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,

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