There was nothing fun lovin’ about the spoonful of bad news overseas last week that left investors with a bad taste in their mouths. New wrinkles to Europe’s debt crisis and slower growth in key emerging markets have shaken the stock market and put the U.S. recovery in doubt. These renewed fears come despite an impressive U.S. earnings season and growing confidence among consumers.

The Dow Jones Industrial Average fell 1.67% last week—the largest weekly drop in 2012—as concerns over the euro-zone crisis mounted. Investors punished large-cap stocks more than small-caps and tech, with the Russell 2000 down 0.22% and the Nasdaq down 0.76%. The 10-year U.S. Treasury yield edged lower to 1.841%, marking the eighth consecutive weekly decline and its longest losing streak since October 1998.

The crisis in Europe intensified last week when news reports surfaced that the euro zone was considering delaying the payment of more than five billion euros in bailout aid to Greece, citing concerns over political turmoil in the wake of last weekend’s elections. Greece was due to receive the money as part of a previously approved disbursement from the 130-billion-euro bailout agreed upon in March with the euro zone and the International Monetary Fund. Germany, Finland and others were wary of making the payment on the heels of comments from Greek politicians calling for the bailout to be renegotiated. Greece needs the money mainly to repay bonds with near-term maturities held by the European Central Bank and national central banks across the euro zone. An immediate default seems to have been averted—at least for now—but the specter of this issue reappearing lurks in the shadows.

Exit Signs
Allianz Global Investors’ Economics and Strategy Group has been following the situation closely. It’s important to reiterate that polls are showing that 75% to 80% of Greek voters still want to remain in the European Monetary Union. As such, the Economics and Strategy Group doesn’t believe that Greece will opt out of the EMU. This remains the base case. However, the risk of Greece’s disorderly exit from the currency union and, consequently, from the EU, has increased significantly since the election. If Greece were to leave the EMU at some point, it would likely boost volatility in the capital markets, at least in the short term.

However, it is unlikely to lead to the collapse of the EMU. In the short term, market implications are obviously negative for risky assets and the financial sector. In the medium term, the result is very much dependent on EU policy makers as well as on the ECB. If EU policy makers and the ECB can continue to credibly build a firewall around Greece, the market implications could be muted. The Economics and Strategy Group takes some comfort from the fact that Greece’s default in the spring did not lead to major disruptions in the financial markets. Its view is more acutely focused on the aftershocks. Even if Greece does leave the euro zone, the impact on financing costs in other southern European nations and the effect on confidence in the union itself are greater concerns.

Adding to the turmoil in Europe was bad news in emerging markets in Asia. Surprising slowdowns in both China and India were reported last week. China saw a drop in industrial output and a decrease in exports in April, while India saw a substantial decline in industrial production in March. The slowdown in China was negative enough—and surprising enough—to cause Chinese policymakers to cut the reserve rate requirement over the weekend.

Should I Stay or Should I Go?
Still, despite developments that clash with the prospects of a strengthening recovery, not all the economic news was discouraging. In fact, a few bright spots could be seen in the United States. Corporate earnings season, which is coming to a close, has been strong with an estimated 70% of companies in the S&P 500 that have reported earnings beating expectations versus the historical average of 62%. March consumer credit came in at $21.4 billion versus expectations of $9.8 billion. Initial jobless claims came in at 367,000, essentially in line with expectations. And the Thomson Reuters/University of Michigan preliminary sentiment index for May climbed to 77.8 from 76.4 in April, exceeding expectations and notching the highest level since January 2008.

But dark clouds remain on the horizon. Continued issues are likely to arise in Europe as the struggle plays out between austerity and growth measures. In addition, the U.S. is creeping closer to its own fiscal cliff, as Fed Chairman Ben Bernanke warned last week. There also appears to be a growing possibility of further geopolitical issues between Israel and Iran.

Unfortunately, the recovery may be weakening and there is a good chance we will see more negative surprises in the near term. This challenging environment calls for investors to be selective in the risk assets they own. An important reminder that bears repeating is that shunning stocks altogether could undermine your long-term financial goals and, ultimately, is a recipe for disaster.

Kristina Hooper, CFP®, CIMA®, is head of portfolio strategies at Allianz Global Investors Distributors LLC.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Forecasts are inherently limited and should not be relied upon as an indicator of future performance.

A Word About Risk: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Treasuries fluctuate in value in response to changes in interest rates, but they are backed by the full faith and credit of the United States as to the timely payment of interest and principal.

The Standard & Poor’s 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market. The NASDAQ Composite Index is a market-value-weighted, technology-oriented index composed of approximately 5,000 domestic and foreign securities. The Russell 2000 Index is an unmanaged index that consists of the 2,000 smallest companies in the Russell 3000 Index and represents approximately 10% of the total market capitalization of the Russell 3000. It is generally considered representative of the small-cap market.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded blue chip stocks, primarily industrials, but including financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index.

The University of Michigan Consumer Sentiment Index is published monthly by the University of Michigan and Thomson Reuters. The index uses telephone surveys to gather information on consumer expectations regarding the overall economy.

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