The week started badly and got worse for equity investors. The S&P dropped just over 2% on the week, outpaced by the NASDAQ’s near 3.5% fall. Europe was the worst place to be, down 3%, whilst Japan and the Emerging Markets fared better than most equity markets. US Treasuries and gold and silver were up. Financial stocks were off 4%.
Two major macro concerns, neither really new, weighed much more heavily on investors last week, raising their risk premia. First there was increased concern of eurozone contagion. The focus remained on Italy, which had seen a spike in its ten year bond yield the week before, and ended last week at 5.7%. This compares with 2.7% for the German ten year.
Italy represents 23% of outstanding eurozone debt and 17% of its GDP. During the week the policymakers’ focus remained clearly on the mechanics of the next phase of a funding strategy for Greece.
The finance ministers aim to agree this on Wednesday and present it to the European Council for approval on Thursday. Whilst this is clearly important, the market concerns over Italian debt signalled that the issue has moved beyond fire fighting in Greece to the need for a comprehensive solution.
After the market closed on Friday the European Banking Authority’s 2011 Bank Stress test results were published. Around 60% of European banks took part in the exercise and eight banks failed the 5% Core Tier 1 minimum, with a total capital deficiency of €2.5bn. Another sixteen banks were below 6% and may need to bolster their capital as well.
The validity of the stress tests was questioned as sovereign default was not part of the potential stress that was tested. However the EBA results offer a great deal of detailed data on exposures to eurozone sovereign debt.
It shows that the eurozone banking system is deeply interconnected and problems in one part of the network can spread to others since around 85% of claims against eurozone governments are held by EMU residents, mostly financial institutions.
The other major concern was growing market focus on the deadlock in Washington ahead of the fast approaching 2nd August deadline for the US House of Representatives to vote to raise the US budget deficit. Talks once again stalled between the House’s Republican majority leader Cantor and the White House.
Republican Senator Mitch McConnell offered an elegant solution which addresses the political implications for many in either supporting or not a raised deficit ceiling; a vote to defer the vote, allowing the ceiling to rise by default. No one would want to be associated with a decision which meant that social security cheques wouldn’t be posted on 3rd August. But the implications are not only political.
Wrapped up with this was the rating agency, Standard & Poor’s, warning last week that the United State’s AAA credit rating would be reviewed unless there were clear plans to reduce the deficit over the next ten years. Any rating cut would not only squeeze the government’s finances further through higher funding costs, but would have a knock on effect on the borrowing costs and credit worthiness of US financial institutions.
There was undoubtedly a lot of noise last week, which raised investor concerns about event risk, to accompany the underlying uncertainty about growth. However the corporate reporting season has got off to a solid start, and this week should produce some clarity on events in both the eurozone and Washington.
Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton