As has been the case for several years, the beginning of summer exhibited a rise in market volatility, triggered by geo-political concerns. In 2014, paranoia over an Ebola pandemic contributed to general market weakness. This year, Greece has captured the spotlight in a slow moving drama that some argue will inevitably end in tragedy. Facing near certain default and possible expulsion from the European Union, the Greek government and European officials continue to negotiate on debt restructuring and austerity measures.
The US exports a mere $770 million to Greece, and Greece contributes only 0.4% to global GDP. Thus, as a factor in the global economy, Greece is rather insignificant. Moreover, Greece has a history of financial crises and has defaulted on its debt in the past. The market’s reaction, therefore, is a bit surprising when the economic significance of Greece is considered in its proper context.
There are market commentators that persist on drawing comparisons between Greece and the Lehman bankruptcy in 2008, which are, in our view, misplaced and misleading. The markets were not given time to prepare for the sudden and surprising collapse of Lehman. Additionally, Lehman served as counter party on thousands of derivatives contracts. By way of contrast, Greece’s dire economic situation is the equivalent of a train wreck moving in super slow motion. Current developments should not be a surprise to anybody that has been following events of the past four years.
The European Union suffered its first existential crisis in 2011. At that time, the region was still recovering from the Financial Crisis. The US stock market corrected 18%, peak to trough, in part because of the uncertainty with Europe. Unlike our Federal Reserve, the European Central Bank failed to aggressively implement monetary stimulus, which effectively destined the region to lag the US in terms of recovery. Economies in Europe such as Ireland, Italy, Spain, Portugal, and Greece were all quite weak and vulnerable. Concerns over contagion (i.e., the prospect of weakness in one country spreading to others through trade and the banking system) were, therefore, well founded at the time.
Today, Europe has joined the US and Japan on the path to economic growth. As indicated by the credit markets, the prospect for contagion among the peripheral European nations is much less pronounced, and it appears the market believes the Greece situation, to the extent conditions worsen, will remain contained. Nevertheless, we eventually expect a satisfactory resolution because Greece’s importance to Europe extends far beyond economics. Geo-political considerations, including its participation in NATO, suggest the European Union will eventually affirm the importance of Greece to the region.
Events in Greece have overshadowed solid economic trends in the US. Most notably, the housing market is beginning to accelerate, and labor markets continue to improve. A strengthening economy is confirmed by the fact that the Fed is expected to raise policy rates later this year, an action that should be viewed positively. Yet, people associate a shift in policy as a negative as tighter monetary conditions are associated with market volatility. The Fed has been very deliberate and measured when raising rates, and historically, the stock market continued rising until the Fed approached the end of the tightening cycle. That suggests rate increases, should they prove a sufficient catalyst for a stock market correction, are a late 2016 or 2017 concern, at the earliest. Despite the Fed’s effort to “normalize” interest rates, we expect interest rates will remain relatively low for an extended period of time.
Perhaps the greatest concern with respect to the US stock market is that it has not experienced a sizable correction in some time. This is a technical argument that suggests a correction is “overdue”. As yet, there is no fundamental basis for this concern. Valuations are reasonable, with expectations for earnings growth in the second half of the year. More important, general market sentiment is profoundly negative. Counter-intuitively, if every investor were unambiguously positive, we would have greater concerns as that would suggest there was prevailing complacency about risk. To the extent market volatility persists, there is a risk that a loss of confidence could spill over to the broad economy through a reduction in consumption. With low oil prices, a strong Dollar, and a strengthening labor market, however, we actually expect economic activity to pick up during the summer and fall.