Can the U.S. Provide Relief for a Spain Shock?

After a bruising week, the global financial system now stands at a crossroads.

Global stock markets were hammered last week and for May as negative fundamental factors and ugly technical indicators rattled investors around the world.  As we enter June, significant events approach that put the entire global financial system at an historic crossroads.

On My Wall Street Radar

The S&P 500 (NYSEARCA:SPY) has now declined 9.9% from recent highs and is on the edge of official “correction” territory which begins at 10%.  For the week, the S&P 500 (NYSEARCA:SPY) shed 3% and for May it declined 6.3%.

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Other major indexes suffered the same fate with the Dow Jones Industrial Average (NYSEARCA:DIA) dropping 2.7% for the week, 6.2% for May and now is negative for the year.  The Nasdaq Composite (NYSEARCA:QQQ) joined in the decline, down 7.2% for May while the Russell 2000 (NYSEARCA:IWM) led the way south with a decline of 10% for the month just ended.

A look at the chart above shows us that the S&P 500 (NYSEARCA:SPY) has broken below its 200 day moving average as of Friday’s close. 

More ominously, all four major U.S. stock market indexes, the Dow  Jones Industrial Average (NYSEARCA:DIA) S&P 500 (NYSEARCA:SPY) Nasdaq Composite (NYSEARCA:QQQ) and Russell 2000 (NYSEARCA:IWM) are now all below their respective 200 day moving averages, the widely watched level that is often considered the demarcation line between bull and bear markets.

The Economic View From 35,000 Feet

The week was generally ugly no matter where one looked around the world.

Europe was a big news maker and ulcer producer as Spain totters under the weight of its crushing debt load and tries to figure out how to rescue its troubled lender, Bankia.  The country’s version of the FDIC is broke, the European Central Bank so far isn’t willing to help, and the country is mired in a long running recession/depression with unemployment of 25%.  Basically, everyone’s wondering where Spain is going to get the money to save Bankia, much less the 16 other banks coming behind it that have been hit with recent credit downgrades.

Markets voiced their displeasure with cascading losses in European equity markets and spiking bond yields in Spain and Italy, with Spain’s 10 year at 6.5%, quickly approaching the unsustainable 7% level.  Credit default swap pricing continued to climb while German 2 year bond interest rates plunged to 0% as investors are willing to take an inflation adjusted loss on their investments in return for the perceived safety of the German government.  Bond market action in the United States was similar as 10 year yields descended to record lows and 30 year bond prices closed in on record low yields and posted higher prices than during the 2008 financial crisis.

Spain has been jawboning the ECB to buy its bonds but the program was rejected and Spanish bonds continued a relentless climb, now at 6.6%, as investors worry about the country’s future and potential for default.  More than $80 billion of capital departed Spain in March as investors doubted the country would find a solution and so they voted with their feet by moving assets to the safety of other currencies and U.S. Treasury obligations.

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German Chancellor Angela Merkel is taking heat from all sides to back down on her demands for austerity and opposition to monetary easing to promote growth.  Italian Prime Minister Mario Monti is squeezing her to allow direct European bailouts for banks while new French President Hollande advances his anti-austerity agenda and ECB head Mario Draghi also joined in the chorus.

For her part, Chancellor Merkel is sticking to her guns even as President Obama applied the considerable power of his office to spur European leaders to faster and more effective action.  Ms. Merkel says that she will not agree to Eurobonds backed by Germany which puts a severe damper on the hopes of the “central banks will save us” crowd.

The Euro doesn’t like the news, either, as it fell close to 2009 lows against the dollar.  Gold, (NYSEARCA:GLD) which has been in a bear market of its own, rallied on Friday, adding 3.8% to close at $1622.

Other ETFs affected by the turmoil in Europe were Vanguard Europe ETF (NYSEARCA:VGK) down 17% from April highs, and iShares MSCI Spain ETF (NYSEARCA:EWP) down 32% since the beginning of April.

And, let’s not forget Greece as Moody’s said the likelihood that Greece would exit the Euro zone was increasing and the anti-austerity and pro-Euro forces continue their battle towards the June 17th elections.

Asia offered some gloomy news, as well, as China’s PMI dropped to 50.4 from 53.3, barely avoiding a dip into official contraction territory, and Hong Kong’s retail sales report was another disappointment.

Meanwhile, at home, things don’t look much better.

U.S. economic reports this week were dismal as new job creation printed a lackluster 69,000 for May, the lowest number in over a year and widely missing estimates,, while unemployment pushed up to 8.2%.  The ISM manufacturing report was another miss, coming in at 53.5 and moving closer to the 50 level that separates economic contraction and expansion.  Initial jobless claims jumped for the week, again missing estimates, Chicago PMI declined and Q1 GDP was revised downward to a very modest 1.9%, well below previous forecasts for the year.

Next week brings another chapter in the European drama and economic reports including factory orders, ISM Non Manufacturing, Fed Beige book and weekly jobs.  Beyond lies the June 17 Greek elections and the all important Federal Reserve meeting on June 19-20.

The Fed’s efforts to boost recovery, including cutting interest rates to near zero and buying more than $2 Trillion in bonds, seem to have failed to kick start a meaningful recovery, and now with Operation Twist coming to an end in June, everyone is looking to Dr. Bernanke and his colleagues to offer even more help.

Further action could come at the June meeting or possibly at the July 31st or September 12th sessions.  The Fed finds itself in an uncomfortable political situation with the Presidential election coming into view and having already taken widespread political pressure in response to its efforts thus far.  Hot debate rages over what the Fed might do, what it can do and if anything it does will have more than just a temporary positive effect.

Bottom line: Technical indicators point to a deteriorating environment for global equities markets.  Bond markets are priced for the end of the world scenario and fundamental factors point to a rapidly slowing global economy.  The most immediate danger is a financial shock coming from Spain in the form of a bank collapse/bank run or a Euro-negative outcome in the Greek elections which would cast the future of Europe into greater doubt and inject even more instability and fear into an already fearful global financial system.

John Nyaradi is the author of The ETF Investing Premium Newsletter.