Even seasoned investment professionals are finding it difficult to maintain their composure in these markets. We’re all aware of the potential importance of sentiment itself, and the collective mood at the moment is grim. Fear can be self-fulfilling in markets, as sell-offs can trigger the very events that investors are worried about. For example, if investors fear that banks have funding difficulties, and decide to sell their bank bonds, the yield rises and the banks then will face higher funding costs.
There are some objective reasons too for the latest bout of volatility. Like ECB President Draghi, we’re disappointed that euro area politicians seem to have made such little progress with the enhanced EFSF heralded by the 27 October communiqué. Across the Atlantic, the probability of the bi-partisan supercommittee reaching agreement on deficit reduction measures by next week’s deadline has been falling steadily.
But we think there have also been some positive objective developments. The new government inItaly, for example, where a non-partisan cabinet has a parliamentary mandate (for the time being at least) in favour of budgetary and supply-side reform. As we write, this weekend’s election in Spain seems likely to result in a similar mandate there too. Meanwhile, bank exposure to troubled euro area borrowers is falling steadily.
Although currently grim, the mood has been worse. Stock market volatility – actual and implied – is elevated, but not unprecedentedly so. The number of days in which the S&P500 moved by 2% or more in a rolling 90-day window was much higher in the 2008/9 episode, and a bit higher in 2002/3. The US and euro area stock markets are still above their recent lows. The euro itself remains well above the levels it dipped to when the crisis began to surface in 2010. True, there are no obvious stabilising catalysts in sight, but they are not always needed.
Meanwhile, US economic data remain qualitatively better than expected back in the late summer. This week’s retail sales and industrial production data for October suggest that the fourth quarter started solidly, and weekly unemployment claims indicate that even the labour market is visibly improving again (though not, of course, as fast as we’d like).
Some perspective on Europe is needed: the euro area banking system does not implode the instant that Italian and/or Spanish bond yields push above 7%; default by either government is very unlikely, in our view; and while the ECB is not formally a lender of last resort, this does not leave it powerless (at either end of the yield curve). And spending sequestration in the US would not lead automatically to rating downgrades (or even an immediate hit to growth). But having seen the world almost end in 2008/9, markets are unwilling to take any of this on trust. We still believe that many risk assets, particularly developed equities, are pricing in too much bad news, but it seems very likely that volatility will continue for a while yet.
Kevin Gardiner, Head of Global Investment Strategy