Market Comment 12 January 2012

Markets have been relatively stable since our last letter, once again highlighting that economic fundamentals and market prices can diverge substantially.

For much of last year, there was good reason to expect constructive actions on Europe, but equity markets plunged. Then, in December European policy makers announced austerity plans that are at best a substantial long-term drag on growth, highlighting that Europe is locked into a downward cycle, and markets respond positively. What is going on?

Markets seem to be doing well for several reasons:
1. The US economic performance has beaten consensus and shows signs of healthy sustainable expansion. The growth trajectory is less of a surprise for this analyst, and represents the long, slow growth path that we have long expected. But investors have been positively surprised, and the US remains the world’s largest single-nation economy, so its growth makes a global difference.

2. Emerging markets globally are looking more interesting. It is important to look at each country individually, but overall the emerging universe is positioned to more aggressively stimulate growth this year as inflation fighting becomes less of a priority.

3. Europe appears to have moved away from the immediate precipice. During 4Q11, Europe moved into an acute phase of economic decline, as credit markets froze over political inaction. Whilst the political process remains painfully dormant, the ECB’s commitment of unlimited funding has provided healthy support in times of market stress, and eased real economy financing concerns. Meanwhile, there is tentative progress toward a write-down of Greek debt.

If Greece is able to secure a material write-down of its debt, then some corners of the European financial system will face some challenges (think Greek financial institutions). However, at the aggregate level, the news will be of huge significance. It is entirely possible that a Greek debt write-down will lead investors to realise that Italian and Spanish economies are materially different (still fighting liquidity not solvency issues). The resulting wave of confidence may drive asset prices for the medium term. Of course, Europe’s growth problems will remain as a long-term issue, hence we would not rule out that the crisis might return at a later date. And, importantly, such an optimistic outlook assumes that the write-down of debt is sufficient to create a hope of future sustainability.

But, the current movement in the market may be justified, if such a write-down is achieved. After so many disappointments, it would be wrong to trust that Europe is about to get it right, but the case for short-term risks, such as Equity Target products, looks reasonable today.

Best regards,