Market Comment 15 December 2011

Much has happened since our last letter (OK, it's the first letter I have posted here, contact me for the backlog!), not least the December meeting of the ECB and another European leadership summit. We became more nervous ahead of the latest round of crisis measures, reflecting that Europe can hold as many summits as it likes, but things may continue to worsen until it moves from discussion to implementation. Has anything changed?

The December summit led to stringent agreements on deficit management - a stricter incarnation of the Eurozone's original Growth and Stability Pact (GSP). This move is concerning, first because it institutionalises austerity measures without leaving room for pro-growth solutions, second because this impractical characteristic means it is unlikely to sustain market confidence. Germany itself was the first to breach the deficit rules of the original GSP, a move that was understandable because it imposed excessively restrictive constraints. By introducing even less flexible rules, the EU is implementing a new economic statute, one which is guaranteed not to suit all countries at all times. There are some positives, such as using the European courts to adjudicate on areas of dispute, but the proposed system is likely to be rejected by more than just the UK before the discussion is over.

Meanwhile, the ECB has dramatically shifted gears, lowering rates another 25bp, and announcing new unlimited lending policies, of the form that helped resolve the 2008 credit crunch. Sure enough, this money is beginning to work its way into the system already, as demonstrated by this week's Spanish bond auction. And the euro has moved sharply downward, as expected.

The question is whether or not the 2008 remedy will work this time? And here the jury is out. At the margin, it may enable to banks to be more supportive of new government issuance. However, there is an open question of whether banks will follow the ECB's lead and prop up the system again. Yes, this is profitable lending and European banks clearly need profits, but is it sustainable? Perhaps the Greek debt restructuring has taught them a degree of caution. Until there is an implemented crisis resolution plan, including measures to cut Greek debt to sustainable levels and help all troubled nations to move back to growth, Europe looks unlikely to shake off its troubles.

Following tradition, the market celebrated the December summit with a sharp sell-off. As we write, markets are back in the green though, and with some momentum. The ECB's recent steps should significantly impact frozen credit markets (good for corporate bonds) and help peripheral sovereign debt to some extent. But December's summit kicked the can down the road. Over the next days we will be watching to see if the festive rally can recover, but, even if it does, we still lack a solid foundation for 2012.

Best regards,

James