What went wrong in the second quarter?

The optimism seen after the European Central Bank’s May bailout package has evaporated with the FTSE ending the quarter down 12.8%.

It had all started so well with the ECB agreeing a €750 billion rescue package and European governments signing up to tighter fiscal policies. The news that China was to accept a revaluation of the renminbi also added to the positive vibes that many expected to help send markets into a June rally.

Instead, markets have tanked and investors have been running pushing US Treasury yields below 3% for the first time since August 2009. Virtually leading indicators have taken a major turn for the worse with sell-off pushing most indices into death cross territory as their 50 day moving averages fell below their 200 day moving averages.

‘One explanation is that most economic data releases have been, at best, disappointing,’ says GaveKal economist James Barnes. ‘Take the past 24 hours as an example: in Japan, we witnessed a rise in unemployment, a large increase in hours worked relative to output (implying weak productivity growth) and a roll-over in industrial production.’

‘In Europe, we saw weak eurozone surveys from retail to construction to services, a negative Spanish CPI release and a drop in UK M4 monetary aggregates.’

In the US, the news has been as bad. Weak Case-Shiller housing data for April and a 10 point drop in consumer confidence have both tested investors’ nerve and raised fears of a double dip recession.

Indeed, the ECRI Weekly Leading Index has declined to -6.9% and Dr. John Hussman, manager of the Hussman Strategic Growth fund, warns that if the ISM Purchasing Managers’ index falls back to 54% from 59.7% currently, history suggests that this will be sufficient to tip the US back into recession.

‘Taking the growth rate of the WLI as a single indicator, the only instance of when a level of -6.9% was not associated with an actual recession was a single observation in 1988,’ he says. ‘Of course, the evidence could be incorrect in this instance, but the broader economic context provides no strong basis for ignoring the present warning in the hope of a contrary outcome.’

‘Indeed, if anything, credit conditions suggest that we should allow for outcomes that are more challenging than we have typically observed in the post-war period.’

The credit markets remain very much at the forefront of investors’ concerns with Spain and Portugal having vast amounts of debt to rollover this week and Barnes says that many are worried that the ECB will not play ball.