France’s left turn wreaks havoc on markets

Who knew one letter could push global capital markets into such turmoil so quickly.

The lonely letter “x” marked a clear message for Europe’s political leaders in last weekend’s elections. French politics moved decidedly to the left, which will likely create turmoil in the Franco-German relationship and the delicate balance between growth and austerity. In Greece, voters couldn’t exactly agree on what they wanted but they spoke loudly and clearly about what they did not want.

Voters are displeased with the government concessions made to EU lenders under the terms of their recent financial bailout. Greece’s inability to form a government suggests another election as early as June 17, which could further pave the way for an exit from the EU. Sources suggest Greek banks may be quietly preparing for an eventual return to the Drachma.

Not surprisingly, global stock markets were reminiscent of a roller-coaster ride last week as sentiment swung from despair to optimism. The week began with renewed European concerns, which were offset somewhat by a reassuring U.S. weekly jobs report, only to conclude with the release of very weak Chinese industrial production data for April.

The resource-heavy S&P/TSX lost 1.5% this week as crude oil, and in particular gold, sold off, with investors dumping bullion in favor of U.S. dollars. The S&P500 rebounded from a two-month low but still finished the week down. Noteworthy was a sharp slide in the shares of JP Morgan

Chase, which reported a surprisingly steep trading loss due to its poor judgment and lax risk management practices. Prior to Thursday’s news, JP Morgan shares had risen 23% this year.

As expected during a “risk-off” period, traders took comfort in holding U.S. treasuries, German Bonds (Bunds) and the U.S. dollar this week. The Canadian dollar followed the commodity-related currencies lower for most of the week, but the loonie shot back above parity on Canada’s April employment gains. After the best two months of job gains in more than 30 years, traders have now increased their bets of a Canadian interest-rate hike this summer.

The market has priced in a 42% likelihood of a rate increase and a 45% chance of no change at all by the September 5 policy-rate setting.

VOLATILITY A POOR PREDICTOR

A recent report out of Citigroup suggests investors seeking to judge what lies ahead for stocks may be better off ignoring the VIX index.

The Chicago Board Options Exchange Volatility Index (VIX) reflects a market estimate of future volatility for the S&P500 index, but has not been a very good predictive indicator for future stock-price direction.

More often than not, share prices are more likely to rise than fall in the 3-6 month period after a surge in the VIX. Even if the VIX was a more insightful indicator, it is so commonly watched that investors cannot gain an edge by following it. The index has ranged between 14 and 23 this year. As of Friday the VIX reading was just under 20.

Click below to read about the trading week ahead, and the impacts of the Greek election.

TRADING WEEK AHEAD

The size and the scope of the JP Morgan trading loss now has regulators scrambling, which means it will likely linger into next week’s trading. Greece is expected to form a government or call new elections by Thursday with either outcome likely to keep investors on edge.

Eurozone finance ministers meet in Brussels today with the Greek and Spanish situations likely to command considerable attention and debate. Sovereign debt auctions are expected to produce higher funding costs for both Italy and Spain.

With Spain having partially nationalized one of its banks last week, investors will closely watcg its funding costs.

On the economic front, U.S. Consumer Prices (PPI), Housing Starts and Industrial Production data should garner the most attention. April CPI should be flat for the first time in four months as gasoline prices appear to have stabilized, albeit at high prices.

The data will show price pressures at a 14-month low. U.S. Canadian CPI data (Friday) is expected to follow the same pattern as the U.S. data. Housing starts could surprise to the upside with the greatest number of new homes being built since last year.

Industrial Production is expected to have had a broad move higher in April after being flat for the past three months. Gains in Mining and Manufacturing should account for the revival. The April FOMC statement contained only minor changes in its language as it balanced an improved labor market against higher energy prices.

The Fed’s tone was little changed from its March statement. The minutes of the April meeting will likely hint at tensions between the six committee members who believe an initial rate hike before 2014 is appropriate and the remaining 11 participants looking for a tightening in 2014 or later.

Earnings are scarce next week, but a couple of significant retailers are due to report. Home Depot, JC Penney, and Ross Stores results will give investors some insight into how consumer behavior has held up post 2011 holiday season.

QUESTIONS OF THE WEEK

Following the indecisive outcome of Greek elections, many clients have raised questions about the Greek political process, her immediate funding needs and whether Greece will remain a member of the European Union.

The election outcome adds to an already uncertain future for Greece. The two main parties gathered only a third of the votes cast. No party garnered more than 20% of the votes and 7 parties made it to parliament.

Efforts are underway to form a coalition but the New Democracy (centre-right) and the SYRIZA (leftist) parties have so far failed to do so, meaning it is now up to the PASOK (socialist) party to forge a deal. If a deal cannot be struck by next Thursday, new elections will follow, with June 17 the most likely date.

In our view, a new round of elections is the most likely outcome, meaning an interim government without legislative power will be put in place ahead of new elections. On May 10, the EU made a €5.2B payment per the terms of the bailout which will help finance a series of Greek debt maturities over the next week or so.

Beyond that, any further payments by the EU will depend of the evolving political situation in Greece at the time.

Regardless of who forms the next Greek government, all of the parties have indicated they would like to renegotiate the terms of the EU bailout package. The range of renegotiations may be as little as introducing more pro-growth measures to abandoning the terms all together. The EU appears willing to discuss allowing more pro-growth policies but it seems unlikely Greek creditors would accept a unilateral decision to abandon the program altogether.

Clearly, there is a great deal of uncertainty around the political situation in Greece. The new government (when formed) must find a way to maintain the interests of its EU creditors in order to keep the stream of financing in place, but they also must boost pro-growth measures in order to appeal to the Greek population now stunted by austerity measures. No easy task.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP