With US data becoming somewhat more reassuring of late and concerns about a possible hard landing in China also lessening, it has mainly been the worsening of the eurozone sovereign debt crisis that has been the biggest area of concern for markets. Consistent with this, among the worst performers this year have been the equity markets of the so-called PIIGS countries, with Greece languishing right at the bottom of the (MSCI indices) list with around a 60% loss.

From a technical viewpoint, the position we are at today has parallels with 2000 and 2007, when many global equity markets ‘topped’ and which signalled the start of global recessions. If the events of 2000 and 2007 were to play out again, then we could go significantly lower from here.  However, while this scenario is clearly a big risk, it is worth remembering that it is by no means certain to materialise.

For such an outturn to become more likely, we would first have to see a break below the summer 2010 market lows, especially in the UK & US. To date, the eurozone is the only region that is trading below these levels and is therefore already technically in confirmed bear market territory.

The key driver of European equity weakness has continued to be the region’s banks many of which reached new lows recently. Looking back to 2008/09, it is easy to recall that it was the governments that were forced to rescue the region’s banks. This time however, in a somewhat ironic reversal, it is the banks’ holdings of EU member country sovereign debt that is causing problems, along with the associated threat of a eurozone recession and the negative effects of forced deleveraging.

So the outlook for the European banks and the questions of whether they can break out of their current negative technical position looks increasingly dependent on whether a timely and effective resolution can be found to the eurozone debt crisis. The recent EU Summit provides some hope in this regard, but the situation still looks very far from resolved at present.

Amid all the gloom however, it is always possible to find some positives. From a technical perspective, periods of elevated pessimism do not last forever and tend be followed very often by some kind of bounce back, at least in the short term. Moments of extreme pessimism are also exactly what contrarian investors look out for on the basis that history shows these periods to be excellent times to invest. Finally, perhaps the single most supportive (albeit non-technical) factor for European equities at the present is that they appear cheap in terms of many key measures such as price-earnings, price-to-book ratios and dividend yields.

In the bond markets, eurozone government yields have dominated market attention in recent months. In November, Italian 10-year benchmark yields crossed above 7.0% – a level widely considered to be unsustainable. Likewise, yields in Spain also moved closer to the key 7.0% level. More recently, yields have fallen back partly owing to optimism stemming form the recent EU summit. However, even at current levels, the situation is far form comfortable.

Of course, the problem with rising yields is that they raise actual financing costs for governments, which raises further concerns about credit quality, which in turn pushes yields even higher, creating a vicious circle.

While US yields have generally continued to head even lower owing to safe haven inflows, in November, German bunds (another traditional safe haven play) took markets by surprise when their yields moved in the opposite direction (to US yields), following a ‘failed’ ‘primary auction. However, although this is a worrying sign, it seems unlikely that this marks the start of a significant (directional) de-coupling of US/German government yields.

Mounting concerns about credit quality in the eurozone sovereign debt markets have led to a generalised increase in investor risk aversion that has also affected other types of assets too. This includes high yield corporates where yields have picked up significantly in the past few months. Although price movements have naturally been less severe, the fallout of the eurozone sovereign debt crisis has also been evident in the investment grade sector. This is despite the fact that corporate fundamentals have remained solid, with no discernable pick-up in corporate default rates as of yet.

Looking ahead, the situation looks likely to remain challenging in both equity markets and bond markets, until we get more tangible progress on the dominant issue of the eurozone sovereign debt crisis. The EU summit was widely been seen as step in the right direction, but the markets will continue to look for more progress.

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