Download Stocks Volatile in Near-term with Greek Election Uncertainty, Euro

June-July 2012
By John Praveen, Chief Investment Strategist of Prudential International Investments Advisers, LLC.*
Financial Market Outlook: Stocks Volatile in Near-term with Greek Election Uncertainty,
Euro Exit Risk & Contagion Fears. Central Bank “Put”, Cheap Valuations & Healthy
Earnings Likely to Lift Stocks if Greece Averts Eurozone’s Lehman Moment
Greek Fears & Spanish Bank Concerns Push Bond Yields to Record Lows. Yields Likely to
Rise as Fears & Uncertainty Ease
John Praveen’s Global Investment Outlook – June-July 2012 expects global stocks to remain volatile ahead of
the June 17 Greek elections as markets brace themselves for the worst case outcome of Greece exiting the
Euro and contagion to the rest of Eurozone. Further, the initial euphoria of the Spanish bank bailout has given way
to concerns about the adverse impact of the bank bailout on Spain’s debt level, and the potential need for a bailout for
the Spanish sovereign. These risks are likely to keep markets volatile in the near-term. However, stocks are
supported by interest rate tailwinds with "Draghi-Bernanke “put” in place, modest improvement in macro
outlook, very attractive valuations and healthy earnings outlook. In the near-term, these positives have been
overshadowed by the Eurozone crisis Déjà vu.
Bottomline: If Greece manages to avert the worst case outcome on June 17 and remain in the Euro, the
interest rate and liquidity tailwinds, cheap valuations, improving macro and earnings outlook should enable
stocks to enjoy a relief rally - albeit brief.
Global bond yields fell to record low, unsustainable, levels on Greek Euro exit and contagion fears, and global growth
concerns. However, yields are likely to rise from these unsustainable lows unless the June 17 Greek election
results in Eurozone’s Lehman moment. With a “muddle-through” a more likely outcome, bond yields are likely to
rise. However, the rise in yields is likely to be limited by continued safe haven demand from uncertainty in Eurozone
(even if Greece exit is averted), lingering concerns about global growth and central banks easing bias.
Market Outlook: Greek Euro Exit Risk & Contagion Fears Casts Shadow on Stock Markets
Despite Interest Rate Tailwinds, Attractive Valuations & Healthy Earnings
Stock Market Outlook (June-July): Equity markets plunged in May almost wiping out the Q1 double digit gains
leaving most markets in the red for the year. Stock markets fell sharply in early May as the worst case scenario
materialized in the Greek elections raising the risk of a disorderly Greek exit from the Euro and contagion to the rest of
Eurozone. Further, in France, a new socialist regime was voted to power raising questions about French domestic
policies, Franco-German partnership and French role in dealing with the Eurozone crisis. In addition, the attack on
Spanish banks intensified as it became increasingly clear that the banks had to be recapitalized while Spain was
holding back from asking for a bailout. Finally, concerns about China slowdown and its global impact, and some
disappointing U.S. data also weighed on markets, pushing stocks lower and bond yields to record lows. The
Developed Market index (MSCI World) fell -9% (in US$) in May wiping out Q1 gains, taking YTD returns to
negative -0.4%. EM stocks fell -11.7% (US$) in May to take YTD returns to -1.1%.
Looking ahead, global stock markets remain nervous in the run up to the June 17 Greek re-election and brace
themselves for the possible worst case outcome of Greece exiting the Euro and contagion to the rest of the periphery
and to Spain and Italy, and/or prolonged uncertainty in Greece. Further, the initial euphoria of the Spanish bank
bailout has given way to skepticism about Spain’s fiscal health and the negative impact of the bank bailout on the
Spanish national debt. These risks are likely to keep markets under pressure and volatility high in the near-term,
despite central bank “puts” in place, improving macro outlook, very attractive valuations and healthy earnings outlook.
1) Greek Re-elections in June and Risk of Euro Exit: Greece is set to have a second election on June 17 as the
May 6 election resulted in a hung parliament with no party securing a majority or able to form a coalition. The June 17
election is likely to be a referendum on whether Greece stays in the Euro and the stakes could not be higher.
