Thursday, October 18, 2012

The next phase in the financial market recovery

The first phase in the recovery of financial markets started at the end of July when ECB president Draghi delivered his London speech where he effectively pre-announced the buying programme for peripheral bonds ("To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate. So we have to cope with this financial fragmentation addressing these issues.”). This transferred the ECB in a de-facto lender-of-last-resort for Eurozone sovereigns. As a result, the tail risks of a Eurozone break-up/a wave of sovereign and bank defaults have been reduced drastically. Amid lower systemic risks, spreads on carry products including peripheral bonds tightened, equity markets recovered and safe-haven yields (Bunds) went into range-trading mode while the Euro recovered against almost any other currency. Over the past weeks, however, markets went into consolidation mode amid still weak economic data and doubts about the effectiveness of monetary policy. Now, however, this consolidation is over and markets are entering a second phase of recovery. 

10y Spain-Bund spread: Long-term tighteing trend since Draghis's London speech intact, temporary consolidation period now over

Source: Bloomberg
While the first phase was driven by lower systemic risks, this second phase should be driven by an improving growth environment as well as by ongoing easy monetary conditions. I have been expecting US growth to recover starting with data referring to September. Reasons are that the longer-term underlying fundamentals have been improving amid a stabilisation in the housing market, a much reduced household debt burden and the restoration of the monetary transmission channel. Seasonal adjustments are still playing havoc with the released data though and seasonally adjusted data paint too weak a picture during spring and summer. However, from September onwards this reverses and seasonally adjusted data paints more or less an accurate picture (September/October) to a too strong picture (from November onwards). Hence, the positive data surprises should continue. Furthermore, the Asian economies seem to be stabilising as indicated by the export data for September from Korea, Taiwan and also China. Finally, in the Eurozone sentiment data has been bottoming out and should improve further, followed by a return to moderate growth (I expect 0,5-1% growth in early 2013). On the other side, inflation has mainly been driven by commodity prices and in the Eurozone also by higher taxes/higher administered prices (amid fiscal tightening) and the core numbers ex administered prices are low (smaller than 1% in the Eurozone). Hence, there are no inflation risks present. In combination with the major economies operating significantly below potential, the major central banks do not need to take any tightening steps for a long time.
This combination of a high level of excess liquidity, no threat from inflation/tighter monetary policy coupled with improving growth should support risky assets over the next months and credit spreads should tighten further. In the periphery, long-end spreads have the most tightening potential (So far I preferred the 4-7y area in Spain/Italy and would now focus on 10y instead). The debt-deflation spiral (higher yields leading to a worsening in the long-term debt dynamics, more fiscal tightening, weaker bank balance sheets and a weaker economy and amid higher credit risks leading also to higher yields) has been broken and the risk of a buyers' strike has been much reduced. In turn, yields can fall significantly further. On the other side, Bund yields should bear-steepen moderately. The recovery in the Euro has further to run. However, while the first phase in the recovery was marked by a general appreciation of the Euro against almost any other currency, from now onwards the recovery should be mainly against former "safe-haven" currencies (such as the USD or the JPY) whereas growth currencies (from commodity producers/emerging markets) should start to fare better again.