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Monetary and capital markets
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The ECB and the Fed confirm the withdrawal of non-conventional measures
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The ECB and the Fed provide details on their exit strategies...
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At the start of December, the European Central Bank (ECB) focused its attention on the markets. On the one hand, there was no doubt that the decision regarding the official interest rate would be to keep it the same. On the other hand, however, the announcement concerning the details of the exit strategy for non-conventional measures was awaited with baited breath. With regard to the first point, the ECB confirmed expectations and kept the reference rate at 1.0%. With regard to the second point, ECB President, Jean-Claude Trichet, did not disappoint the markets and explained in great detail the gradual withdrawal of measures that had been introduced exceptionally during the crisis.
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...while making it clear that this does not involve raising interest rates in the short term.
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The steps to be taken by the ECB show that the strategy will focus on restoring the system for ensuring liquidity that was in place prior to the financial crisis. The institution's decision to withdraw special 12-month operations (LTRO) came as no surprise and the LTRO of 16 December was therefore the last. In this operation, the ECB allotted 96,000 million euros to 224 banks at an interest rate that is the average of the minimum bid accepted in the weekly auctions (MRO) held until maturity. Regarding six month refinancing operations, the ECB announced that the last will be held on 31 March 2010, covering the whole demand and at a fixed interest rate. Non-regular monthly auctions will continue at least during the first quarter of 2010. The ECB also confirmed that MRO conditions will not be altered until at least April 2010, i.e. all liquidity required will continue to be provided at the fixed interest rate of 1.0%.
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In addition to the announced measures, we should also underline the last paragraph of the ECB's communication. This contains an indirect reference to the possibility of a specific operation being carried out to drain liquidity related to one-year operations that mature during the second half of 2010.
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In spite of the central banks taking a firm stance, the steps taken will be gradual.
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By the middle of December, the markets' attention shifted to the United States due to the meeting of the Federal Open Market Committee (FOMC). After this meeting, on 16 December, the Federal Reserve Chairman, Ben Bernanke, announced that the official rate would remain within the range of 0.00%-0.25%. But here also the most eagerly awaited announcement was the one concerning non-conventional monetary measures. In this respect, the Fed confirmed that most special liquidity facilities will mature on 1 February 2010. With this decision, the Fed acknowledges that the improvement in credit markets can be sustained.
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Among the special facilities maturing in February are the lines for Asset Backed Commercial Paper Money Market Mutual Fund Liquidity, Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF) and the Term Security Lending Facility (TSLF).
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Moreover, the Fed also announced its plans to close down the currency swap lines held with the main central banks in the world, these being created temporarily because of the crisis.
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Cutting back the Fed's independence might affect price trends.
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The monetary authority will also continue to gradually reduce the Term Auction Facility (TAF) throughout the first quarter of 2010. However, the commercial mortgage-backed Term Asset-Backed Securities Loan Facility (TALF) will be kept until 30 June, and up to 31 March 2010 for non-mortgage-backed loans.
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In spite of the Fed indicating the firmness and confidence of its Committee members in its communication, significant room for manoeuvre has also been provided as a precaution. Consequently, the Fed explicitly stated that it is prepared and ready to modify any plan in order to maintain financial and economic stability.
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Interbank interest rate reflects the market's great liquidity.
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Another issue of great interest to the markets are the initiatives to audit the Fed's decisions, to limit its capacity to supervise banks and to allow politicians to vote for the chairmen of the regional banks that form part of the Federal Reserve System. These initiatives are creating uncertainty since the markets believe they would weaken one of the most highly valued aspects in a central bank: its independence. Greater or lesser independence in the area of monetary policy is associated with greater or lesser credibility, the fundamental basis for forming and anchoring the expectations of economic agents. Attacking this principle might damage the stability of inflation in the medium and long term and therefore economic performance.
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The United State's public debt has maintained stability over the last few months.
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The details revealed by the central banks regarding their exit strategies have not altered the relative stability noted in the interbank markets (of the United States and the euro area) throughout the last month. Once again, December saw a reduction of around five basis points in the 7-12 month tranche of the US curve.
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When interpreting the stability of the interbank curve in the euro area, we must take into account the fact that the volume of operations is still very low. This, in turn, is influenced by the huge liquidity maintained by institutions due to operations carried out by the ECB with different maturities. Ultimately, the low level of the EONIA, at around 0.35%, is a reflection of the excess liquidity in the banking system of the euro area as a whole.
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Discrimination of sovereign risk in the euro area
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During the last month of the year, stability was maintained in the US government bond market. 10-year US government bonds currently offer a return of 3.58%. This stability is a reflection of two elements remaining unaltered. The first factor is the purchase of public debt by the Fed and commercial banks. The second is that economic agents expect inflation to remain steady.
