Giving markets what they want

At last, markets are getting what they wanted: bad employment data from the US to force the hand of the US Federal Reserve, a clear statement of intent from the ECB that keeps everyone happy, and signs that the slow moving, but eminently powerful Chinese Communist Party is upping its stimulus game. Markets have moved up. Fixed income has rallied in Club Med with 5yr yields now in the range last seen in March and April, when the ECB’s long-term lending programme (LTRO) was still giving sentiment a boost pretty much everywhere.    

Equities and commodities have also gained across the board. Eastern European equities have rallied as the threat of cross-border capital flows disruption has diminished. Chinese and Russian equities have also gained; the latter as a high-beta play on global reflation. Korea has been upgraded. Commodities have been the biggest gainers in absolute return terms with soft commodities, industrial and precious metals up by anywhere between 5-20%. Silver has gained almost 20% month-to-date. EUR has also moved up to hug 1.2800, partly as policy moves have tended to signal a lower USD, and partly as short positions have been liquidated.  EUR is now at its highest since mid-May.   

What has been especially invigorating for risk-taking portions of the market? It’s the combination of policy moves discussed here last week. US data is fine overall (note the decent non-manufacturing PMI number last week), but European and Asian (especially Chinese) has been poor and deteriorating. One central bank or fiscal authority moving in isolation isn’t going to achieve much. A combination or full house is what markets want. That is what they’ve got.    

US Federal Reserve chairman, Ben Bernanke, clearly set out his need to see deteriorating employment data before activating further monetary stimulus. That is, to a degree, what we got. Thursday’s ADP employment survey wasn’t weak. It came in well above expectations. But the overall tone of US labour market numbers hasn’t been good recently. And Bernanke can’t add stimulus measures after an election for fear of looking like he’s unwilling to act beforehand, when it’s most needed.   

In Europe, the ECB’s decision on Thursday to announce a bond-buying programme that satisfied most people’s needs was a masterstroke of politics, if not financial economics. Spain and Italy got an unlimited commitment to purchase their bonds of maturity 2-5 years, while German fears of fiscal profligacy were placated by conditionality. The latter locks in nations to IMF style restructuring programmes that can be terminated if funds aren’t used properly or if budget reduction targets aren’t met. And Spain and Italy got what they wanted because they will only become recipients of financial assistance from dedicated European bailout funds if they specifically ask for assistance – both claim they don’t need any assistance. 

The only strange thing about the plan was the announcement that the funds that have already been spent by the existing ECB assistance plan will remain senior in lien terms to new funding outlays (in the event of a bankruptcy the funds will be the first to be repaid). It has been suggested that the ECB knows a restructuring event is imminent in Portugal (the main beneficiary of ECB assistance to date). But in all, markets have liked what they got.   

In Asia, the Communist Party has complemented People’s Bank of China monetary stimulus measures by introducing infrastructure spending plans worth up to 3% of GDP. This makes sense in that the programmes aren’t roads to nowhere or further additions to China’s collection of ghost towns. It’s long-term infrastructure – metros, port facilities, water plants etc. 

These play two roles: first, they create jobs and second, they create the strong impression within a Communist Party with a passion for big ticket events that something solid is being done ahead of the hand-over of authority in the party at the end of this year. Naturally, commodities and food stocks have gained. 

From a tactical perspective, we are advising clients that this rally is real, but that there are serious pitfalls if proper risk management isn’t employed. On September 12, two days from now, the German courts sit to determine whether the European Stability Mechanism (ESM) is legal under German law. It’s not clear that the German legal system will decide that Germany’s constitution allows for large scale assistance of other nations, particularly those with a much lower retirement age than Germany’s.

A no vote would put an abrupt stop to market euphoria as it would reduce the size of Europe’s bailout fund by at least one-third.