FINANCIAL MARKET VOLATILITY has increased over the past several weeks, amid growing investor concern over happenings in Europe, the prospect of increased financial market regulation in the US and, more generally, worry that the economic recovery has hit a rough patch. In Europe, the rescue package announced by the European Central Bank a couple of weeks ago should be enough to prevent the threat of an outright default by Greece, but investors remain concerned about the sharp fall in the value of the euro and are questioning whether the sovereign debt crisis will spill over into other markets.

 

Regarding US financial regulations, the Senate passed its version of a reform package during the week of May 16, which will now need to be reconciled with the House of Representatives. Specific provisions of the Bill are still in flux, but investors have been interpreting its overall tone as equity- market-unfriendly. In reference to the economy, investors were disheartened of late when initial jobless claims unexpectedly rose, bucking the trend of a slowly improving labour market.

 

The combination of these factors was enough to drive equity markets down for the week ended May 21, with the Dow Jones Industrial Average losing 4% to close at 10,193, the Standard & Poor’s 500 Index declining 4.2% to 1,088 and the Nasdaq Composite Index falling 5% to 2,229. With these losses, stocks are back in negative territory for the year.

 

While many investors have been unnerved by current events, BlackRock believes the broader economic recovery remains on track. The cyclical recovery in most countries (including the US) remains intact, as interest rates remain low and leading economic indicators continue to have a positive tone. That said, we acknowledge that US economic data has been somewhat less positive in recent weeks, with the decline in unemployment claims having stalled and with upward revisions to corporate earnings slowing down. In any case, BlackRock expects 2Q GDP growth to come in over the 3% level, but it will likely not be more than 4%.

 

Given the magnitude of the recent currency and sovereign debt concerns, equity market performance is likely to be driven by the broad macro outlook rather than company-specific fundamentals. This is usually the sort of environment where volatility remains high in both directions. It is important to remember that corrections during times of economic recovery are normal, but are often intense and quick.

 

Regarding the current correction, BlackRock believes the worst should be behind us in terms of the magnitude of the downturn, but it will likely take additional time before markets can repair themselves. Looking ahead, one positive factor is that market valuations have become more attractive in recent weeks, as prices have dropped while earnings have increased. Over time, we expect additional clarity around the situation in Europe and the US financial market reform to provide a measure of stability; and a sense that the economic recovery remains on track should help spark a turnaround in the recent aversion to higher-risk assets.