Investors Shun Risk
Last week was dominated by a widespread aversion to risk, a function primarily of increasing worries over Greece, with most equity markets falling and so-called “safe haven” bonds rallying. The Dow Jones Industrial Average fell 1.21% to 17,730, the S&P 500 Index declined 1.19% to 2,076 and the tech-heavy Nasdaq Composite Index lost 1.40% to close the week at 5,009. Meanwhile, the yield on the 10-year Treasury fell from 2.48% to 2.39%, as its price correspondingly rose. Still, most of the selling was confined to last Monday following the unexpected announcement of a Greek referendum. And although volatility rose, the decline was orderly and modest relative to past incidents. While the market is likely to experience further selling as investors digest the chaotic situation in Greece, a still benign monetary environment and low bond yields should mitigate the size of any correction.Central Banks Still Helping—Except in China
Stocks sold off sharply last Monday with the U.S. trading down to a three-month low, but the damage was contained. Volatility briefly spiked, with the VIX Index hitting a four-month high of nearly 19. However, even at its peak, volatility remains below both its January high and its long-term average. Even in Europe, obviously more exposed to the outcome of the crisis in Greece, selling was measured. Stocks were down roughly 4%, but peripheral bond spreads held steady.
The damage to equities was at least partially muted by a good week for bonds. Despite more credit risk emanating from Puerto Rico, where the governor signaled his intention to seek a broad restructuring of debt, U.S. bonds benefited from a safe-haven bid as well as a recalibration of the date of a likely interest rate hike by the Federal Reserve (Fed) following June’s jobs report. While job creation continues to be strong (the 12-month average is close to 250,000), investors took note of stagnant hourly earnings and a 38-year low in labor force participation. Given that wages have yet to rise as fast as job creation would imply, the Fed may temper any plans for a September hike. This helped the two-year Treasury note rally, pushing yields down to 0.63%, below where they started the year, while the yield on 10-year government bonds fell back below 2.40%.
Interestingly, the central bank that appears to be losing its sway over financial markets, at least temporarily, is China’s. Chinese equities fell sharply again last week despite several new efforts by the central bank. Last weekend, the People’s Bank of China cut both reserve requirements and interest rates, the first simultaneous cut since 2009. The central bank followed up with additional liquidity on Wednesday. Despite these efforts, the Shanghai Composite fell below 4,000 for the first time since April; the index is now down roughly 30% from its June high. An announcement over the weekend indicated that government officials will take additional steps to help stabilize the market. However, given that as the market’s momentum has been broken and China’s equity market is still trading at a significant premium to its average valuation, for now we would avoid aggressively buying into the decline.
Watch Greece Then Earnings
This week, markets are likely to take their cue, at least initially, from Greece. On Sunday, Greek voters rejected the terms of the recent referendum, rebuffing the latest bailout proposal. While this does not necessarily translate into an immediate Greek exit from the euro, it substantially raises the odds that one will occur. At the very least, this outcome will lead to a prolonged period of chaos as European officials try to salvage the situation.
The uncertainty surrounding Greece will almost undoubtedly lead to a sharp, negative reaction from investors. However, we don’t believe the outcome in Greece poses a longer-term threat to the global economy or financial markets. Perhaps more important for U.S.-based investors will be the outcome of second-quarter earnings. With estimates coming down aggressively, the U.S. economy recovering and dollar strength moderating, companies should have an easier time beating estimates this quarter.
Russ Koesterich, BlackRock
