Signs of Rebound, But Risk Aversion Still In Play Amid Eurozone Tensions

Markets appear to eye a possible rebound after Tuesday’s move into safety mode on political tension in the Eurozone.

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(Wednesday Market Open) After weeks of Asian issues like North Korean nuclear arms and China tariffs dominating international news, Europe reminded investors Tuesday that it’s still over there with troubles of its own. In response, the U.S. markets are off to a rocky start this week, with financials particularly hard hit and losing any of the momentum they might have had.

There were signs early Wednesday of a possible rebound. Stocks in Europe rose after more weakness in Asia overnight, and oil prices crept back up above $67 a barrel. Volatility eased, and closely-watched Italian bond prices looked a little steadier ahead as Italy prepared to sell $7 billion worth of government bonds. Still, it would take a pretty big rally to recover from yesterday’s nearly 400-point loss in the Dow Jones Industrial Average ($DJI), and a downward revision in estimated U.S. Q1 gross domestic product (GDP) to 2.2% early Wednesday from the previous 2.3% won’t necessarily help.

What we likely saw yesterday was a safety play as investors look for assets that might potentially offer protection from any shakiness in the European economy. That’s probably why U.S. 10-year Treasury bonds rallied fiercely Tuesday and corresponding yields fell back below 2.8% after recently trading above 3.1% (the 10-year yield climbed back to 2.87% by early Wednesday). It also might help explain why the Japanese yen—often seen as a “safety” investment—reached seven-year highs vs. the U.S. dollar even as the dollar rallied against most other major currencies.

Two of Three “Risk Horsemen” On the Move

Of the so-called “three horsemen of risk,” otherwise known as bonds, volatility, and gold, two galloped higher Tuesday. Bonds were one, and volatility as measured by the Cboe VIX was the other. At one point Tuesday, VIX was trading up above 19 before falling back a bit, quite a contrast to levels of around 13 last week that brought to mind the relaxed trading of 2017 to mind. Gold, however, didn’t move too much. That could be a sign that the action Tuesday was driven more by concerns of a European economic downturn than by any worries about inflation.

That could be an important takeaway, because it might point toward this downturn perhaps being less of a long-term issue and more of a pause. Any big move up in gold that signifies a return of inflation concerns would probably be more damaging to the stock market. That said, this remains the biggest bout of uncertainty since February when inflation fears flared during a sell-off in U.S. bonds.

In general, the cautious feelings that dogged the market back before earnings season seem to be back. There’s a sense of fragility, and that applies not just to the U.S., but worldwide. In the short term, with a positive earnings season now in the rearview, stocks may struggle for reasons to move higher even if they can quickly recover from Tuesday’s sell-off. Speaking of which, there wasn’t a lot of panic in the market Tuesday. Selling seemed orderly, a sign perhaps that people were just taking off risk, not bailing completely out.

Looking more closely at Europe, one school of thought is that the Italian political crisis could mean the European Central Bank (ECB) might need to keep rates lower and hold off drawing down its balance sheet. Europe has been slower than the U.S. to start removing its economic stimulus, but some analysts had been expecting more movement on this front over the coming months. Now that’s in question, and that could raise concern about Europe’s imports and general consumer demand throughout the continent. 

Fed Prediction Becoming More Complicated

When European rates remain low and the economy there struggles, that often flows across the Atlantic. We’re already seeing this breeze help to blow U.S. yields down sharply. The futures market now projects a 78% chance of a Fed hike this coming month, down from 100% just a week ago. And odds for a fourth hike this year, which stood near 50% not long ago, now are around just 20%, according to futures prices.

The chance for looser monetary policy, which the Fed also hinted at in its minutes issued last week, might sound good for stocks from a 30,000-foot view, but from closer up it’s not necessarily so bright. Rising rates and a hawkish Fed are often the sign of a thriving economy, and vice versa. The Fed has a very fine line to navigate in coming months as it tries to assess whether European weakness is starting to slow U.S. growth and how much it can raise rates without pushing the dollar so high vs. the euro that it might hurt exports.

All this makes the June 12-13 Fed meeting start to look a lot more interesting. Not so much as far as what the Fed might do with rates at that point, but about what it might say in its statement. Fed Chair Jerome Powell’s press conference immediately after the meeting also could take on added importance amid instability around the world.

As the political issues across the Atlantic play out, long-term investors might want to take a look at their stock allocations and see which, if any, of their holdings give them heavy exposure to Europe. It’s not necessarily time to exit those positions, but the turmoil in Italy and Spain, as well as ongoing Brexit issues, means it could be time to decide if you’re willing to live with heightened risk. 

Figure 1: Eurozone Swiss Cheese? Political uncertainty in eurozone nations such as Italy and Spain has led to a softer currency in recent days versus other major currencies, notably the Swiss franc. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Franc Talk: Some traders watch the euro vs. the Swiss franc as a proxy for the strength of the Eurozone. Why? Switzerland, which has long maintained a neutral stance politically as well as financially and monetarily, is still subject to regional macroeconomic conditions. However, because the nation maintains its own currency, it's often viewed as a safe haven in times of economic uncertainty. The unfolding political drama in eurozone nations such as Italy and Spain have sent the euro down sharply versus the franc over the past month (see fig 1).

2011 Nostalgia: This week’s Italian excursion has some investors worried about how European shakiness might affect U.S. markets in the longer term. Up until this hiccup, European stock performance year-to-date looked pretty similar to the S&P 500 Index (SPX), with both pivoting around unchanged after lots of ups and downs. Both the pan-European STOXX 600 (STOXX) and the SPX started the year driving upward before hitting the skids in February and then chopping around through March and April. In May, both rallied but now find themselves on the defensive. Make no mistake, concerns about the European financial situation could continue to weigh on U.S. markets. Consider 2011, when fears that Greece might default on its debt helped send the U.S. stock market to a flat performance as European stock markets fell 5% to 15%. History, of course, doesn’t always repeat, but U.S. investors might want to consider keeping a close eye on the June 14 European Central Bank (ECB) meeting, which now could take on more urgency.

Small Fry Gain Respect: All this geopolitical turmoil seems to be benefiting one part of the U.S. market: Small caps. The Russell 2000 (RUT) index of small-cap stocks fell quite a bit less than the SPX Tuesday and recently set new all-time highs, helped in part by many investors feeling this part of the market might be less exposed to issues like Italian politics and Chinese tariffs. Since the SPX hit an all-time high on Jan. 26, it had fallen more than 5% heading into Tuesday. During the same time span, the RUT was up 2.6%. According to research firm CFRA, it’s possible this out-performance by small caps might continue, helped in part by the fact that small caps now trade at a nearly 9% discount to SPX stocks based on estimated 2019 earnings. Also, CFRA projects small-cap company earnings growth of around 31% in 2018 vs. around 20.6% for large caps. On Tuesday, it appeared small-caps might be attracting some money that otherwise may have gone into bonds.

Good Trading, 

 JJ

@TDAJJKinahan 

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