to be reflecting the goodwill of men and holiday cheer, certain markets are behaving more like Mr. Scrooge.
It’s come down to this — the latest summit of European leaders to try to tackle their worsening financial crisis concludes today. The market’s rally of the past two weeks seems to imply that investors are betting they’ll get it right this time. The definition of “getting it right” apparently consists of a credible framework for controlling future fiscal deficits, which would then provide cover for the ECB to buy troubled European debt on the open market with vigor in order to bring down the soaring interest rates of countries like Italy and Spain.