manufacturing

Why Market Moves Have Been Misguided

As U.S. stocks and the European equity index ended last week in positive territory, against a backdrop of disappointing data, market moves seems misplaced. Instead, Central Bank action is cosmetic not medicinal, a tool for reassurance not economic change. Developments from the recent EU Summit are either temporary or limited and capital remains restricted. However, economic deterioration heats up the pressure for action. Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.

Watch this being hotly debated on CNBC, with an entertaining edge…

Central Bank Action is Cosmetic Not Medicinal

Central bank action is being met with scepticism, and initial market rallies used as selling opportunities for profit taking. This is because moves are cosmetic and not medicinal, as in the short term they may reassure markets that measures are being taken, but they are of limited effectiveness at significantly boosting growth. Even Draghi himself, the President of the European Central Bank, argued “price signals (have) relatively limited immediate effect”. They won’t stimulate demand and, by potentially hurting bank profitability, could reduce the incentive to lend – the opposite of the target outcome.

Nevertheless, for the first time, we have seen the ECB cut the benchmark interest rate below 1%. In the same week, the Bank of England announced it will be increasing asset purchases by £50m. With weak US data and Bernanke already cautious, the pressure will be on to turn ‘Operation Twist’ into a more traditional waltz. Investors will be hoping the Fed will pump more liquidity into the system instead of ‘twisting’ or neutralising purchases by selling elsewhere along the yield curve.

Summit Moves Are Limited

The outcome of extensive talks at the EU Summit likewise fuelled a ‘false rally’. Spanish government bonds have since returned to hover around the unsustainable 7% level again despite developments. Instead, the 3 key ‘achievements’ are temporary or limited, as explained below…

1.     Senior not guaranteed: Investors have been moved higher up the pecking order and will now be repaid for loans made to Spanish banks before the bailout fund. Being the ‘first’ in line to get money back is indeed an improvement but crucially the risk of loss is still there and may continue to worry the markets.

2.     Wishful thinking? The government has been removed from the equation with bailout funds now able to offer loans to struggling Spanish banks directly. Removing government involvement in bank bailouts to protects sovereign bond yields ignores the possibility investors will continue to view the health of the banks as a driver of economic health.

3.     Bond buying boost limited: Bailout funds may now buy debt directly from “solvent countries” (read: Italy). However, this is a limited source of demand and again short-sighted.

Capital Remains Restricted

The size of the problem remains a key concern and a crucial measure missing from the Summit was a substantial strengthening of the ‘firewalls’. At €500bn, the rescue fund is only 20% of the €2.4tn combined debt burden of Spain and Italy. The risk that a lack of funding will leave European leaders unable to stop the crisis spreading remains.

Economic Deterioration Heats up the Pressure for Action

With a backdrop of a deteriorating economic environment, Europe is far from able to ‘grow out of the problem’. German manufacturing deteriorated for 4th consecutive month. Relied upon as a rare source of growth, the outlook is dimming. European unemployment has reached its highest level since the creation euro. This is unlikely to spur spending and instead put the pressure back on Central Banks to do something to kick-start economic growth.

Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.

Note some of this article has been published by the Financial Times

What may drive markets this week?

Inflation, hard-to-beat expectations and political stalemate provide a significant downward risk to market this week. (Quoted in the Weekend edition of the Financial Times)

Last week was dominated by disappointing manufacturing data from Europe and China, whilst markets shrugged off a less than impressive Budget. After such a substantial rally year to date, this correction is healthy.

Graph showing the correction in world equity markets over the past week (S&P 500 in white, Eurostoxx 600 in orange, FTSE 100 in yellow); put in context of the substantial upward move year to date. Source: Bloomberg

Graph showing the correction in world equity markets over the past week (S&P 500 in white, Eurostoxx 600 in orange, FTSE 100 in yellow); put in context of the substantial upward move year to date. Source: Bloomberg

This week, issues concerning Europe’s firepower, the US consumer and broader economic growth will determine the direction of markets. Inflation, hard-to-beat expectations and political stalemate provide a significant downward risk to market, although upward momentum could always drive them further.

As fuel price inflation dents sentiment in the US, the consumer may be squeezed and figures for income and spending may disappoint. Furthermore, the opportunity for upside surprises in durable goods orders and Q4 GDP growth is limited as forecasted figures are already high.

A two-day meeting of Europe’s finance ministers will be closely watched for signs of an expansion in the firepower of the rescue fund. The deadline to do so draws near and the pressure for progress grows. However, Germany remains staunchly against such a move and, even if achieved, the figure reached may still not be enough.