Indices Insider Europe And US: Sovereign Debt Fears Rock The Boat

Stock markets have had a mixed week. After selling off sharply in the first half they have clawed back some gains in the second half. This lack of direction is down to a couple of factors:

1. Spanish bond yields continue to move higher, sparking fears about another flare up of the sovereign debt crisis; and

2. The economic outlook for the US has darkened somewhat after the disappointing US payrolls number last Friday.

Payrolls data in the US can help set the tone in the markets for the rest of the month and the disappointing 120k print has left the markets concerned about the underlying strength of the US economy and wondering if the Federal Reserve will step back in to provide more stimulus if the economy shows further signs of easing.

Central bank liquidity has been a major driver of stock markets in recent years and it is no coincidence that markets started to recover this week after comments from an ECB official that the bank could provide more support to the weak peripheral nations if it was necessary. The mere hint at more liquidity support (the official gave no details like the form the support may take or even a time frame) was enough to help stocks reverse course.

Thus, as we end the week, stock markets look like they are in correction mode although the deterioration in the eurozone debt crisis could trigger some defensiveness in markets next week. However, the US market looks less vulnerable than Europe, especially the domestic indices in Spain and Italy. On Friday a number of Italian banks had their shares halted on the Italian stock market after large losses throughout the day. We saw bank shares get hammered back in November 2011 when the markets were tanking and sovereign strains were high. Thus, we will be watching developments in Europe closely in the coming days especially next week’s two debt auctions in Spain.

Overall we believe that stocks won’t be able to push higher before more liquidity is pledged by central banks especially from the ECB.

It’s not all doom and gloom out there as the first quarter earnings season has been fairly good so far. Alcoa kicked things off by beating its estimates. JP Morgan also beat the street although it saw profits fall relative to the first quarter of 2011. Revenues rose to $27.42 bn, analysts had been looking for $24.68bn. If earnings surprises continue then this could protect US stocks from contagion from European weakness caused by the latest flare up in the debt crisis.

SPX 500

1,360 acted as a good support last week. Prices bounced off this level, nicely setting the scene for a re-test of 1,400. However, further gains will depend on the overall risk environment. As we mentioned above, although we believe US stocks are better protected from the crisis in Europe, they are not immune to the currency bloc’s problems.

Interestingly, the daily RSI and the MACD are pointing in different directions. The MACD is still pointing down, however it tends to be a lagging indicator and the RSI has turned higher after the recent selloff. This suggests that we could be range-bound. Support lies at 1,360 then 1,320 – the 21-day sma, while resistance lies at 1,400 then the 1,422 highs from early February.

FRA 40

The French index is looking vulnerable as the country heads to the election polls later this month. The Presidential election is a fight between Sarkozy, the centre-right incumbent, and Hollande, a Socialist. A victory for Hollande would be market negative in our view. The two candidates are neck and neck at the moment and as we get closer to the elections we think investor sentiment could drain from the French index.

We believe there is further momentum on the downside after the index broke through support at 3,289 last week – the bottom of the Ichimoku cloud and the start of a technical downtrend – as you can see in the chart below. The RSI suggests that we could be moving into oversold territory so expect some stickiness around the 3,200 mark. Below here we could test the 3,125 lows from early January.

As we mention above, the real driver of stocks in Europe will be whether or not the ECB intervenes to smooth the sovereign strains that have emerged once more. If it offers more cheap money then we could reverse course back towards the 3,400 then the 3,600 highs reached in mid- March. However, in the absence of further support it is hard to drum up much enthusiasm for European stocks, especially in France as political and sovereign risk come back to haunt the markets.