German constitutional court and Dutch electorate strengthen the political muscle in support of the euro

In this week’s bulletin:

  • Global equity and commodity markets rally strongly as confidence grows over the outlook for the US and Eurozone.
  • Federal Reserve takes bold steps to boost  US economy with open-ended support as Wall Street hits its highest level since 2007.
  • German constitutional court and Dutch electorate strengthen the political muscle in support of the euro.
  • China makes clear its commitment to sustainable economic growth levels as political changes loom.

Market eye

  • Global equity markets rally strongly as confidence grows over the outlook for the US and eurozone
  • Wall Street hits its highest level since 2007 as investors welcome QE3

“What we are seeing now are the first signs of a more normal working [of markets] but we still have a long way to go.”

Mario Draghi, president of the ECB

Global markets soaked up the warmth of what can only be described as an Indian financial summer last week, basking in the rays of sunshine emanating from Brussels and Wall Street. The decision ten days ago by Europe’s central bank, the ECB, to make unlimited purchases of government bonds in secondary markets gave equity markets the catalyst they needed, reassuring investors that Mario Draghi was as good as his word and that the euro would not be allowed to fail. Last week’s decision by the US Federal Reserve to launch an open-ended effort to spark a recovery in the US – dubbed QE3 – significantly reinforced the positive mood. European shares hit highs not seen for more than a year; and on Wall Street the S&P 500 extended a rally that has pushed the leading index to its highest level since late 2007 when it reached a new, all-time high. Investors are convinced that the decisive action taken by both central banks will buttress the world’s two largest economic regions and buy time for the eurozone politicians to resolve the euro’s shortcomings. Mario Draghi, ECB president, neatly summed up events saying, “What we are seeing now are the first signs of a more normal working [of markets] but we still have a long way to go.” So it was no surprise that, by the end of the week, asset prices – with the exception of the US dollar which unsurprisingly fell – made significant advances, with equities ahead by 2% or more, closely followed by gold, silver and oil prices.

Bernanke pops the cork

  • Bernanke unveils new, open-ended support for the US economy in order to boost growth
  • Equities and commodities rally strongly whilst dollar weakens on the news

“A highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens.”

Ben Bernanke, Chairman of the US Federal Reserve

Last week, Ben Bernanke, the Chairman of the United States Federal Reserve, stepped up to the plate and announced the central bank’s long-awaited decision to give the US economy another financial shot in the arm to boost growth. As ever, Mr Bernanke’s plan had a twist to surprise the markets. In a stunningly bold move, he launched an open-ended programme pumping an extra $40 billion into the economy each month through purchases of mortgage-backed securities. Previous stimulus policies have been straightforward and directive; for example, promising to hold official US interest rates at today’s very low level, for a minimum period of time. Before this latest meeting, the promise had been that interest rates would not rise before the end of 2014. As expected, that has now been pushed back, with the Fed statement suggesting that rates will stay close to zero until at least the middle of 2015.

But when it comes to injecting money into the economy, this latest decision has the Fed embracing an equally unprecedented amount of flexibility. That is not what some were expecting and there is also, for the first time, a suggestion that rates will stay very low even after that. Mr Bernanke said that “A highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens.” The latest round of quantitative easing is different insofar as it does not have a defined limit and will continue until the labour market improves. The change in policy runs in parallel with Mr Draghi’s change of tack when he said he would do “whatever it takes” to save the euro. The Fed chairman is sending a similar message, saying there is no pre-announced limit to QE3: that it will sail indefinitely; and that largely it will be the state of the real economy – particularly unemployment – that will set its course. Republican critics in Congress and general inflation ‘hawks’ do not like the idea of the Fed creating yet more money – possibly another $1.4 trillion or more, if it continues to buy bonds right up until the middle of 2015. That’s on top of the $2.3 trillion the central bank has already spent in its various rounds of quantitative easing.

But with the economy at the top of the US political agenda, the central bank is surely not going to please everyone with this new approach. Nor, given all the uncertainties hanging over US fiscal policy and the global economy, has it necessarily found the key to unlock America’s jobs market. There are some economists and analysts who think that, for a true stimulus, the Fed should drop QE3, arguing that printing money has had unintended consequences. Traditional theory used to mean that easy money reliably drove up the price of stocks but not of commodities. However, post-2007 since the Fed first embarked on its aggressive policy easing, billions of dollars have flowed into financial products that allow investors to trade commodities the way they trade stocks. The outcome? Today there is a tight correlation between stocks and commodities, with prices rising and falling in lockstep. During round one (sixteen months to March 2010), the CRB Continuous Commodity price index rose 36%, food prices rose 20% and oil shot up 59%. Round two – the eight months to June 2011 – saw prices increase by 10%, 15% and 30% respectively.