The two major parties (the centre-right New Democracy and centre-left Pasok) which are pro-Euro and had given
*Prudential International Investments Advisers, LLC. (PIIA) is a business of Prudential Financial, Inc., (PFI), which is not affiliated in any manner with
Prudential plc, a company headquartered in the United Kingdom. For Informational Use Only. Not Intended As Investment Advice. See “Disclosures” on the
last page for important information.
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June-July 2012
written assurances to the EU/IMF about implementing the austerity measures secured just 32% of the vote between
them in the May election. While opinion polls show that 78% of Greeks want to remain in the Eurozone and
keep the Euro, less than 40% support the two major pro-Euro parties (the ND and Pasok). On the other hand,
the anti-Euro, radical Syriza party, riding a wave of popular resentment against the austerity measures, did
surprisingly well in the May election is expected to gather around 20% of the vote in June 17 election. The Syriza
party has vowed to cancel the austerity program if elected to power which is likely to lead to suspension of loan
disbursements and drying up of funding for Greece. Further, deposit outflows are raising concerns about bank
liquidity and the increasing dependence on Eurozone/ECB funding.
The outcome of the June 17 elections - and the result in this episode of the Greek drama - remains uncertain.
Many Greeks still seem to be under the illusion that Eurozone is bluffing and will continue to bail-out Greece and keep
it in the Euro, even if Greece rejects the conditions of the bailout. If the pro-Euro parties (ND and Pasok) fail to
muster enough support to form a coalition in the June elections and the radical left Syriza party and other
anti-Euro, anti-austerity parties secure a majority, the risk of a disorderly Greek exit from the Euro increases.
In addition the risk of contagion to other Eurozone markets, especially Spain and Italy, and collateral damage
to Eurozone banks could push Eurozone over the cliff and plunge the global economy into another recession.
Even if the worst case scenario (Greek exit) does not materialize on June 17, there is likely to be a extended
period of uncertainty as the political parties jockey for power and the new government is likely to haggle with
the EU/IMF/ECB of some relaxation of the austerity conditions for the bailout and ask for more time to get
their fiscal house in order.
2) Spanish Bank Bailout Fails to Ease Market Concerns – Bailout Worsens Debt Ratio: Concerns about Spain’s
fiscal health and the condition of its banks have been festering for the past several months with a negative feedback
loop between the economy in recession, fiscal consolidation and the banking system struggling with non-performing
loans and high funding costs. Fears about the health of Spanish banking system intensified following the injection of
€19bn into Bankia, the country’s fourth largest bank, in May. In addition to the problems in the banking sector, recent
Spanish economic data has been very weak with GDP down -1.3% in Q1 and unemployment remaining at 24%.
Growing concerns about the potential costs of bank recapitalization have kept markets struggling in May.
In early June, Spain warned that it was locked out of capital markets, adding to fears that the fourth largest Eurozone
economy will default on its debts. The Spanish10-year bond yield spiked to over 6.5% in late May from under 5% in
early March. Despite the turmoil, Spain refused to request for a bailout due to “national pride”. However, a few days
later, the Rajoy government caved in to pressure, threw in the towel and announced that it will seek financial
assistance from the European Financial Stability Fund (EFSF) to recapitalize its banking system. On June 9,
Eurozone finance ministers offered Spain a €100bn loan to support Spanish banks. This is well above the IMF
estimates that Spanish banks will require between € 40 and 80bn in capital, depending on the additional capital buffer.
Markets initially rallied on the big Spanish bank bailout package but the rally fizzled as markets realized that
the bank bailout will add to the public sector debt and worsen the debt/GDP ratio. The bailout funds cannot be
injected directly into Spanish banks but have to be channeled from the EFSF through the government entity, the
Spanish bank restructuring agency (FROB) established to clean up the Spanish banking system. General government
debt in Spain has risen from just 40% of GDP in 2008 to almost 80% in 2012. The IMF estimates general
government debt will reach 89% of GDP in 2015, even before accepting the bailout. Spain was already on an
unsustainable fiscal path. The bank bailout is expected to increase the country’s debt to GDP ratio by around
10%. However, one positive element of the bailout was that there was no austerity related conditionality attached to
the loan but a focus on financial sector reforms, which should provide some breathing room and avoid pushing the
economy deeper into recession.
