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Tariq's Take: Next Week Puts Focus on Europe

30 August 2012 in Trading Ideas

This summer has been a slow and tranquil one for US investors as economic policymakers headed for their  homes after calming the markets by promising bold action this fall.  The result has been the S&P 500 rising by about 6% over the last three months, while trading volumes have fallen to a five-year low.

Usually, this means higher volumes and volatility in September, which has traditionally been a month of large market swings.

Meanwhile, economic data has confirmed that China, India and Brazil are slowing down, the US economy is experiencing sluggish growth, and most of Europe is in recession.  Throw in rising commodity prices, declining consumer confidence, and a sovereign debt crisis raging in Europe and it is no wonder the market is taking its cues from the statements and actions of the central banks.

Zoned In On Europe

With that in mind, what financial markets will be watching most closely next week is actually taking place in Europe, not the US.  On Thursday, Mario Draghi will chair the European Central Bank’s policy meeting, where the markets will expect him to follow through on his pledge made July 26, in to “do whatever it takes to preserve the euro” and “believe me, it will be enough.”

The European markets apparently took Draghi at his word – they have risen by an average of 11% since his speech, while Italian and Spanish bond yields both dropped well below the critical 7% level.

Draghi now needs to deliver on his plan to control Spanish and Italian bond yields by having the ECB restart bond purchases – or yields are likely to rise and equity markets are likely to fall. If he fails, the world could once again be facing the possibility of a disintegrating euro and a sovereign debt crisis in Spain and Italy, which are two of the world’ s largest government bond markets.

The problem is that Draghi’s plan faces some legal and political problems. In particular, it isn’t clear that either the ECB mandate or the German constitution allows for this, and the legal basis for the plan is already being challenged in Germany’s Constitutional Court.

In addition, public opinion in creditor nations, led by Germany, is adamantly opposed to monetizing and effectively underwriting the debt of their poorer and profligate southern neighbors. Unfortunately, these disputes are being played out in public. Draghi just canceled his trip to the Federal Reserve Symposium in Jackson Hole, Wyo., to work on his plan — and write op-eds for the German newspapers to counter unusually hostile public opposition by the Bundesbank. 

Despite all this, financial markets in both Europe and the US is somewhat complacently assuming the bond buying program will occur, when in truth anything that is subject to court rulings — like the “Obamacare” ruling in the US — is inherently unpredictable. In addition, the European Union has consistently demonstrated that it tends to be slow to react, so this expectation of aggressive action is dangerous especially, given the elevated levels markets are sitting at after the summer rally.

Home for the Holiday

On the home front, Labor Day means a short week, and one with little in the way of new economic data. The main report to give a read on the state of the economy is the ISM manufacturing index due  Tuesday. The August report came in at 49.8, which was viewed as bad news, given that any reading under 50 shows economic contraction. A reading above 50 could validate this week’s revision upward to the second-quarter GDP report, but another monthly contraction could bring disappointment.

The other economic report to keep an eye on is the jobless claims report due out  Thursday. The most recent report of 374,000 new filers was flat with the previous week. Markets will be hoping for an improvement, though they may interpret a poor report as a positive if it works toward spurring the Federal Reserve to launch a third round of quantitative easing.

Overall, given the strong, but low-volume market rally this summer and the uncertainties around the ECB meeting, this week could  be a difficult one for the markets. Any policy missteps or disappointments could spur profit-taking, while it seems likely that a healthy dose of optimism and high expectations is already present in equity prices.

Tariq Hilaly is co-founder and chief investment officer of Motif Investing.