Europe has lost its ability to surprise
Last Friday global stock markets and the euro enjoyed their biggest one-day gains of the year. The S&P 500 jumped by 2.5 percent and the euro by 1.8 percent against the dollar. This Friday we will find out whether these moves were just a blip. Why this Friday? Because that is when the U.S. government publishes its monthly employment statistics – and these figures have more influence on global markets than anything that European leaders may or may not decide.
There are four reasons to believe this. The first is the very fact that Europe so dominates the news. Financial markets are not moved by events; they are moved by unexpected events. Once a story has appeared on newspaper front pages around the world every day for months, what are the chances that it will radically surprise? At this time last year, there was still widespread misunderstanding and complacency about the European crisis. The European Central Bank, for example, was so complacent that it was raising interest rates when it should have been cutting them. But today, investors and policymakers are obsessed with Europe’s grim prospects. A genuine surprise would have to be something much worse, or much better, than the scenarios market participants already know.
This observation leads to the second reason for shifting attention from Europe. For Europe to generate a favorable surprise that lasts for more than a few days or weeks is literally impossible. The market is too aware that for the euro to survive it has to go through a lengthy and uncertain process of political federation. But Europe’s capacity for negative surprise is quite limited too. Everybody knows that Europe is in deep recession, that Greece will never repay its debts, that Spanish banks are insolvent, that debtor countries will all miss their budget targets and that German-imposed austerity will prolong the recession for years. The only news from Europe that would shock the markets would be a total breakup of the euro and Lehman-style financial meltdown. Such a breakup is possible, but it isn’t yet the most likely scenario. Unless a breakup happens, Europe will create lots of volatility, but the trend in financial markets will be set by events elsewhere.
Which brings us to the U.S. and the third reason to shift attention. The U.S., unlike Europe, really does have the capacity to surprise. The U.S. economy is balanced on a knife-edge. In the months ahead, the U.S. could accelerate back to the fairly robust growth it enjoyed in the fall of 2011 and winter of 2012. If this happened, it would come as a big surprise to bond markets in the U.S., Germany and Britain, which are now priced for many years of Japanese-style stagnation. Alternatively, the U.S. economy could continue to weaken, as it has since April. In that case a double-dip recession would become increasingly likely – and stock market investors everywhere would be in for a shock.
So should we expect the U.S. to produce a bullish or bearish surprise? Nobody can say for sure – and that is the final reason to expect U.S. news to drive the markets. Because the U.S. is balanced so finely between expansion and recession, every statistical release can tip expectations in a significant way. Recent experience confirms this. Since late 2010, the sustained trends in global financial markets have been driven largely by U.S. statistics, especially the monthly employment reports. The unexpectedly strong employment report of Oct. 7 last year launched the 30 percent bull market that began that week – and the end of that powerful rally in early April exactly coincided with the shockingly weak employment report published on Apr. 6, a bearish trend that was then reinforced by bad employment figures on May 4 and June 1.
In short, Europe creates a lot of noise in financial markets, but the signal comes mostly from the U.S. Why then is the opposite impression so widespread? Partly because debating European politics is much more fun than drily dissecting U.S. statistics. But mainly it’s because the euro and global stock markets tend to move in the same direction from day to day. This daily correlation, which reflects the mood swings of short-term traders between risk-aversion and risk-seeking, creates the impression that Europe is driving financial markets around the world. But on anything longer than a daily basis, the euro and the global stock markets are not correlated at all. Think back to the start of the post-Lehman recovery in global markets, on Mar. 10, 2009. Since that day, when one euro was worth $1.26, it has gone exactly nowhere, while the S&P 500 has more than doubled and the MSCI world equity index has risen by 78 percent.
So where will stock markets move next? If the employment growth announced on Friday proves better than the expected 90,000, the global equity rally will probably gain momentum. If the payrolls disappoint, the rally will quickly fade. The euro, meanwhile, will remain a hostage to the European story, whose tragic futility brings to mind the famous lament from Macbeth about human life: “It is a tale told by an idiot: full of sound and fury, signifying nothing.”