Last week’s column noted the surprising strength that has recently characterized the European financial markets — from the euro itself, which touched 1.40 dollars last Thursday, to the equity and bond markets. Virtually every bourse across the continent has been powering ahead, some (like Germany) reaching all-time highs and others (mostly those of the PIIGS countries) climbing to levels not seen since the early stages of the European crisis in 2010-2011.
Most dramatic of all, from an economic point of view, were the bond markets, where the yields demanded from sovereign bonds issued by countries that were quite recently in the untouchable caste tumbled sharply lower (remember, lower yields = higher prices == good). In some cases (Italy and Spain) yields reached levels below even those seen in 2007, and/or lower than ever before — lower even than those demanded of United States Treasury bonds.
All of this has been widely remarked upon, mostly in tones of amazement, if not outright incomprehension. After all, there were no solid data underpinning this boom, only an improvement from imminent collapse to chronic weakness at the macro level, while the recovery in corporate earnings has largely fizzled. Rather, what was supporting the markets and fuelling the boom, was endless amounts of almost-free money — especially in the US and Japan — and seemingly inexhaustible quantities of hope and optimism (“hopium”, in the bear’s lexicon).
This week, and especially yesterday (Thursday) has seen this façade of phoney improvement crack and, in some cases, crumble. Why now and why yesterday? The correct answer is that you never know with respect to timing, although there is always some event or news item to pin market developments to. Thus the ‘disappointing” GDP figures of virtually every EU country, that were published yesterday morning, were cited by some news reports as the immediate cause, just as ECB President Mario Draghi’s overt threat to cut interest rates next month was blamed last Thursday for the abrupt and major reversal in the euro: after it finally reached 1.40, it plunged 1.5 cents that same day and continued falling on Friday and through this week.
The more valid question is not why did the markets fall now, but why did they go up so much and for so long beforehand. In any event, the reversal was — as usual — both dramatic and vicious. The PIIGS were once again in the vanguard, this time of a wild slaughter which saw the stock exchanges of Greece — whose domestic politics is once again becoming a Europe-wide issue — and Portugal fall several percent yesterday alone, and nearly 9% apiece in the last five trading days. Italy, Spain and Ireland were not far behind, and France is also looking shaky.
But, once again, it is the bond market that really matters — and here too, the good times are over, at least for now. The yields on Spanish and Italian bonds which, when they fell below the 3% per annum level a week or two ago, had commentators and even politicians cheering like football supporters when their team scores, soared yesterday — straight back through the 3% benchmark, with Portugal and Ireland falling even faster and the recently-issued Greek bond that had so enamored investors just a few days ago, now back in pariah status.
The situation is not much different in the US. Since early March — i.e. for over two months — a clear split has developed in the American equity marlets. The wider indices, encompassing thousands of shares which are, by definition, “small-cap” — meaning they have a relatively low capitalization, because they are small or medium-sized — have been displaying weakness and had already dropped several percent away from their all-time highs made earlier in the year. Meanwhile, the very large companies — those in the S&P500 index or the much narrower Dow Jones Industrials or Transportations averages — have been marching upwards, recording a steady succession of new highs.
The general public, via the mainstream media and even the financial TV channels, hear about the Dow and the S&P and are thus led to believe that all is still hunky-dory. But more and more professionals, hedge-fund managers and even bankers, have begun to express discomfort with both the price levels and the market ‘internals’ — things that only professionals watch, such as that ‘insiders’ have been selling very heavily, or that the market has been propelled higher by fewer and fewer shares
On Monday, the entire American market jumped sharply higher. The supposed reasons are irrelevant, as was the rise itself — because it came on low volume and saw no follow-through the next day. Instead, the small-cap indices renewed their erosion and the big indices tried to rise — but failed. Yesterday — again, for whatever reason — the entire market fell sharply, below the levels seen at the end of last week. Bond prices, of course, jumped higher, pushing the yields on government bonds sharply lower — reconfirming that the US is still a better borrower than Italy.
Yesterday, per se, is not important. What is clear is that the liquidity-led equity boom of the last several years has run its course. Given where prices are and given the gloomy outlook for corporate profits (as Walmart confirmed yesterday), the direction is down. The question for stock investors is how far and how fast — but the larger question, for bond investors and for ordinary citizens, is to whether the latent weakness of the developed economies will now be exposed for all to see.