North America

  • The stock market was in an upbeat mood last week - responding with great optimism to some corporate earnings reports that came in close to expectations. It appears that after a longish period of gloom investors were looking for a reason to cheer up. From a seasonal point of view, November and December have generally been favourable to equity upswings. However, this year, there are more challenges than usual. The economic picture is a little murky and geopolitical risks are high.
  • Consumer sentiment, as measured by the University of Michigan index released last Friday, remains weak. However, in this cycle, there hasn’t been a close short-term correlation with actual spending. Thus far, households have time and again refused to retrench. When the government gave them tax breaks they spent most of the money, and when the Fed gave them dramatically low interest rates they took advantage of it by running up even more debt. Much of this profligacy has been underwritten by continuing house price appreciation, as well as hopes for a robust labour-market recovery. This has also allowed homeowners to weather the storm of declining stock prices. While it is not an immediate prospect, any serious re-pricing of their principal asset would force households into unpleasant adjustments on the debt front.
  • Bank stocks have been taking it on the chin lately as worries about corporate defaults have increased. Weakness in capital markets and the downturn in profitable underwriting business have taken their toll on the bottom line. In addition, some banks are also suffering because of the acquisition of over-priced businesses during the boom years. Now, they have to write-off some of those investments and downsize all round. The most profitable part of their business has been the consumer sector and, touch wood, this should see them through a tough period. In general, their risk management practices have worked better in this cycle than previous ones. Nevertheless, credit spreads on bank debt have widened significantly. We are not out of the woods yet, as far as corporate and consumer issues are concerned, but the major money-centre banks will eventually rebound from their current problems.
  • The Bush administration is intent on pursuing the conflict with Iraq to its ultimate conclusion, irrespective of any voiced opposition. Their underlying hope is to score a quick "victory" and tie up any loose ends, later. Prospects for a rapid and successful military campaign are good and this should, initially, provide a morale boost for consumers, businesses and the markets. It is still too early to say how longer-run stability issues will be handled.

Europe

  • Once more, at its most recent meeting, the European Central Bank refrained from cutting interest rates. It is, of course, facing some tough challenges, even as the Eurozone economy shows further weakness. The problem is that the ECB’s primary role is to control inflation via monetary policy instruments. Its main fear is of being put in the position of having to validate unsound government fiscal policies and inertia on restructuring
  • Currently, there has been some relaxation of commitment, by core Eurozone governments, to fulfil Stability Pact agreements on debts and deficits. Also, supply-side reforms are slow in coming. Naturally all of this puts the ECB on the defensive, despite recognisably challenging economic conditions. Ultimately, they are still likely to effect an interest rate cut before the end of the year. But, longer run, investors have to ask themselves which model they prefer: a central bank committed to price stability, or the Canadian model where the Bank of Canada has always been ready to tailor its policy to validate irresponsible government fiscal action.

Asia/Pacific

  • Japan continues to suffer from deflation, and with the government now set to tackle the bad-loan problem at the banks more vigorously, the downside risk for the economy has increased. In this context, a normal countervailing tactic would be to adopt an easier monetary policy. Unfortunately, the Bank of Japan has traditionally been reluctant to ease substantially, often offsetting and neutralising its own actions on the foreign exchange market. They have always pushed for reform, and now that it appears to be underway there may be increased pressure on the BOJ to adopt quantitative easing and inflation targeting.

Bonds

  • The rally in equities, last week, demonstrated the vulnerability of Treasury yields to sudden moves on the stock market. Treasuries sold off and investors reduced duration. If the rally holds, we should expect yields to edge even higher. But volatility will remain relatively high because of the safe-haven status of government-issued securities as geopolitical risk rises. On the supply side, the next few weeks will see heavy issuance of Treasury notes.

Currencies

  • With the U.S. equity markets having found a bit of a footing this should have been positive for the dollar, but its gains against the euro have been rather modest. This indicates that investors need more convincing in order to redirect additional flows into dollar assets.
  • With a backdrop of weak global growth, commodity currencies have been out of favour for a while. The Bali explosion added to the problems for the Australian and New Zealand dollars, which weakened further because of their exposure to Asia.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.