While the Greek election uncertainty and Euro exit risk has once again raised tail risks of a disorderly Euro break-up
and global recession, the interest rate, macro, earnings and valuation fundamentals remain favorable with: 1) Interest
rate and liquidity tailwinds with low rates and further rate cuts; 2) Modestly improving growth outlook in the U.S. &
Japan; 3) Attractive valuations, and 4) Healthy earnings growth.
1) Interest rate tailwinds and central bank “put”: Stocks remain supported by low interest rates and liquidity. The
ECB, the BoE and Fed have signaled that they stand ready to undertake further easing measures in response to the
worsening Eurozone crisis and prevent contagion in case of a potential Greek Euro exit. Further, growth
For Informational Use Only. Not Intended As Investment Advice.
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disappointments in the U.S., weak growth in core Eurozone and recession in the Eurozone periphery and the U.K.,
are likely to prompt policy response from the developed central banks. For now, the Fed and ECB are keeping their
powder dry and putting pressure on policy makers to do their part to address the Eurozone crisis and U.S. fiscal
challenges. Emerging central banks continue to ease policy/cut rates as another flare-up of the Eurozone crisis and
slower China growth poses risks to these economies which are already experiencing domestic slowdown.
2) Improving Growth Outlook: The growth outlook in the U.S. and Japan continues to improve. Japan posted a solid
Q1 rebound and remains on track for healthy growth in Q2. The U.S. economy remains on a moderate growth path
with Q2 GDP on track to improve to around 2% from the disappointing Q1 GDP reading. However, in Eurozone the
outlook remains weak as the renewed Eurozone crisis threatens to push the periphery – especially Greece and Spain
- even deeper into recession and likely to drag down core Eurozone growth which surprised on the upside in Q1. In
the emerging economies, GDP growth is likely to have bottomed in Q1 and appears on track to improve in H2 in
response to interest rate cuts and relief to consumers from lower oil prices.
3) Stocks Cheap - Attractive Valuations: With equity markets falling around 10% in April-May, market multiples fell
sharply to levels seen at the end of 2011. Developed Markets P/E multiple fell to 13.4X in May from 14.6X in April.
The current P/E multiple is close to 2011 low of 13.2X and the 12.3X multiple at the trough of the financial crisis in
Match 2009. Markets are trading at multiples well below the long term average of 17.9X. Stocks have become even
cheaper relative to bonds. The gap between stock and bond yields widened significantly in May with a sharp rise in
stock yields (with falling P/E) and a plunge in bond yields.
4) Healthy Earnings Outlook Despite Weakness in Eurozone Earnings: The Q1 2012 earnings results surprised
on the upside in the U.S. but were weaker in the Eurozone and Japan. Global earnings are likely to be adversely
impacted by the European recession. However, GDP growth remains moderate in the U.S. and solid in Japan, while
growth is expected to recover in emerging economies in H2. Earnings in 2012 are expected to rise around 8% in the
U.S., 9% in Emerging Markets, around 8% in Japan, 4% in Eurozone and 1% in U.K.
Bottom-line: Stocks plunged in April and May to almost wipe out the double digit gains in Q1 as worst case
outcomes in Greek and French elections and Spanish bank woes roiled global stock markets.
Stocks remain volatile ahead of the June 17 Greek elections as markets brace themselves for the worst case
outcome of Greece exiting the Euro and contagion to the rest of the periphery and to Spain and Italy. Further,
the initial euphoria of the Spanish bank bailout has given way to concerns about the adverse impact of the
bank bailout on Spain’s debt level, and the potential need for a bailout for the Spanish sovereign. These risks
are likely to keep markets under pressure and volatility high in the near-term.
However, equities are supported by interest rate tailwinds with Draghi-Bernanke “put” in place, modest
improvement in macro outlook, very attractive valuations and healthy earnings outlook. In the near-term,
these positives are overshadowed by the Eurozone crisis Déjà vu.
