Risk Off?

The S&P500 lost 2% last week, its largest weekly loss of the year, and its only second consecutive weekly loss of the year. Volume jumped, which implies that the selling was meaningful. And volatility soared 17%, suggesting that the complacency of the last three months is ending.

What caused this sudden acceleration of losses? Exactly what we mentioned as the greatest risk factors here last week and the week before—a slowing US economy and the return of the euro crisis, particularly in Spain.

First, the US macro news. Import prices rose much faster than export prices; the result is that corporate margins are getting squeezed. Core producer prices rose faster than expected. This also squeezes corporate profits, and it makes it more difficult for the Fed to print more money. Initial jobless claims spiked to 380,000—the highest level in several months. Finally, consumer sentiment fell, instead of rising slightly as expected.

The bottom line is that the US economy is most likely NOT decoupling from the rest of the world, which has slowed markedly….or even entered a recession. It seems more and more likely that the parade of positive (or not so bad) economic news over the last three months was nothing more than a burst of pulled forward demand that came from the historically warm weather enjoyed by most of the country. Folks simply bought things, and did things, in February and March instead of waiting for April and May. And now that April has arrived, there’s LESS to do. The parade of positive news as a flash in the pan. Now, it’s time to economic return to reality, a reality which is nothing to write home about.

In Europe, the euro crisis is roaring back, especially in Spain. Government debt prices (in Spain, Italy and other periphery state) are plunging. Major bank stock and bond prices are plunging. The sugar highs from the LTRO program administered by the ECB is clearly wearing off. And the terrible truth—that the peripheral states and their banking systems are insolvent—is being exposed once again.

Sadly, only a couple of months ago, the leaders of the core states tried to claim otherwise. “Today the problem is solved” asserted French president Sarkozy, who continued “how happy I am a solution to the Greek crisis ….. has been found”.

He was wrong.

And this time, it’s could get much uglier. Spain is the 4th largest economy in Europe, and the 12th largest in the world. Greece was a pimple compared to Spain.

And the pain in spain goes far beyond public and financial debt. Total private debt in Spain is almost 300% of GDP. It’s housing market is collapsing……just now. It’s unemployment rate is almost 25% and youth unemployment is almost 50%.

The Spanish economy is officially back in recession, and to top it all off, the new prime minister is about to impose a massive fiscal shock by slashing the government deficit, which will lead to even greater economic pain, higher unemployment, and more borrowing relative to GDP.

So let’s hope that the problems in Spain remain only that–problems. Because there is a growing risk that if Spain loses control or if the stronger core states lose patience with weakening states like Spain, that a disorderly break-up of the eurozone and a series of massive sovereign defaults all become more likely.

In that case, “risk off” would not even begin to describe the sell-off that would follow.

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