Weekly Market Update: Insights from TIAA-CREF Experts
Familiar Market Themes Dominate, but with a Few Twists
Ed Grzybowski, Chief Investment Officer
Familiar themes continued to drive the markets this week, as investors remained focused on sluggish U.S. growth, the potential impact of Europe’s sovereign debt and banking crisis on the broader economy, and whether public policy is likely to be effective in addressing these concerns. Amid the thematically consistent headlines, some new specifics emerged, providing investors with a few twists to the recent market narrative.
One such “twist” was the September 21 announcement by the Fed that it would sell $400 billion in short-term bonds and reinvest in bonds with longer maturities of between six and 30 years. This step, seen as one of the last remaining stimulus tools available to the Fed, is designed in part to inject some life into the stagnant housing market by helping to lower mortgage rates and encourage refinancing.
While a Fed action of this sort was largely anticipated by the markets, the immediate reaction to the specific announcement was a nearly 3% drop in major U.S. equity indices, reflecting both skepticism that efforts to drive rates even lower will produce the desired results and disappointment that the Fed did not exceed the market’s expectations with a more dramatic proposal. U.S. bank stocks, down nearly 11% since the beginning of September, have sold off further because the effect of the Fed action is to flatten the yield curve. This squeezes banks’ net interest margins due to potentially higher rates paid on short-term deposits and lower reinvestment rates on longer-term investments. The bellwether 10-year Treasury yield hit a new low of 1.88% by the close of trading on Wednesday, and the 30-year yield dipped below 3% on Thursday.
The day before the Fed’s announcement, the International Monetary Fund (IMF) issued a report lowering its global economic growth forecast for 2011 and 2012. Not surprisingly, the IMF cited rising potential losses by European banks due to the sovereign debt crisis as a significant concern that could lead to a contraction in the real economy. Perhaps more tellingly, the IMF observed that the long-running credit and real estate boom in China has increased the potential risk of a financial crisis there. Chinese bank stocks have fallen, as the cost of insuring against a potential credit default by China has climbed. Moreover, while GDP growth in China and many other emerging-market nations remains robust, concerns that weak demand from developed countries will restrain this growth has put pressure on emerging-market equities.
Simply put, investors have lost their appetite for risk, at least in the near term. U.S. equity markets have seen a continued rotation into large-cap stocks and defensive sectors such as consumer staples and utilities. Emerging-market equities have declined nearly 9% in September, underperforming U.S. and developed-market foreign stocks. In the credit markets, riskier fixed-income assets, including high-yield and emerging market bonds, have sold off as investors seek the safety of U.S. Treasuries.
The flight to quality is likely to continue as markets seek reassurance that genuine progress is being made on the public policy front. Given the fragile global economic environment and the heightened sense of urgency in Europe, we would expect to see meaningful policy actions taken in an attempt to reverse these trends. These actions could include an attempt to re-liquefy European banks and to coordinate monetary easing by central banks—not just in Europe, but also in China, which until now has pursued a steady course of tightening.
While long-term solutions seem elusive, Europe has the capacity to resolve its issues and will likely muster the political will to do so. In the meantime, markets remain volatile and hyper-sensitive to short-term news. Current sentiment is bearish enough that even incremental progress or suboptimal solutions could result in a sharp rebound, particularly in Europe and the emerging markets.
The information provided herein is as of September 23, 2011.
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