After a strong first four months of the year, May has turned out to be anything but merry. The S&P 500 closed at 1406 on May 1, and it has fallen over 5.5% since. Indeed, last weeks performance was the worst of the year.
Not to sound like the crazy relative who tells the same story over and over again at family reunions, but we only need to look at Spanish and Italian bond yields to identify the problem: The sovereign debt crisis in Europe has reared its ugly head again, especially in the place where it all started two years ago.
As you know, Greece’s government is in turmoil, and the country is headed for yet another election next month, which raises the question whether a new government will abide by the austerity measures put in place for Greece to receive financial aid. This, in turn, raises the questions of whether Greece might have to default on some of its debt and, ultimately, whether it will remain a part of the eurozone. An exit is looking more and more likely, although German Chancellor Angela Merkel said she is committed to keeping Greece in the European Union (EU) and the G-8 members voiced their concurrence over the weekend.
We’re also seeing the debt crisis in other parts of Europe. The yield on 10-year Spanish bonds is now approaching 6.5%, and Prime Minister Mariano Rajoy warned his parliament today that failure to enact austerity measures could result in Spain being shut out of the financial markets.
And in Italy, 10-year bond yields are once again approaching 6%. The economic challenges there were underscored by a series of downgrades of Italian banks by Moody’s on Friday. The downgrade will make it more difficult for banks to loan to businesses, which in turn threatens to slow the Italian economy more and pressure both budget deficits and interest rates.
With earnings season in the U.S. winding down, we can expect the situation in Europe to dominate much of the headlines the next few weeks. The election in Greece could go a long way in determining what happens next. A default and/or an exit from the eurozone would be messy in the short term, but honestly, the market is already beginning to expect something along these lines and is pricing that into stocks.
Longer term, I think the U.S. economy and stock markets will eventually be able to absorb whatever happens with relatively little lasting impact.
Another event that will be closely watched will be the EU summit on Wednesday, May 23. It is uncertain whether any new plan of action will be taken at the meeting, given the new government in France and disagreements over the role of the European Central Bank (ECB).
One thing I’ll be looking for is whether there will be another round of lending to troubled European Banks, at least in the short term. Such actions lifted the markets in late November and ignited the strong rally that took the S&P 500 over 1400.
The situation in Europe has the market uncomfortable at the moment, and I expect more choppiness in the coming weeks as the situation plays out. Technically, we haven’t even seen a full correction yet. The S&P 500 is down 6% from its April 2 high, which is less than the 10% decline that is the technical definition of a correction.
At the same time, the economic news here in the U.S. is better today, with both housing starts and industrial production exceeding expectations. That bodes well for the long term, along with the Presidential election cycle, which is historically positive for stocks, as well as the Federal Reserve on standby should the economy stumble.