World
Equity market resilience in the face of triangulation of concerns
Markets are currently encountering a triangulation of headwinds. The first concerns US monetary policy. After experiencing fierce criticism post the commencement of QE2, speculation has grown that the Federal Reserve will curtail the bond purchase programme. This is extremely unlikely, and QE2 will continue until the objective of higher core CPI and employment have been achieved.
The second concerns fears that the interest rate tightening cycle in China will produce a hard landing for the economy next year; this has resulted in a 10% correction in the equity market. Again these fears seem overstated. Higher rates are designed to curb excessive speculative credit and not radically change the growth trajectory.
The third headwind emanates from Europe. German insistence that bond holders share the cost of any future sovereign rescue precipitated the collapse in Irish bonds and the subsequent request for an Irish EU/IMF financed bail-out. Contagion fears have reignited with Portugal and Spain seen as the most exposed to solvency pressures. It might well transpire that the ECB have to respond to these pressures by restarting QE. This suggests that the euro, which has fallen by 6% against the dollar, will have more downside.
Europe
German shift triggers turmoil in peripheral bond markets
Sentiment regarding sovereign debt risks ratcheted up substantially in November. The insistence by the German chancellor that private bondholders must expect to share the cost of any future bail-out saw bond holders and corporate deposit holders run for the door. The subsequent surge in bond yields from 6% to 8.9% by mid November forced the Irish Government to accept an IMF/EU rescue package drawing upon the emergency stability fund. The ECB president presciently cautioned that such a move by Germany underestimated the 'reality of the situation' and was adding fuel to the fire.
Concerns rapidly extended from Ireland to other peripheral markets with the spread between German bond yields and those of Portugal, Greece and Spain reverting to levels seen last May.
The principal problem for the peripheral economies remains 'solvency' (the inability to shrink the debt to GDP ratio). With their real effective exchange rates very overvalued relative to Germany we are likely to see more pulses of tension emerge in 2011. While Portugal is seen as the next domino, Spain remains the main focus of attention. In many ways it exhibits similar characteristics to Ireland (high unemployment, and a massive real estate inventory). At the moment the banking sector in Spain looks less vulnerable than Ireland's but we have learnt how quickly perceptions can change. More bank restructuring and recapitalisation in Europe should be expected. Ultimately the way to resolve the crisis would be to establish a fiscal union with a centralised EU treasury function. However, given the shift in German attitude this has de minimis chance of coming to fruition. Hence, concerns over the structure of the euro itself will persist.
UK
Persistent inflation delays the prospect of QE2
The persistence of inflation and the forecast that CPI will remain above the 2% target level until 2012 is proving to be extremely frustrating for the MPC. While IMF analysis shows that the reason UK inflation dynamic has been so different to the US and Europe is mainly due to the pass-through effect of the 20% devaluation of trade weighted sterling over the last three years, any prospect of the UK introducing QE2 has effectively been pushed out into 2011. Mervyn King remains of the view that monetary policy needs to incorporate de facto demand management as the UK faces a combination of fiscal contraction, household deleveraging, weak credit growth and negative real earnings growth.
The labour market in the UK has been remarkably resilient with a total of 167,000 jobs having been created between July and September. However, aggregate earnings growth has been hampered by all the job creation coming entirely from part time vacancies. This is helping to subdue inflation expectations.
The UK Government's pledge of £7bn to the Irish Government is justified by the fact that UK banks, principally Lloyds and RBS, have significant loan exposure to Ireland. Ireland is also an important export market.
The equity market is consolidating after the strong rally between September and November. Given the recent turmoil in Europe it has shown remarkable resilience. With liquidity remaining supportive, any sign of positive earnings revisions should act as a catalyst for another upward move.
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