Research & Analysis for Business
and Investment Clients
Since the financial collapse of 2008, markets have been buoyed by World Central Banks. The Federal Reserve continues purchases of MBS and long-term Treasury securities at a rate of $85 billion per month. The Bank of England and European Central Bank (ECB) have similar stability programs.
Between July 2007 and February 2013 the Federal Reserve and Bank of England grew their balance sheets by 254% and 394% respectively. In contrast, the European Central Bank shrank its balance sheet with early repayments of 224 billion euros. European markets stabilized in July 2012 when the ECB said that it would do “whatever it takes to stabilize the euro”.
Money flowed into safe haven assets pushing yields down. Seeking yield, money is flowing from less risky assets to more risky assets such as equities.
Equity markets have rallied 23% since the low reached in June 2012. This trend occurred because the markets perceive governments to be limiting downside risks. The OECD countries as a whole saw GDP shrink in Q4 with Germany & France contracting. Earnings per share for US corporates were successively revised downward.
Regulatory developments also reduced fears that liquidity coverage ratios (LCR) would be phased in abruptly. In January the Basel Committee on Banking Supervision introduced a revised LCR that includes qualified MBS, corporate bonds, and equity as liquid assets to be phased in more slowly with more lenient run-off restrictions. As a result, equities were lifted and CDS spreads compressed.
Policy accommodation is the market driver, not improved fundamentals . Without macroeconomic growth, this trend will only continue while governments support mortgage backed securities, infrastructure programs, and troubled asset repurchases.
Country Specific Information
Emerging markets are a bright spot with more robust growth (approximately 3.5% Latin America, 2.7% Eastern Europe, 4.8% Asia – measurement errors not-reported), offsetting Greece and Spain whose unemployment exceeded 25% (50% for youths under 25 years of age)
Given the ECB and proxy reassurance from the Federal Reserve stabilization, Italian and Spanish bonds had robust demand in spite of weak growth, deepening recessions, and political uncertainty. Central Bank stabilization caused corporate bond yields to decline, raising the relative attractiveness of equities.
Capital inflows into emerging market (EM) funds surged with the largest portion going to dedicated equity funds. Investors increasingly sought funds investing in local currency-denominated bonds, exposing themselves to EM currency risk
China allayed fears of a hard landing by expanding infrastructure investment and promoting bank lending.
Japan saw growth as a result of expansionary policies, however, Japan’s stimulus package was financed with funds that lack tax revenue support for 51% of the issuance. Japan’s current debt-to-GDP ratio exceeds 200%. The Bank of Japan is expected to further expand quantitative easing to hit an inflation target of 2%.
Underlying economic weakness combined with government debt expansion exceeding GDP growth is cause for concern.
Without growth, it is unlikely that equity markets will continue to rally significantly. However, it is expected that modest growth and continued Central Bank support will maintain a small upward tailwind for the predictable future. Markets are expecting Central Bank repurchasing programs to diminish. Should Federal Reserve language suggest programs to be reduced, expect a market dip.
Japan is expected to make a concerted effort to devalue the Yen. With Debt-to-GDP exceeding 200%, an aging population, and significant competitive pressure from surrounding countries, Japan must make exports less expensive.