Americans are preparing to celebrate Independence Day, and most of the world is fixated on Brazil as the World Cup tournament field tightens.
Yet market attention might soon swivel toward Europe, with a full economic calendar set for the days ahead. Next week's activity comes amid concerns that economic lethargy could displace investor optimism about a return to growth and the effectiveness of central-bank stimulus efforts in the region.
The European Commission Friday reported an unexpected decline in household and business economic sentiment, and inflation in the euro zone has stubbornly remained below 1% since the fall, keeping big-picture fears of deflation nearby. The European economy nudged ahead by 0.2% in the first quarter, down from 0.3% the prior period, and now higher oil prices and skittishness over Russia and Ukraine are serving as the unanticipated threats of the moment. As Reuters quoted Christoph Weil, economist at Commerzbank: "The good news from the euro zone is that the economy is growing again. The bad news is that growth is excruciatingly slow."
European financial markets have retreated over the past week, with the iShares Europe fund (IEV) sliding 3.6% since Monday, led lower by pronounced weakness in large bank stocks. Continental banks continue to face the prospect of further capital-raising stock sales, and with BNP Paribas (BNP.PA) and Barclays PLC (BCS) perceived to be under continued regulatory assault in the U.S., they have lost favor.
Giving back the reflex gains
Equity markets across Europe have given back all, and more, of the reflex gains they enjoyed after the ECB’s June 5 move to charge banks for idle reserves in a bid to get credit flowing into the economy. This sets a slightly apprehensive context for the data, ECB policy meeting and series of speaking engagements by finance officials that will occur between Monday and Thursday.
Yes, this probably sounds like more of the same – false starts on growth, bold statements out of the European Central Bank that only fleetingly excite financial markets. One difference now, perhaps, is just how optimistic investors had become this time about assumptions of stable European markets and the prospects for further upside.
In the latest Bank of America Merrill Lynch global fund manager survey, professional investors had their second-steepest “overweight” position in European equities since mid-2007. Meantime, “peripheral” European debt – the bonds of Italy, Portugal and Spain, specifically – has rallied stupendously, with yields on Spanish 10-year notes dipping below those of the U.S. as deflationary pressures and the ECB’s backstop have emboldened investors. In that same survey, European peripheral debt was deemed the “most crowded trade” in world markets.
Merrill credit strategist Hans Mikkelson remarked this week that, in his recent visit to Italian fund-manager clients, “they are drinking champagne at lunch” because they all own so much Italian debt and have been riding the rally.
Raising the stakes
The broadly recognized and avidly embraced stability of euro zone capital markets is certainly a positive development, and counts as an interim victory for the ECB’s campaign of economic healing. Yet investors’ more upbeat posture also raises the stakes for the coming updates on actual economic progress and the next round of central-banker rhetoric.
Monday each major EU country releases its final manufacturing purchasing-managers index, which follow a softer-than-hoped set of preliminary figures. Crucial inflation updates will be closely parsed. There will also be housing numbers from the U.K. – where the Bank of England is openly trying to talk down a frothy property market – and Europe-wide retail sales.
Michael Block, market strategist at Rhino Trading in New York, says, “Those European PMIs are crucial. I have dialed down my optimism on Europe relative to the U.S. based on the recent data divergences, and I am watching these numbers anxiously.” Still, he adds, “The bar is low” after the soft preliminary estimates this month.
The ECB is now broadly expected to take no further action when it releases its policy statement early Thursday morning – just ahead of the U.S. monthly payrolls report. Its June 5 plans on negative deposit rates were not expected to have an immediate effect.
Still, we may be back in a situation where easy-money maneuvers are celebrated upon announcement, fail to have lasting energizing results, and before long generate a greater appetite for more from ECB President Mario Draghi. Already, commentators are anticipating some small-scale asset purchases as an incremental ECB measure later this year.
Minor backsliding in progress is all it takes to revive the long-term economic ice age discussion. Moody’s Analytics Friday pointed out it doesn’t expect European output to return to 2008 levels until late 2015, and “should growth continue to disappoint, as it did in the first quarter of 2014, an additional year could be required.” And if cautious household-spending behavior becomes ingrained amid persistent deflationary headwinds, “a lost decade would be a distinct possibility,” Moody’s Melanie Bowler says.
None of this means investors will need to brace for a long, nauseous summer of European economic angst, such as they endured in 2010 and 2011. But with “globally synchronized growth” expectations already undercut by the decline in U.S. GDP in the first quarter, further disappointments out of Europe could provide an answer to contented U.S. investors asking, “What could go wrong?” with our comfortable slow-growth/high-liquidity/generous-Fed supported markets.