Kristina Hooper, CFP®, CIMA®, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The market’s reaction to world events can be hard to predict, but market volatility is hard to ignore.
US investors went on an emotional roller-coaster ride last week: A comedian’s strong showing in Italy’s inconclusive elections caused angst in America; the sequester and worse-than-expected gross domestic product (GDP) news barely registered; and Fed Chairman Bernanke’s latest comments soothed.
But the key takeaway was the jump in volatility as stocks fell early in the week. The CBOE Volatility Index (VIX)—widely known as the “fear index”—rose 34% to 19.18 on Feb. 25, its largest one-day percentage increase since August 2011.
Yet it wasn’t concern about the lack of a deal on the “sequester” that sent fear higher and stocks lower—or even worries about revised fourth-quarter GDP numbers, which came in below expectations. Instead, what troubled the markets was the uncertainty created by the elections in Italy.
Surprise No. 1: Italy’s Inconclusive Elections a Concern for US
In Italy last week, no candidate garnered enough votes to be elected prime minister. What’s more, anti-austerity comedian and blogger Beppe Grillo beat out incumbent Mario Monti, grabbing third place out of a pool of four major candidates and parties.
So why did Italy’s elections rock the US stock market as much as they did, when the results seem to have been largely anticipated in Europe? Perhaps they reminded US investors of Greece’s elections last May. Not only was there no clear victor in either election, but in both instances the results showed obvious disdain for austerity measures. Investors are worried that if Italy doesn’t honor the fiscal compact it agreed to in 2012, it could destabilize the European Monetary Union—which rekindles bad memories of Greece in 2012.
Surprise No. 2: The Sequester Gets a Shrug
It’s hard to believe stocks didn’t sell off last week on the lack of agreement on budget cuts to avoid the sequestration measures that kicked in on March 1. Yet it seems investors simply assumed a deal would be reached at the eleventh hour—or perhaps even the thirteenth hour, like when “fiscal-cliff” legislation was finally passed after the Dec. 31, 2012 deadline. In both instances, we saw much more political posturing than actual negotiation. This time around, investors anticipated the same kind of last-minute resolution.
Although no agreement was reached, investors may have found solace in the fact that the sequestration may be far less toxic than originally expected. The actual cuts to occur this year will not be $110 billion, as originally planned, but $85 billion, the amount agreed to in January’s fiscal-cliff legislation. Moreover, some of those $85 billion in cuts could occur over several years. All in all, the net impact of sequestration is expected to be about a 4% cut in defense spending, a 2% cut in Medicare and a 3% reduction in other eligible programs. While this is nothing to sneeze at, it doesn’t mean the US will go into a recession this year—especially given a very accommodative central bank.
No Surprise: Bernanke Keeps the Spigot Open
What isn’t surprising is the great comfort investors found in Fed Chairman Ben Bernanke’s Humphrey-Hawkins testimony speech last week—the mirror image of their negative reaction to the release of Federal Open Market Committee (FOMC) minutes on Feb. 20. Monetary policy has become such an important underpinning of the economy and the stock market that the words of FOMC members can and do move markets.
In his semiannual testimony, Bernanke acknowledged that the job recovery remained weak and that monetary policy was the source of vital economic support for the fragile economy. Most importantly, he rebutted renewed concerns about the cessation of quantitative easing, saying that he didn’t believe “the potential costs of increased risk-taking in some financial markets” outweighed “the benefits of promoting stronger economic growth.” The easy-money spigot remains open, and the stock market registered its approval.
US Investors More Tolerant of Troubles at Home
Last week’s stock-market roller coaster and the big spike in the VIX suggest that US investors remain very cautious about equities, especially when it comes to the euro zone. At the same time, they’re far more forgiving about domestic fiscal and political issues. Adding credence to that theory is the positive investor reaction to the surprisingly strong ISM Index reading for February—which served as a reminder that US fundamentals are much stronger than those in Europe. Given that investors calmed down so quickly last week, we can only hope that the recent jump in volatility is not the start of a familiar bumpy ride.
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