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Debt differentials increase for the periphery countries in the euro area.
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In the euro area, the government bonds issued by Germany, France and Italy have hardly undergone any significant variation. However, doubts concerning the fiscal sustainability of periphery countries such as Greece and Portugal have significantly increased their interest rate differentials with Germany. Investors believe these periphery countries have a worse credit profile and therefore demand a better yield from the public debt they issue. So the market is discriminating between the sovereign risk of the different countries in the euro area.
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Rating agencies downgrade Greece's credit rating.
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Certainly, reducing public deficit is the main challenge facing the economic managers of developed countries in the coming years, these fiscal deficits being the result of the intense expenditure carried out to stabilize the economies. For this reason, rating agencies have decided to reflect this deterioration and have downgraded or revised the credit ratings of several countries in the euro area.
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The country that has suffered most from such changes is Greece. Fitch and Standard & Poor's (S&P) have downgraded Greece's debt rating from A to BBB+. Moreover, S&P has kept Greece's rating under review and with a negative perspective. Finally, doubts regarding the Greek government's shock plan, designed to avoid excessive rises in debt, has greatly affected the country's government bond market and the markets of the region as a whole. While Germany can finance itself by issuing 10-year bonds offering a yield of 3.25%, investors require 5.76% from Greek public debt, i.e. 251 additional basis points.
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In the case of the United States and Germany, the expectation that economic recovery will continue over the coming months helps to explain the absence of significant changes in the value of their public debt. Compared with those euro area countries that are suffering wider interest rate differentials with Germany, future developments will depend critically on the solidity and viability of the fiscal consolidation plans published. As usual, the markets are not showing much patience and time is running out.
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The dollar appreciates strongly against the euro
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The dollar appreciates strongly against the euro.
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During the month of December, the most significant change in the currency market has been the appreciation of the dollar compared with the euro. While, at the end of November, one euro was worth 1.51 dollars, on 16 December this had fallen to 1.44 dollars. This means that the dollar has appreciated 5%.
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This movement has been surprising due to its intensity but there is consensus regarding its causes. The combination of three factors has boosted the dollar. Firstly, the good macroeconomic figures published for the United States, slightly better than the market expected, in particular in terms of the job market and real estate sector. Secondly, the growing doubts, already mentioned, regarding the fiscal sustainability of some countries in the euro area. Lastly, the dollar has also been boosted by the end of speculative positions in carry trade, given the likely interest rate rises in the United States. Carry trade is a financial operation where debt is bought in currencies with lower interest rates and the money then invested in financial assets issued in other currencies with higher returns.
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These factors have not only strengthened the dollar against the single European currency but have also boosted its appreciation against the rest of the important currencies, such as the Japanese yen, the Pound sterling and the Swiss franc.
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Expectations of US monetary policy getting back to normal boost the dollar.
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Throughout 2010, the dollar should appreciate moderately against the euro and, for this to happen, the key factor will be the start of the cycle of monetary normalization in the United States. How exchange policy is handled in China will also be important, apparently keen to allow the yuan to start appreciating again. In any case, although the news of economic improvement in the United States may have advanced the dollar's appreciation, after such an intense, fast episode we cannot rule out the possibility of a certain reversal, just because of profit-taking by investors.
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New boost to corporate bond markets
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Corporate bond markets on the up again.
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After several months of consolidation, private bond markets picked up again in December. Credit spreads fell back below the thresholds in place when the Lehman Brothers went bust and were approaching the levels prior to the Bear Stearns bankruptcy. The announcement by the central banks that they would start to withdraw temporary measures to support liquidity and credit has not significantly affected the positive tone of this market. Neither are the tensions in the government bond markets of Dubai, Greece and, to a lesser extent, Portugal having a negative effect.
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Economic recovery is the decisive factor.
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The decisive factor in this good phase for private bond markets is the economic recovery that, to a greater or lesser extent, is spreading throughout all geographic regions and almost all economic sectors. This is reflected in the widespread improvement in the debt rating of firms by rating agencies, unlike what has been happening recently with the public debt of some countries. This process has developed most positively in the United States, while in the euro area and South-East Asia improvement is still in its infancy.
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The positive tone of indices has been accompanied by constant growth in the volume of corporate debt issues, which continue to break records.
