Despite being a shortened holiday week, the U.S. equity market experienced elevated trading with a sharp spike in price volatility early on that faded as the week ended. Thanks to a 1.85% gain in the technology sector, the S&P 500® Index managed to finish the week with a fractional gain of 0.3%. Despite that small victory, the week witnessed both the financial and industrial sectors falling into negative territory for the year, on respective declines of 1.65% and 0.75%. The bulk of this week’s weakness in the financial group was attributable to the decline in interest rates sparked by the flight to quality over renewed fears of European financial instability. The decline in interest rates sparked fears that the Federal Reserve Bank would be forced to alter its plans, thus negatively impacting lending spreads for money center and regional banks. These fears abated as the week progressed, thanks to a reasonably positive 10-year Italian bond offering on Friday, and the replacement of a controversial candidate for Italian finance minister with one espousing more pro-Euro sentiments. The decline in U.S. interest rates led to a notable outperformance of growth stocks over value this week, as witnessed by the 1% gain for the Russell 1000 Growth Index and the 0.4% decline for the Russell 1000 Value Index. Capitalization was again a major factor this past week, as the S&P 600 Small Cap Index gained 1.04% to the S&P 100 Index gain of 0.36%. Negative currency translation again haunted international returns, as the MSCI EAFE® Index fell another 1.1%, and the MSCI Emerging Market Index slipped 0.56%. Despite the market turmoil, there were several positive economic data releases this week, as the Chicago PMI Index added 5 percentage points last month, and Friday’s employment data showed strength in hiring and wages.
One of the popular beliefs in modern finance is that markets are all-knowing and that prices reflect the sum total of available information. The following price graphs, the first of which is that of the yield on the Italian ten-year bond, and the second of which is a price graph for one of Toys-R-Us’ corporate bonds, show the sort of unexpected events we are on watch for and why. If we are not being adequately compensated, we will not participate in a given asset or asset class. The threat in both cases is not the obvious one; it is what comes next. For sovereign European debt, the ECB, like the Federal Reserve, will stand in the breach. As we experienced with the bursting of the Tech Bubble, what about the vendor financing? Northern Europe’s economic strength was built on exports to the countries of the south. How reliable will the credit ratings on that debt be? In the U.S. high yield corporate debt market, what assurances do we have of an orderly market should events unfold where one is needed? These are among the reasons we have recommended shorter maturity, higher quality bond portfolios for our clients.
Exhibit 1 (Source: Bloomberg)
Exhibit 2 (Source: Bloomberg)
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Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.
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