If Greece manages to avoid the worst case outcome in the June 17election and remain in the Euro, the
interest rate and liquidity tailwinds, cheap valuations, improving macro and earnings outlook should enable
stocks to enjoy a relief rally – albeit brief.
Bonds: Bond Yields Likely to Rise after Sinking to Record Lows on Risk Aversion. Rise in Yields Limited by
Safe Haven Demand & Central Bank “Put”
Global bond yields are likely to rise from the current unsustainably low level unless the June 17 Greek election results
in Eurozone’s Lehman moment with a disorderly Greek exit and contagion that could push the Eurozone and the
global economy into another recession. However, with the extreme scenario less likely and a “muddle-through” a
more likely outcome, risk aversion is likely to decline pushing bond yields higher. Further while the growth outlook
remains weak in Eurozone, the growth outlook is improving modestly with GDP growth in the 2 to 2.5% range in the
U.S. and Japan. GDP growth is also on track to improve in the Emerging Economies with rate cuts and the relief from
lower oil prices. However, the rise in bond yields is likely to be limited by continued safe haven demand from
uncertainty in Eurozone (even if Greece exit is averted), lingering concerns about global growth and central banks
maintaining an easing bias.
For Informational Use Only. Not Intended As Investment Advice.
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June-July 2012
Investment Strategy: Remain Neutral on Stocks with Greek Uncertainty. Tactically Reduce
Bonds to Underweight with Yields at Unsustainable Lows
Asset Allocation: Stocks vs. Bonds
Stocks - Tactically Remain Neutral: Stocks remain volatile ahead of the June 17 Greek elections with risk of
disorderly Greek exit and contagion. Markets skeptical of Spanish bank bailout. However, stocks are supported by
central bank “put”, very attractive valuations and healthy earnings outlook. These positives should help stocks have a
relief rally if Greek Euro exit is averted on June 17. Keep stocks at Neutral on Greek uncertainty but position for
a Greek relief rally.
Bonds - Tactically Reduce to Modest Underweight: Global bond yields are likely to rise after falling to
unsustainably low levels during April-May due to Eurozone fears. With a disorderly Greek exit less likely, yields are
likely to rise from current record lows. Improving growth outlook in the U.S. and Japan is also expected to put upward
pressure on yields. However, rise in yields limited due to continued safe haven demand from ongoing Eurozone
uncertainty, lingering growth concerns, and central banks easing bias. Tactically reduce bonds to modest
underweight with yields at unsustainable lows.
Global Equities:
 Modest Overweight Japan & Emerging Markets
 Reduce U.S. to Neutral
 Remain Underweight Eurozone & U.K.
Global Bonds
 Remain Overweight Eurozone Bonds & U.K. Gilts
 Reduce JGBs to Underweight
 Remain Underweight U.S. Treasuries
Global Sectors
 Overweight: Industrials, Information Technology, Consumer Discretionary
 Neutral: Energy, Financials, Healthcare, Telecomm and Consumer Staples
 Underweight: Materials and Utilities
Currencies
 Overweight: U.S. Dollar;
 Neutral: EM Currencies, Yen; Underweight: Euro and Sterling
The U.S. Dollar is likely to remain firm against the euro and sterling but range-bound against the yen. The ongoing
sovereign debt crisis in Europe with fears about a Greek euro exit and contagion to other Peripherals and Spain and
Italy, and lingering concerns about Spanish banks are likely to keep the downward pressure on the euro. The sterling
is likely to remain weak driven both by the European crisis as well as its weak economic outlook and the possibility of
additional asset purchases. The yen is likely to remain range-bound with strength due to safe haven demand offset by
BoJ’s asset purchase program. The near-term outlook for EM currencies is neutral with weak investor risk appetite
resulting in sharply lower demand for EM assets offset by relatively solid GDP growth.
For Informational Use Only. Not Intended As Investment Advice.
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June-July 2012
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For more information contact: Lisa Villareal: 973-367-2503, [email protected]
Disclosures: Prudential International Investments Advisers, LLC. (PIIA), a Prudential Financial, Inc. (PFI) company, is an investment adviser
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For Informational Use Only. Not Intended As Investment Advice.
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