05/14/2012 05:01 EDT | Updated 07/14/2012 05:12 EDT

Economy Being Squeezed Between Greece and China

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As I commented in last week's Capital Strategy, investor unease has built up in recent weeks over the prospect that we might be in for a repeat performance of what happened to equities after April in both 2010 and 2011 -- namely, correction and heightened volatility.

While there are some similarities between these periods and today, as well as some key differences, perhaps the biggest factor at play here is that a second quarter downdraft becomes a self-fulfilling prophecy. In other words, investors will sell in anticipation of a correction, even if the fundamentals don't necessarily support one. Keep in mind also that the "sell in May and go away" mantra has been played up more in recent years, which would also add another psychological element to the market as we move through May.

Some have quipped that the recent slowdown in U.S. economic growth is the first step to another recession sometime very soon, yet fundamentals in this part of the world argue against that development. Interest rates remain low, and the Federal Reserve stands ready to inject added liquidity if needed, while energy prices have cooled down, offering some relief to household pocket books.

Now, if there is a central driver behind a potential sharp move lower in global stocks, it would have to be Europe. From last weekend's elections in France and Germany, highlighting a shift in the populace away from fiscal austerity, to the gridlock in Greece's parliament (and more probable threat that the country will leave the euro), the region has created a conundrum for investors.

Stock valuations will likely slide if growth conditions deteriorate because of the drag imposed by said austerity; however, those hiding in bond caverns face a similar hazard from sovereign debt downgrades. Combined, these threats could lead to heavier outflows of capital from the Eurozone, which would put downward pressure on the euro, and upside pressure on the US dollar -- again, not a wonderful thing for stocks.

At the same time, there are parts of the world where slow growth may become less of a concern -- such as China. Yes, growth in the country has fallen from near 12 per cent in 2010 to close to 8 per cent as of the first quarter, but Chinese authorities will not want growth to fall below its soft-landing target.

Given that changes to monetary (or fiscal) policy act with a lag on the economy, Beijing will need to begin re-stimulating sooner than later. My best guess is that we'll start to hear the first hints of either lower bank reserve ratios or central bank rate cuts by the time we get into the summer, and the latest Chinese inflation statistics offer support for this view.

April saw an inflation rate of 3.4 per cent versus 3.6 percent in March, representing the third straight month that the increase in consumer prices has been below the government's target. Assuming authorities act in the coming weeks to address slowing domestic demand growth, this will bolster so-called "risk-on" trades, with an emphasis on commodities and resource stocks.

This would definitely be welcome news for the TSX, given its concentration in resources (roughly 45 per cent), but it is unclear whether a Chinese good-news boost will be enough to counter the negative sentiment coming from Europe. And the longer it takes for this news to emerge and permeate through global markets, the greater the risk that Europe adds to the self-fulfilling prophecy of the "sell in May."