The European effect has faded, to a certain extent. Although Spanish 10-year bond yields have risen to a one-year high at 7.27% and its equity market is breaking down, investors outside of Europe appear to have acclimatized to such woes (Figure 1).
Image courtesy of Stockcharts.com
Figure 1: Spanish equities (IBEX) breaking down while US equities (SPX) are recovering nicely.
The EU may have approved the 100 billion euros Spanish banking bailout but the European troubles are far from over. The high interest rate demanded for Spain bonds (as well as for Italy) makes the debt burden unsustainable for both Spain & Italy. The odds are high that Spain would request for help to bring debt levels and interest payments to sustainable levels. Hence it is crucial that the European Stability Mechanism is established, operational and armed with sufficient firepower. Unfortunately, this will take months to accomplish.
Nonetheless, as seen from the relative strength of other markets, Europe as a macro risk is receding. Fears of a breakup of the Eurozone have fallen as investors focus on economic growth and earnings. The US continues to show a mixed bag of data with manufacturing indicators weaker but housing data surprising on the upside. This week's release of advance estimates of manufacturing PMI data should give us a sense of whether the weakness is a short term phenomenon induced by European panic or something more serious. On housing, the strength in homebuilders' confidence (Figure 2) is likely to be a sign of higher home construction and sales activity in the months ahead.
Figure 2: National Association of Home Builders housing market index rising sharply.
In terms of market signals, equity markets remain mixed while bond markets continue to show strength with investors chasing yields. Junk and emerging market bonds continue to post new highs despite the uncertain economic environment. Importantly, we see strength in growth currencies like the Aussie and Canadian dollar, against traditional safe havens (Figure 3). The risk on trade remains alive
Image courtesy of Stockcharts.com
Figure 3: Australian dollar in a uptrend against the US dollar since June 2012.
With renewed pessimism on the global outlook1, policy makers are more likely to adopt stimulus measures to arrest the slowdown in economic growth. China's NDRC is fast tracking infrastructure projects while the tepid employment situation and low inflation in the US has given the Federal Reserve room to pursue QE3.
The recovery in risk assets since the start of June looks intact. Although volatility is expected to be high (as with any recovery after a correction), markets are forward looking and are probably discounting measures to invigorate the economy given the lacklustre performance in recent months. This is especially so when the US and China are headed into a period of leadership transition.
No changes recommended at this time.
1. IMF cuts global growth forecast as emerging economies slow. 16 July 2012 Reuters
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