Week Ahead: Outlook for Stocks Volatile, with Headwinds
Choppy, with political headwinds and chillier credit conditions, is the forecast for stocks in the week ahead.
Markets come off a volatile week that saw heavy selling and violent swings in risk assets of all types. Investors piled into the safety of U.S. government bonds, pushing yields sharply lower. Spreads between Treasurys and other credits, like investment grade and high-yield corporates, mortgages and emerging markets all widened, and the closely watched London interbank offered rate (Libor) continued to creep higher.
Currencies called the tune, as the euro swooned to a 4-year low and then recovered to $1.2574 Friday, gaining 1.5 percent against the dollar for the week.
Stocks officially crossed into correction territory Thursday for the first time since the 14-month rally began. For the week, the Dow lost 426 points or 4 percent, to end at 10,193, while the S&P 500 shed 47 points, or 4.2 percent to 1087. The Nasdaq lost 5 percent of its value, or 117 points to 2229.
"I think it's going to be more stable this week, but relative to most weeks this year, it will be a volatile week, and we'll probably get a move in both directions," said BlackRock Vice Chairman Bob Doll.
"The question is do all of the confluence of events, meaning monetary tightening fears; the credit issues from Europe and political issues in the U.S., do they overwhelm the cyclical recovery? Or are we still having a recovery? My bet is the latter," said Doll.
Doll said he expects the heightened volatility to remain for now, and he would rethink his view on the recovery if stocks head much lower. But, he also said it's possible stocks may have gotten close to a near term bottom.
"The correction from a 'point' standpoint could be pretty much finished, but we could still bounce around and take some time for investors to get conviction again," he said.
What to Watch
In the coming week, the Treasury will auction $113 billion in 2-year, 5-year and 7-year notes Tuesday through Thursday. Markets will on alert for headlines related to the European sovereign debt crisis and U.S. financial regulatory reform. There will also be interest in news from China, where U.S. Treasury Secretary Tim Geithner and other officials attend the Strategic and Economic Dialogue Summit.
There's a long list of economic reports on next week's calendar including housing data, but most of it could be overshadowed by the behavior of financial markets themselves. Economists are increasingly worried that the searing decline in risk assets, and the parallel creep up of rates in the interbank lending market and the widening of other credit spreads will have a negative effect on the economic recovery.
The renewed chill around credit markets, and the steep decline in risk assets bears watching, according to Citigroup economist Steve Wieting. Compared to late 2008 when markets reacted to the collapse of Lehman Brothers, the cooling off of credit markets is mild, more like a light frost. Wieting notes also that the underlying economy is not on the same path of decline it was on at that time.
"It's pretty clear to us...that financial conditions lead demand in the economy, which then leads production, employment and investment," he said. "The fact we have employment gains now has been building for over a year, and basically confirms the upturn in easing financial conditions and the improvements in profits."
"There's a lot of speculation about right now, and the imagination goes wild. The actual dislocations thus far have not, to date, been monstrous. A 10 percent stock market correction is not a 50 percent correction," he said.
Wieting said, however, the shift in financial markets have changed the outlook for many investors who thought the economy would outpace expectations. ""It's been an amazingly swift revision to expectations," he said, noting that there is now more risk to the downside for economic forecasts. "What is important is just a few weeks ago it seemed that the balance of risks were to the upside."
Nomura Treasury strategist George Goncalves said in addition to the $113 billion in notes auctions, the bond market is also focused on interbank lending rates and other signs of stress.
"Next week, as long as it's steady and we don't have these violent moves like we did this week, if things stabilize, then it could be a good scenario for both (bond and stock) markets. But it's still too early to call that conclusion. I'm still betting the funding markets aren't operating properly. I still think there's another shoe to drop in the European banking system," he said. Goncalves said 3-month Libor/OIS has gone from a low of 0.8 to 0.27 in the past month, and it continues to rise.
"The rating agencies haven't downgraded the European banking system, but the rate markets have because libor keeps going up," he said. "There's a premium European banks are paying to get access to dollars, and that's been the case since August, 2007 and it hasn't gone away. It's a relic of the credit crunch and it's just coming back to the fore."
Kevin Ferry of Cronus Futures Management said, however, the moves in credit markets were to be expected and are not that extreme. "There is no funding problem for dollars or euros in the world today. It's just not there...You see the market, from a timing perspective, is making adjustments and moving toward a new world," he said.
"If the credit spreads were getting any worse, we would think they were getting out of hand...I think it's going to die down," he said. Ferry said he thinks high yield and other credit markets will stabilize and the low yields of the summer for Treasurys will be seen within the next few weeks. "That's going to correspond to stability in the risk markets and in the funding markets," he said.
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Besides housing data, Thursday's weekly jobless claims, which disappointed this past week, will be closely watched. Claims were reported this past Thursday at 471,000, up 25,000. "There's not a good explanation for it...had we not had four consecutive weekly declines right behind it, we would be very concerned...If we had several weekly rises in claims, I'd be very concerned," said Wieting.
The first housing report in the coming week is Monday's existing home sales. Tuesday's release is the S&P/Case-Shiller home price index, and on Wednesday, new home sales are reported.
Other data includes consumer confidence on Tuesday; durable goods Wednesday; and a second look at first quarter GDP Thursday. On Friday, there is personal income, the Chicago purchasing managers survey and consumer sentiment.
China will also be an important focus in the coming week. Given the moves in currency markets, China is now unlikely to make any move to allow its currency to appreciate, as foreign exchange strategists had previously expected.
"I do think there will be trade concessions, but I don't think there'll be much on the currency. China exports more to Europe than it does to the U.S., and commodity prices suggest that China won't be experiencing inflation for very long, so why would China move on its currency when its export outlook is challenged and the outlook for inflation is tame," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.
A major worry in markets has been that China will be too successful slowing its growth engine, as its tightens bank lending and takes other steps to slow down. The impact from a slower Europe on China has also been a concern.