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The Bottom Line: Plenty of Uncertainty Ahead

By James Solloway


  • There are optimistic statements coming out of Europe, and markets have rallied, but the story remains the same.
  • The upcoming U.S. election adds to the uncertainty.
  • While stock markets could end the year higher, we have more conviction in our belief that the recent rally will fade in the near term and that markets will remain choppy and news driven for the balance of the year.

Global equities have continued to rally of late; however, we have maintained a neutral position between our strategic (long term) and active (short term) asset allocation recommendations. We believe there is still a great deal of uncertainty around economic fundamentals and policy actions, while markets have priced in some fairly optimistic expectations. If markets are disappointed on either the economic or policy fronts in the months ahead, risk assets could take a tumble.

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It’s “Risk On” in Europe, But We Aren’t Biting

Markets have had a “risk-on” flavor since European Central Bank (ECB) President Mario Draghi’s remarks two weeks ago. Yet most of this rally remains based on the expectation of what might happen, rather than what is actually being done. Despite that reality, European equities have enjoyed a strong run relative to U.S. equities since mid-June and have broken through a long-term downtrend. Whether this reflects a genuine improvement in the eurozone policy environment or just a sharp short-covering phase that will fade in a few weeks remains to be seen. Prior turnarounds have all disappointed, and it’s a hard to call at this point.

While we continue to believe that a game-changing event is required in what European leaders are doing to resolve the crisis, the European Stability Mechanism (ESM) rescue facility is not likely to be granted a banking license at this point. In fact, the German Constitutional Court still has yet to rule favorably on the ESM’s existence and powers. The Constitutional Court’s decision will be delivered September 12, the same day that Dutch elections take place.

Full fiscal union and joint issuance of eurobonds would work to end the crisis, but Angela Merkel and her party remain opposed along with (seemingly) most Germans (although the opposition party, SPD, recently took a pro-integration stance). Fiscal union needs a fair amount of time to evolve and will eventually require approval of all 17 nations in the single-currency zone. It is simply not realistic to expect significant fiscal integration at this time.

Meanwhile, Europe is sinking deeper into recession. Italy’s gross domestic product (GDP) was down at almost a 3% annualized rate in the second quarter from the first. Even Germany has suffered a year-to-year decline in industrial production, and although it recorded positive growth in GDP during the second quarter, data such as the Institute for Economic Research’s Business Climate Survey is pointing to the potential for an outright recession in Europe’s strongest economy.

The bottom line, in our view, is that recessionary conditions remain in effect in Europe, and the expectations implied by current market levels have yet to be matched by concrete actions from policymakers. ECB President Mario Draghi incited the most recent market rally by saying, essentially, “If you speculate against the euro, you will lose.” But it’s not entirely clear yet what that will mean in practice.

A Really Mixed Bag of U.S. Economic Data

U.S economic releases have been a really mixed bag of late. It was surprising to see the manufacturing component of the purchasing managers index stay below 50 in June; this suggests that the manufacturing pullback seen in May was not a mere statistical blip. However, employment data have turned more positive again. The July payrolls report was decent at 163,000 and weekly initial unemployment claims have fallen back from their highs earlier in the year. We may be coming out of the ‘payback period’ created by a warm winter that pulled a good deal of hiring and economic activity forward into the first quarter from the second. It appears we’re returning to normal, but that normal is still weak, and we’ve experienced the same summer funk as in the prior two years.

Presidential Politics Picking Up Steam

Mitt Romney, who is expected to win the Republican party’s nomination for president at the party’s convention in late August, selected Representative Paul Ryan from Wisconsin as his vice presidential running mate. Ryan learned his political lessons from Senator Jack Kemp, one of the original members of the “supply-side” movement that influenced economic policy under President Reagan. He is also a leading representative of the party’s next generation of leaders along with Senator Marco Rubio of Florida and Louisiana Governor Bobby Jindal.

Ryan's presence on the ticket is likely to shore up Tea Party and conservative Republican voters that have been reluctant to embrace Romney’s cautious style and record as governor of Massachusetts. We expect the selection to energize the Republican base, which could present a challenge to President Obama, who has had some trouble motivating his base. On the other hand, Ryan’s presence might have the effect of adding some life to the Democratic side, as Romney could now be more vulnerable to claims of far-right radicalism.
While Romney and Ryan will argue that significant entitlement reforms are needed now to prevent larger problems down the road, this could work against them if, for example, a significant number of elderly voters in battleground states like Florida start to fear that they are going to lose their federal benefits. Either way, we continue to believe that the race for the presidency will go down to the wire. In the meantime, the lack of clarity continues to roil financial markets.

Our Positioning

One can make the case that nothing has fundamentally changed in recent weeks, whether looking at Europe, the U.S. or emerging markets. Therefore, the current risk-on trade is not likely to last.

Against this backdrop, we recently unwound an active overweight to high-yield debt in those mandates where it remained, moving back to our strategic position. While we continue to believe that credit is more attractive than developed sovereign debt, especially so-called safe havens like U.S. Treasurys and German Bunds, investors reaching for yield have left high-yield debt fairly valued in our opinion.

We continue to maintain a hedge against exposure to the euro. The rebound in that currency that occurred after Mario Draghi’s remarks has already faded for the most part, and it failed once again to break through its 50-day moving average.

Our View

Looking ahead, Fed Chairman Ben Bernanke will be speaking at the Jackson Hole conference in late August.  We’ll see if he provides an indication of when and how the Fed will proceed with additional quantitative easing. 

September will be a critical month for Europe, with the German Constitutional Court ruling on the ESM and Dutch elections which should be a good barometer of citizens’ current views on the euro and eurozone membership. Anti-euro parties are unlikely to win, but as in other countries, they have struck a sympathetic chord with the electorate. Greece faces a deadline for obtaining its next funding tranche, and we expect the funding to be granted. This will get the country through another quarter but is not a long-term solution. 

Spain and Italy, on the other hand, have seen tremendous market rallies, especially in their short-term debt. This is the maturity range where the ECB has said it will focus its purchases. However, Mr. Draghi and other ECB representatives continue to emphasize that governments of the eurozone have to move first by buying periphery debt using rescue facility funds before the ECB steps in.

On balance, we believe the risk-on rally could fade in the near term. However, the character of market trading is starting to change, and there could be a stronger tone to equity markets across the globe by year end. We may see a value of 1450 on the S&P 500 by then, although we do not have a great deal of conviction at this point. We are far more confident that markets will experience continued choppiness and volatility, especially in the September and October time frame.
The bottom line is that markets don’t know what to discount at this point because, when it comes to the European debt crisis, the U.S. elections or the next moves in fiscal and monetary policies around the world, “Nobody knows anything.”1 

1William Goldman, Adventures in the Screen Trade, New York: Grand Central Publishing, 1989


This material is provided by SEI Investments Management Corporation (SIMC) for educational purposes only and is not meant to be investment advice. The reader should consult with his/her financial advisor for more information. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. There are risks involved with investing, including possible loss of principal. SIMC is a wholly owned subsidiary of SEI Investments Company.