While this week brought us some influential manufacturing and employment data out of the U.S., the driver of the capital markets continued to be Europe. The week had a dreadful start as fears continued to escalate that European governments were ill prepared to deal with the potential fallout from a sovereign debt default, namely Greece.
These fears pushed volatility higher as investors did not know what European governments would do if capital levels amongst banks declined and access to capital disappeared. That is, until rumours started to emerge late on Tuesday that perhaps European finance ministers were in fact working on such a plan, although such rumours still have yet to be confirmed.
Regardless, the idea that something in Europe was actually being done to help solve either the credit crisis or its potential fallout provided some encouragement to the markets that European officials would be able to manage a sovereign default or any other direct or indirect financial shock.
While buyers returned to the market mid week, the strength of the buying disappeared on Friday as response plan rumours have yet to materialize. Crossing back over the Atlantic, we did actually have a decent week of economic data in the United States relative to expectations. The ISM Manufacturing and Non-Manufacturing Indices both came in higher than expected and today’s employment reports in both Canada and the U.S. provided a positive surprise.
However, the market remains unimpressed by the rate of job creation in the United States which needs to accelerate materially in order to make up for the close to 7 million jobs that still remain lost from the last recession. Commodity prices continued to feel selling pressure as the global economic outlook remains challenging and precious metals were still held back by investor determination to seek out the U.S. dollar thanks to the ongoing financial uncertainty in Europe. This pressure also held back the Canadian dollar which could only manage a marginal gain after last month’s steep decline.
The trading week ahead
Europe was the focus this week and we do not expect that focus to change as we move further into October. In fact, Europe will likely remain top of mind until we get to the G20 meetings held in France at the beginning of November.
However, we are about to begin third quarter reporting season in the U.S. next week as Alcoa will kick things off as usual on Monday. JP Morgan Chase will set the tone for financial earnings while Google will give us an idea of what we can expect from the Technology sector.
We are not expecting many economic releases in the week ahead, but we’re sure the Federal Open Market Committee (FOMC) Minutes will get some attention on Wednesday even though nothing new will likely be revealed and U.S. retail sales on Friday will give us an idea if Americans are growing their economy by hitting the shops or saving their money at home.
Canadian markets will remain quiet for a number of reasons as economic data flow is light, earnings season won’t kick off until later in October and markets will be closed on Monday for the Thanksgiving holiday. Seeing that we probably won’t see much movement on the problems facing Europe next week, the U.S. dollar should be able to maintain its recent strength. This means we may not see too much activity in commodity prices unless U.S. corporate earnings far exceed expectations and investors become more positive about the longer term global economic outlook.
Question of the week
What on earth caused such wild mood swings with the market this week? It seemed like the Monday and Tuesday told a very different story than Wednesday and Thursday.
Yes, we would agree, this week has certainly had its share of rallies and declines. It would be easy to have short answers to explain these moves such as “increased volatility” or “uncertainty”, but those answers then lead to the question of “why” yet again. If we dig deeper, we believe this week illustrated how the market reacts to the “European problem” in different ways and we feel it necessary to explain to our clients why these different reactions exist.
First, we must make the distinction between 1) European sovereign debt and 2) exposure to European sovereign debt. For almost two years now, you have heard about the national debt problems of various countries such as Greece, Ireland, Portugal, Spain and Italy. Simply put, these countries have spent more money than they’ve brought in and the debt levels are so big now that there are questions as to whether or not that debt can be repaid. This is nothing new to the market as we’ve known about these problems for a while now, but, more importantly, we are “certain” about the actual value of debt involved. For the most part, the market knows how much debt is outstanding, it knows how much new debt will cost, and it knows how likely repayment will be in a country like Greece which at this point is remotely small.
However, what the market does not know, and where the uncertainty lies, is what the impact to the market and financial system will be if one of these countries defaults. Most government debt information is easily available to the public; however, sovereign debt owned by banks or other corporations may not be so readily accessible. What would happen to European banks owning Greek debt if Greece actually defaults? If we have an idea of the impact on one bank, will it affect any other banks that don’t have direct exposure to that debt? Will cash levels and liquidity dry up? Will higher borrowing costs choke economic growth further?
These are all questions that leave us “uncertain” because we do not know exactly what will happen, nor do we have exact figures to work with. So when thinking about Europe’s problems, remember there is a difference between sovereign debt and exposure to that debt from a market perspective.
The beginning of this week was squarely focused on the “exposure” issue as the market was concerned that European countries did not have a plan to recapitalize their banks if Greece defaulted. However, as rumours started to emerge that a possible plan may be in the works, the market became more comfortable that the financial system would survive such a shock.