Volatility and market turmoil carried over from late April and into the month of May on fears that European nations such as Greece and Portugal might be unable to repay its debt and that the euro could collapse as a result.

The global flight to safety helped push up the U.S. dollar, which in turn pressures commodity and stock prices.  Some view pressures on commodity prices as a net positive occurrence for consumers.  The most noticeable advantage may be cheaper gasoline prices, but a stronger dollar also lowers input costs for U.S. companies.  Although input costs may be lower, a stronger dollar may hurt companies with large foreign exposures – 50% of S&P 500 revenue comes from abroad and almost 30% from Europe.  Furthermore, a stronger dollar weighs on domestic equities.

Perhaps more importantly, the stronger dollar and global stampede into U.S. Treasuries has made it easier for the Federal Reserve to maintain its stimulative interest rate policy.  Market confidence that the Fed will hold interest rates at their current levels for the near-term, measured by the futures market, rose sharply in May.

Despite efforts to control the European crisis – headlined by a bailout totaling $1 trillion pledged by various European nations and the International Monetary Fund – market volatility, as measured by the VIX Index, rose to its highest level since the Lehman Brothers bankruptcy.   The VIX index peak on May 20 above 45 before finishing the month at 32 – the long-term average for the VIX is 20.  Having the market move several percentage points in a single day is becoming a common occurrence again, and it’s difficult to imagine that trend ending soon because the overhanging fears unlikely to be resolved quickly.

International markets were hit the hardest in May. The MSCI EAFE Index – which tracks stocks from Europe, Australia and the Far East – lost 11.31 percent and the MSCI Emerging Market Index sagged 8.74 percent.  Headlining the Emerging Market declines was the Chinese stock market officially entering bear market territory.

The S&P 500 and the Dow Jones Industrial Average recorded losses of 7.98 percent and 7.54 percent, respectively.  Domestic equity losses were similar across all market capitalizations with the S&P 400 Mid Cap Index and the Russell 2000 Small Cap Index losing 7.19 percent and 7.58 percent, respectively.  Domestic REITs were the relative winners among equity asset classes with a loss of 5.33 percent.

It’s no surprise that defensive sectors such as Telecoms, Utilities and Consumer Staples were the top performing sectors in May.  The Energy sector was the worst performing S&P 500 sector as the oil spill in the Gulf of Mexico brought about a great deal of negative press to the industry.  Even more, energy prices declined as market participants considered weaker demand and slower economic growth as a result of European financial woes.  The Materials sector also lagged on demand concerns as well.

In the fixed income markets, U.S. Treasuries benefited from global investors seeking a safe haven.  Meanwhile, corporate credit saw a sharp reversal in May with yield premiums rising in response to more risk adverse investors.  Bonds in the Financial sector were hit particularly hard as both weak country sovereign exposure and regulations from lawmakers threaten future earnings.

Unlike past sell-offs during the last 18 months, the stresses induced and questions raised are likely to mean a slower healing process than before.  Eurozone debt concerns, lower market confidence, and lower risk appetite could all poke holes in the global economic recovery.  All signs point to global economic growth remaining positive, but as the pace of growth decelerates we should expect the market to churn and spend time consolidating.

Peter Lazaroff, Investment Analyst

www.acrinv.com