LP L FINANCIAL R E S E AR C H

Weekly Market Commentary

January 22, 2013

Same Europe, Different Crisis

Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
This weeks European nance ministers meeting is a reminder that each spring for the past three years, U.S. stocks have started a slide of about 10% during the second quarter, led by events in Europe. In 2012, the European fear gauge was the rise in southern European bond yields as the nancial crisis worsened. In 2013, it is northern European bond yields falling as the economic crisis worsens.

While fourth quarter 2012 earnings results will again garner attention this week, investors may also be looking overseas to gauge market direction, since this week holds the rst meeting of the year for European nance ministers. It is worth remembering that each spring for the past three years, the S&P 500 has started a slide of about 10% during the second quarter, led by events in Europe.

Stocks Spring Slides

S&P 500 Index Percent Change 2010 2011 2012 2013

15% 10% 5% 0% -5% -10%

Jan Feb Mar Apr May Jun

Source: Bloomberg, LPL Financial 01/22/13 The S&P 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

However, this year may be different. In 2012, the European Union nally took two important steps to halt the nancial aspect of its ongoing crisis.

Europe has traded a nancial crisis for an economic one.

One of those steps was the creation of the European Stability Mechanism (ESM), a permanent rescue fund for countries in need of credit and unable to borrow in the market. Another important measure was the authorization of Outright Monetary Transactions (OMT), granting the European Central Bank (ECB) more power to intervene in the bond markets to assist countries in distress. With these programs able to lend with few limits to banks and willing to buy bonds of any country that will accept the conditions, we do not expect market participants to fear a European nancial crisis this spring and drive a

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10% decline for U.S. stocks as they have in recent years. But Europes crisis is far from over, and market participants may drive stocks lower later this year. Europe has traded a nancial crisis for an economic one. The ECB is able and willing to only ght one crisis. The price Europe has paid to avoid a nancial crisis is in the form of recession and unemployment rising above 10% including France at 10.7%, Italy at 11.1%, Ireland at 14.7%, Portugal at 16.3%, and Spain at 26.2%. The Eurozone is mired in a recession that the ECB has little ability to mitigate. Ination is still over the 2% target.

Investors may be increasingly better off focusing on U.S. and emerging market stocks as the year matures and the European economic crisis deepens.

This is not just a shift in the crisis facing Europes southern countries. It has now started to infect the core. In 2012, the economies of northern Europe, such as Germany, France, and Finland, were less negatively affected with economic growth and lower levels of unemployment more similar to that of the United States than the countries of southern Europe, including Italy, Spain, and Portugal. However, in 2013, the two largest economies of the Eurozone, Germany and France, will face low growth or even stagnation and rising unemployment. 2 Portugals 10-Year Bond Yield Fell Sharply in 2012 as Financial Crisis Averted
Portugals 10-Year Bond Yield

18% 16% 14% 12% 10% 8% 6% 4%

Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13

Source: Bloomberg, LPL Financial 01/22/13

Germanys 10-Year Bond Yield Fell Further in 2012 as Economic Crisis Deepened
Germanys 10-Year Bond Yield

4%

3%

2%

1%
Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13

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Source: Bloomberg, LPL Financial 01/22/13

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The slowdown in northern Europe can make conditions in southern Europe worse by returning some risk of nancial crisis. The economic slowdown in northern Europe may make these countries more reluctant to approve the release of aid packages to the southern countries. This is noteworthy, since if the Italian elections in February 2013 fail to produce a government that achieves political stability and applies economic reforms, the increased market pressure on Italy will likely require nancial aid. Germany, the de facto decision maker as a result of making up the lions share of any aid package, may already be averse to approve any more unpopular aid packages ahead of the German elections coming this fall. With the elections slowing the decision-making process in Germany, no fundamental changes in policy will likely be made before the elections that may avert the growing economic crisis. In early 2012, the European fear gauge was the bond yield of southern European countries rising as the nancial crisis worsened. But now that a nancial crisis has been allayed, the decline in northern European bond yields is a sign of a worsening economic crisis. In a remarkable sign of how the European nancial crisis has eased, Portugals 10-year bond yield fell from 16% last summer to 6% [Figure 2], and Italian bond yields fell from 7.5% to under 5%. But at the same time, Germanys 10-year bond yield fell below 1.5% [Figure 3]. This is not a sign of crisis averted, but of a different one brewing. Economists estimates for Germanys gross domestic product (GDP) in 2013 are still coming down. Europes 2012 auto sales fell -8.2% from the prior year, the biggest drop in 19 years. The investment consequences are that the bond yields of southern European countries may once again begin to rise, fall elections highlight the challenges putting pressure on stocks, and recession continues and ensnares more of the core nations of Europe. We may again see a stock market slide related to Europes evolving crisis, but it may not be until the summer or fall that it appears this year rather than in the spring. After the powerful rise in European stocks since the nancial crisis was averted last summer, investors may be increasingly better off focusing on U.S. and emerging market stocks as the year matures and the European economic crisis deepens.

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IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specic advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risk, including the risk of loss. International and emerging market investing involves special risks such as currency uctuation and political instability and may not be suitable for all investors. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

INDEX DEFINITIONS The Standard & Poors 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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