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Expansion in the private bond market is following a trend supported by several factors. Firstly, banks have made an effort to contain their risk positions in order to comply with the new and more demanding capital ratios. Secondly, after the seriously high cost of borrowing suffered by firms, they have decided to resort to the capital markets, sometimes by way of prevention or experiment. They have therefore relegated bank funding to a secondary level, as well as diversifying their sources of financing and extending maturities. Thirdly, numerous end investors, both institutional and private, with high levels of liquidity have found investments in this market with a very reasonable return to risk ratio.
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In summary, the demand for private bond assets is growing steadily and this is expected to continue in the future. Private and institutional investors still have high liquidity and, due to the lack of return from other investments (such as monetary assets or public debt), the flow towards markets with higher yields and risk is likely to continue. Within this context, it is very likely that corporate debt credit spreads will continue to reduce, albeit moderately given the amount they have already fallen and logically with the possibility of temporary corrections.
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2009 has ultimately been a good year for the stock markets
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The stock markets' annual balance is positive, although the rate of increase is slowing up.
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2009, which started dominated by a scenario of risk and business losses, ended positively with an average stock market revaluation of more than 15%. The main gains in the stock market at a global level were concentrated between March and October, with a notable slowdown in the rate of rises in the year's home straight. Stock markets performed irregularly in December depending on the economic area in question. While indices resisted breaking the records made in the previous month in developed countries, in emerging economies the incipient shift in monetary policy towards a scenario of rising interest rates led to revaluation slowing up.
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It should be noted that, in spite of equity markets in the United States and the euro area being reluctant to reach higher values, in both cases investor take-up was satisfactory for the capital increases carried out by companies, particularly those issued by US banks in order to achieve financing to return the aid received from the American Treasury via the TARP.
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Stock markets value the improved perspectives for economic growth.
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There are two aspects of stock market trends in December that are worth highlighting. The first is the apparent changeover of the factor that boosts share value. Up until a few months ago, the aspect of primary importance in the markets was an abundance of liquidity, as this situation minimized credit risk. But now that the ECB and the Fed have revealed the details of their exit strategies, investors have started to prioritize a purely economic aspect: the expected growth in GDP and profits. This is the main variable that has allowed stock markets to consolidate their gains in the home straight of 2009.
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The dollar exchange rate and the S&P 500 are moving in synch.
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The second relevant fact was the break with the negative correlation between the dollar's value and the US stock market. Historically, there has been a high negative correlation between trends in the dollar and the S&P 500, i.e. the stock market rises when the dollar weakens, and vice versa. In December this relationship became positive, something that had not happened since the period 1997-2000.
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It is also worth mentioning the effect of a series of factors that had aroused doubt among investors but which ended up being fleeting, showing that the market's foundations are now stronger. On the one hand, the request for deferral by Dubai World, the real estate holding owned by the Dubai government, in repaying its debt totalling 60,000 million dollars. This piece of news revived doubts concerning the possibility of another corporate bankruptcy that would seriously affect the balance sheets of many international banks. On the other hand, the downgrade carried out by the rating agency Standard & Poor's for the debt issued by some governments in the European Union.
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In general, everything suggests that, once all these factors have been taken into account, equity is seen as an attractive alternative investment, as are corporate bonds, where the potential revaluation can still provide profitable margins in the medium term. However, in the short term we must still be cautious, as we cannot rule out the emergence of risks associated with the withdrawal of liquidity. Neither can we rule out those aspects that limit the rate of recovery in economic growth and that therefore reduce the potential of stock market indices.
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Stock market prospects: keeping a watchful eye on portfolios
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Investor mood is significantly different from a year ago
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The climate among investors was radically different at the close of the 2009 stock market year from what it was twelve months earlier. The fear of total financial collapse, depression and deflation dissipated as the year advanced, driving revaluations that, considering March's minimums, must be classed as extraordinary (in round numbers, 80% for Spain's Ibex 35, 60% for the S&P 500 of the United States and Eurostoxx 50 of the euro area, 40% for the Japanese Nikkei and 70% for the MSCI-Emerging Markets).
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With all eyes on the new year, the challenge is to identify which elements might have a decisive effect on equity markets and future prospects. But first of all it's useful to examine the road taken by markets within a broader timeframe and to weigh up some basic indicators of the current situation. This information, sensibly, calls us to curb the feeling of euphoria that might be generated by the aforementioned spectacular figures.
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The graph below illustrates that, for the main international stock market indices, 2009's gains have merely served to recover part of the losses suffered in the second half of 2007 and in 2008. Moreover, the S&P 500, Eurostoxx 50 and Ibex 35 all closed 2009 below their levels of 1999, thereby constituting a «lost decade» for stock market investors.(1) And in the case of the Nikkei, at year-end its levels were the same as in 1984, evidence of particularly adverse conditions in this stock market. The counterpoint lies in the markets of emerging countries that, although they have not completely escaped periods of downward trends, have accumulated notable gains over the last ten years.
