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Markets brace for more volatility next year

Volatility in global markets promises to continue well into next year given the relative failure of a European summit last week and pending reviews of government creditworthiness by the world's major rating agencies.

Investors are on alert not only for potential downgrades of euro zone debt by Moody's Investors Service and Standard & Poor's, but also for further signs of slowing growth in the United States and China, the world's two largest economies. The uncertainties over next November's presidential election in the United States will be an additional weight through the year.

Stock markets in Europe and North America sank Monday after Moody's said it might cut European debt ratings in the first quarter of 2012 based on the "absence of decisive initiatives" from last week's summit. S&P had said previously that it could lower ratings after the meeting.

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The drops in equities erased much of Friday's summit-related rally, exacerbating the sense that investors trying to make sense of Europe are confused, scared or both. Concern in the third quarter about Europe, the U.S. and China dragged the S&P 500 to its biggest decline since the depths of the financial crisis in the fourth quarter of 2008, but this quarter is shaping up to be positive.

"We anticipate that the high level of market volatility since the summer will persist into the first half of 2012," Myles Zyblock, chief strategist at RBC Dominion Securities in Toronto, said with colleagues in a research report on Friday.

The chief worry in recent months related to a debt default by Greece. If uncertainties over a default or a rescue of a relatively tiny country can cause markets to yo-yo, a wave of downgrades of Europe's biggest economies could be far more dramatic.

Sluggish economic growth and persistent unemployment in the U.S., and slowing manufacturing, exports and economic expansion in China could also continue to weigh on financial markets.

The measure of U.S. market volatility known as the VIX, also dubbed the "fear index," traded close to 50 on several days between August and October. While that's only half the level reached during the depths of the financial crisis, it's in line with the VIX's peaks after the attacks in New York City on Sept. 11, 2001. (A higher number suggests higher expected volatility.)

Eight of the 10 biggest daily moves in the past 18 months by the S&P 500, a benchmark for U.S. equities, have occurred since August this year. Yields on U.S. government bonds have fallen to record lows as investors bought Treasuries as a haven from volatility elsewhere.

Last week's European summit not only failed to fix the region's finances, the U.K.'s refusal to back key proposals further added to worries that the European Union is beginning to unravel.

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"The absence of measures to stabilize credit markets over the short term means that the euro area, and the wider EU, remain prone to further shocks and the cohesion of the euro area [remains]under continued threat," Moody's said in statement Monday. "The announced measures therefore do not change Moody's previously expressed view that the crisis is in a critical and volatile stage, with sovereign and bank debt markets prone to acute dislocation which policy makers will find increasingly hard to contain."

And Europe's affairs could worsen as over-indebted governments curb spending to cut budget deficits, just as signs increasingly suggest that the European Union is sliding toward a recession.

"European markets have dropped sharply [Monday]in the wake of the fudge that was last week's euro summit," Michael Hewson, an analyst at CMC Markets in London, said in a note to clients. "The determination of EU leaders to enforce even more austerity by way of the fiscal compact will have an even more cancerous effect on growth in Europe and exacerbate the already weak outlook for Europe into 2012."



KEY FACTORS



Europe



Europe's leaders have failed to solve a debt crisis that is threatening to break up the European Union. Major rating companies could soon unleash a wave of downgrades.

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U.S. economy



Sluggish growth and persistent unemployment in the world's biggest economy could continue to drag on financial markets worldwide next year.



U.S. election



The uncertainties about the lead-up and the results of next November's presidential election add a further burden to already jittery investors.



China



Any further indications that growth is slowing in the world's fastest-rising major economy could cause financial markets around the globe to decline.





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