Market Comment 22 December 2011

Last week we noted that the foundations for a healthy 2012 are not yet in place, and that the jury is still out on the implications for sovereign bonds of the ECB's decision to once again offer unlimited liquidity. Thus far, we don't have conclusive progress on either point, but the trend is stable at the moment.

This week, Spain had a successful bond auction, and the first unlimited refinancing operation today has been met with high demand. The early indications are that the ECB has succeeded in restoring confidence, and that the banks will play along, using liquidity to reduce risk premiums. Whilst we welcome the risk-on nature of markets, particularly at these technically important levels, we would caution on excessive optimism. With Eurozone sovereigns needing to issue an almost €1.5 tln of debt next year, the jury will remain out for some time.

Unlimited liquidity may be enough to help reverse the credit freeze, a big plus to be sure, and possibly enough to help governments get their debt issuances done. But, unless there is a structural change in the European economy, it is unlikely to be enough to bring yields to sustainable levels, meaning that the debt crisis may continue to worsen, even if it does so away from the media spotlight. The current market dynamic is driven by monetary factors, but unfortunately political news is not presently moving forward as clearly as it was earlier in the year.

China is growing well, but more cautiously than in recent years. The US is currently performing well, in line with our predictions and better than many had expected. But unlike in the early noughties, it is not growing enough to pull the rest of the world up with it. Europe cannot expect another global macro free lunch, and needs to act decisively. Absent such assertive action, it is unlikely to experience an economic upswing sufficient to reverse the enormous economic damage caused by its reluctance to implement crisis response agreements.

For now, the market has a bit of a festive mood, and we welcome this. Technically and tactically, this rally might carry us through for several weeks, but it could turn at any time, and if the party goes on into January without reforms, it will quickly start smelling of excess.

Since the markets wait for no man (well, except perhaps a central bank head or two), we are working through the festive season. And so we will have a chance next week to wish you Happy New Year. But, Christmas itself is upon us. Enjoy it to the fullest.

Best regards,

James

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