This link effectively neuters policymakers because rising commodity prices impact directly on consumers, reducing their discretionary spending power with more of their income needed for staples. Another way of looking at it is that rising oil prices act in the same way as rising interest rates used to: by discouraging consumption. This is the complete reverse of what the Fed is trying to achieve, of course. The Fed’s policies have also impacted on the emerging world where food and energy constitute an even larger share of consumer spending. The Fed’s actions may, arguably, have been the catalyst behind geopolitical tensions in the Middle East. Not that the US is alone in creating unintended consequences: China’s unprecedented easing of monetary policy after the 2008 crisis has fuelled inflation and created a housing bubble which it is now trying to gently deflate. But for now, whilst QE3 may have upset the Republicans et al, the financial markets are on the front foot and only the very brave would bet against the Fed, Mario Draghi and China.

Good news for eurozone

  • ECB’s bond-buying programme boosts sentiment and allays fears of euro break-up
  • Ruling by German constitutional court and Dutch election result strengthen political muscle for support of euro

As mentioned, the ECB’s daring decision to buy unlimited quantities of government debt has put a floor underneath bonds and led to lower borrowing costs for the likes of Spain and Italy as they struggle with austerity and recession. The purpose of the move, though, was not just about easing short-term outcomes, as member states endeavour to put their houses in good order, but to eliminate the risk of a complete eurozone break-up forced by the markets. It should also buy time for the politicians to bring about fiscal union and, of course, much-needed growth policies. So, for once, there was some collective good news for the embattled region. As said, bond yields have fallen for peripheral states as confidence returns, although the plan does require the likes of Spain and possibly Italy to formally request help. Midweek, Germany’s constitutional court ruled that the centrepiece of the eurozone’s rescue fund – the European Stability Mechanism – did not violate the German constitution and hence removed a further shadow over the EU’s rescue efforts. In Holland, Dutch voters veered away from anti-EU parties, resulting in unexpected gains for Mark Rutte’s Liberal Party. Finally, calls from German politicians to eject Greece have gone quiet and confidence has grown that Greece will be granted more time to meet tough budget reforms, reducing the possibility of a ‘Grexit’. Unsurprisingly, all this helped spur gains in European equity markets; particularly in financials, where the sector has rallied almost 50% in the last few weeks.

Chinese whispers

  • Outgoing premier highlights action taken to re-invigorate growth
  • Local governments announce spending plans totalling RMB 10 trillion ($1.6 trillion) in effort to boost growth
  • China continues to dominate emerging-market growth

As the world’s second-largest economy prepares to undergo a once-in-a-decade leadership change next month, the apparent disappearance in recent weeks of the country’s leader-in-waiting Xi Jinping started rumours that all was not well within the ruling Communist Party, or indeed with Mr Jinping himself. Events though echo many previous Chinese power transitions over the last 40 years and are typical of the country’s secretive political elite. There is another parallel too: leadership transitions have, like clockwork, been accompanied by a big jump in government spending. In recent months, markets have become very concerned about a slowdown in one of the world’s key powerhouses. Data showing falling exports and industrial production along with rising inflation have fuelled concerns that all is not well and that the economy faces the hard landing the authorities have worked hard to avoid. To put events into context though, having grown at an average of 10% per annum for the last three decades, it was inevitable that China could not sustain this. But recent growth rates of around 7.6% are exactly in line with Beijing’s current five-year economic plan to slow annual growth to a more sustainable 7.5% and, at the same time, shift the economy’s dependence away from investment-driven, infrastructure-led growth to a more consumer-based economy.

China’s outgoing premier, Wen Jiabao, defended his policies and, whilst acknowledging that the downturn had gathered pace in recent months, insisted the government still had the ability to stabilise the economy, pointing to tax and interest-rate cuts made this year, steady growth in money supply and increased spending, including on infrastructure. Recent bank-lending numbers suggest that Beijing is steadily increasing the economic boost it wants to deliver, with some $111 billion being lent in August alone and with the trend firmly on the rise. Many municipal and provincial governments have announced new spending plans which already total some $1.6 trillion and, with inflation back under control, the groundwork has been laid for more monetary easing and fiscal spending next year. This will be good news for many of the world’s international corporations whose fortunes are tied to the continued growth of the emerging-world economies, led by China, and reinforces the need for investors to continue to diversify their portfolios to maximise their opportunities for growth.

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