Markets over-react to improved growth
Developed equity markets rose, outpacing bonds, as concerns over the implications of Cyprus’s bailout were outweighed by strong US data and signs of a pick-up in economic activity in other regions. The gains masked a wide dispersion in returns across both countries and sectors, however.
Although equities outperformed bonds, defensive sectors fared better than cyclical stocks, with health care, telecoms and consumer staples delivering the best returns. The preference for defensive equities was also evident when it came to country returns. Emerging market stocks fell over the month, further widening the gap in performance relative to their developed counterparts, while Swiss, German and UK stocks fared far better than peripheral European markets such as Italy and Spain, which both declined.
In fixed income, returns were positive for euro-based investors but negative for US dollar participants as the euro lost ground in the currency markets in the wake of the Cyprus bailout. Speculative-grade bonds proved to be the standout performers as investors showed no sign of losing their appetite for higher-yielding debt.
While the upward move in equities suggested markets had taken the bailout of Cyprus’s banks in their stride, a spike in the cost of insuring against bank bond defaults testified to investor concerns over the terms of the deal. Credit default swaps on European banks rose by some 20 to 30 basis points over the month.
The fear among market participants is that the island’s rescue package, which involved imposing heavy losses on depositors, might turn out to be policymakers’ preferred template for future bank bailouts. Were this to be the case, it would potentially expose banking groups in Spain, Italy and Portugal to the risk of bank runs and possibly raise funding costs for all European banks.