Jeff Hochman takes a technical analysts’s look at the developing situation in the euro zone.
With US data more reassuring lately and worries about a hard landing in China lessening, the worsening of the eurozone sovereign debt crisis fuels market concern.
The market position we are at today has parallels with 2000 and 2007, when global equity markets topped and signalled the start of global recession. If these events play out again, we could go significantly lower.
However, while this scenario is clearly a big risk, it is worth remembering that it is not certain to materialise. For such a result to become more likely, we would first have to see a break below the summer 2010 market lows, especially in the UK and US. To date, the eurozone is the only region that is trading below these levels and is therefore already technically in bear market territory.
The key driver of European equity weakness has continued to be the region’s banks, many of which reached new lows recently. Looking back to 2008–09, it is easy to recall that it was the governments that were forced to rescue the region’s banks. This time however, in an ironic reversal, it is the banks’ holdings of EU member country sovereign debt that is causing problems, along with the associated threat of a eurozone recession and the negative effects of forced deleveraging.
The glass half full It is always possible to find some positives amid the gloom. From a technical perspective, periods of elevated pessimism do not last forever and tend to be followed by some kind of bounce back, at least in the short term. Moments of extreme pessimism are also exactly what contrarian investors look out for on the basis that history shows these periods to be excellent times to invest.
Finally, perhaps the single most supportive non-technical factor for European equities at present is that they appear cheap in terms of key measures such as price-earnings, price-to-book ratios and dividend yields.
In the bond markets, eurozone government yields have dominated market attention in recent months with rising yields. The problem with rising yields is that they raise actual financing costs for governments, which raises further concerns about credit quality, in turn pushing yields even higher to create a vicious circle.
Mounting concerns about credit quality in the eurozone sovereign debt markets have led to a generalised increase in investor risk aversion that has also affected other types of assets. This includes high-yield corporates, where yields have picked up significantly in the past few months. Although price movements have naturally been less severe, the fallout of the eurozone sovereign debt crisis has also been evident in the investment grade sector. This is despite the fact that corporate fundamentals have remained solid, with no discernable pick-up in corporate default rates as of yet.
Looking ahead, the situation is likely to remain challenging in both equity and bond markets until we get more tangible progress on the dominant issue of the eurozone sovereign debt crisis. The EU summit was widely been seen as step in the right direction, but the markets will continue to look for more progress.
Jeff Hochman is director of technical analysis at Fidelity Worldwide Investment
