For Better or for Worse
Markets in Europe and China also showed their reliance on the behavior of central banks—but it remains clear that this can be either good or bad.
Last week saw European stocks struggle, as investor sentiment is increasingly driven by the tenuous situation in Greece. With a 1.5 billion euro payment to the International Monetary Fund due on June 30, and funds flowing out of the Greek banking system, the window for reaching a resolution is closing. Progress has been made on certain issues, but differences remain on Greek pension reform—a critical topic given that the pension system represents an astounding 16% of Greece's gross domestic product.
The European Central Bank (ECB) has stepped in to manage the risk of outflows from the Greek banking system. Last week the ECB raised the ceiling on its emergency liquidity assistance facility, the mechanism that is providing liquidity to Greek banks in the face of exiting deposits. But even this may not be enough. In the absence of a more comprehensive political settlement, there is a growing likelihood that the Greek government will need to resort to some form of capital controls, perhaps as early as this week.
That said, investors should not equate the imposition of capital controls with a Greek exit from the euro. We continue to expect that a solution, albeit a temporary one, will be found. In addition, by providing liquidity to the broader eurozone (in the form of its monthly bond-buying program), the ECB is helping to limit the scale and duration of any contagion related to events in Greece.
Finally, there is China, where last week equity markets entered correction territory. Exchanges in both Shanghai and Shenzhen were down roughly 13% on the week. While there was no single catalyst, the loss of momentum is mostly a reaction to a crackdown in margin lending and an expected surge in IPO supply.
This comes after a more than 130% year-over-year increase in equity market valuations, largely driven by liquidity and central bank actions. The upshot is that Chinese stocks are likely to continue their ascent only as long as the authorities are willing to provide significant monetary stimulus.
The key takeaway for investors is that even as the Fed starts to normalize U.S. rates later this year, markets will still be benefiting from historically low rates and aggressive monetary stimulus from most of the world's central banks. For better or worse, we're still in a world in which market returns are heavily influenced by what central banks are doing, saying and even thinking.
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