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This extensive period of poor performance on the part of western stock markets begs the question of whether they are now in a particularly attractive situation for long-term investors. We should note that the interpretation of valuation indicators based on «price/earnings» (PER) ratios is particularly problematic in periods of macroeconomic instability such as the present, with the added factor of uncertainty surrounding the structural transformation of the financial sector and of high weighting in reference stock market indices. In any case, the graphs below show that, at the end of 2009, cycle-adjusted PER figures(2) suggest that valuation is correct in the United States (which is perhaps a bit disappointing) and slightly undervalued in the euro area, balanced interpretations compared with the extremes of the end of 1999 (overvaluation) and March 2009 (undervaluation).
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With such a starting point, and employing the most likely scenario of gradual economic recovery and the absence of sustained financial tension, these two indices might reasonably perform in line with the current predictions by stock market analysts: revaluation in the order of 10% for the S&P 500 and 15% for the Eurostoxx 50. These figures are somewhat on the optimistic side but, even so, they are much lower than the gains over the last nine months. And, even more importantly, they are projected within a context where very high risks still hover over equity, either due to a relapse in economic activity or an upswing in inflation and interest rates.
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Logically, the potential revaluation (and risk incurred) differs depending on the portfolio choices made, according to criteria such as geography, sector or investor profile (e.g. company size). In fact, in macroeconomic contexts that are dominated by uncertainty, as in the current post-financial crisis, the spread or divergence of returns depending on this choice tends to increase.(3) Signs of this could already be seen in the last few months of 2009 and it is very likely to continue for some time yet. It is therefore useful to examine a few aspects that are important when selecting a portfolio for 2010.
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With regard to the geographical criterion, there is still the basic dilemma between developed and emerging countries. The phenomenon of globalization boosted global GDP growth in the years of economic boom but has also been a means of passing on systemic risks. Thanks to each country maintaining its own economic characteristics related to its degree and model of development, the economic and financial crisis has not had the same impact on all countries. In turn, these differences are becoming crucial now that we are coming out of recession. Emerging economies, and specifically those of the BRIC (Brazil, Russia, India and China), have shown a lower level of deterioration during the global economic crisis and their activity has also shown a greater capacity to recover than the North American and European blocs. Forecasts also predict that these economies will head the process of growth over the coming years. Such aspects have taken priority in stock markets during the last year, leading to greater advances in the indices of emerging countries than those in developed countries, and this pattern is likely to continue throughout 2010.
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Another notable element in the recent revaluation of equity is unequal sector trends. The shift in analysts' consensus estimates towards a scenario of a slow recovery in business margins, as well as the stabilization of economic data, led to a sector revaluation that was out of proportion. A clear example can be seen in a sector analysis of the S&P 500, especially (see the left-hand graph below) the recoveries throughout 2009 in the financial sector, benefitted by the actions of central banks, and in other cyclical elements such as commodities and information technology, closely linked to the point in the business cycle. In 2010, and in general, the sectors that led this recovery are likely to give way to other alternative sectors and areas. After notable rises in valuations, and given that global risks still exist, one option that will probably gain in popularity is the search for safer rates of return via dividends, particularly through defensive sectors (e.g. energy and utilities).
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Thirdly, choice according to the criterion of company size might take on particular importance in stock markets such as the one in Spain. As can be seen in the right-hand graph below, since the start of the crisis the Ibex 35 (made up of the largest companies with the greatest stock market liquidity) has performed manifestly better than the Ibex Small Cap index (made up of the smaller firms on the stock market). Apart from the factor of size in its purest sense (with considerations of company quality and security), the divergence between these two indices actually includes other, even more powerful effects. One that is particularly significant is the degree of exposure to international demand(4) (i.e. the percentage of turnover and/or profit gained abroad), which is much higher in the Ibex 35. The relative tardiness and weakness of the Spanish economy's recovery lies behind this pattern and it's likely to continue for some time yet. But throughout 2010 we must watch out for a likely change in forces, as investors start to perceive the reactivation of the Spanish economy and this is reflected in share prices.
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(1) The calculation of the three indices mentioned do not include dividends that nonetheless contribute to the total return on investment.
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(2) PER using the average earnings over the last ten years as a measure of «earnings».
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(3) See for example: Nicholas Bloom, The Impact of Uncertainty Shocks, Econometrica, May 2009.
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(4) Another is the weighting of the financial sector, much higher in the Ibex 35.
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This box was prepared by Beatriz Villafranca and Avelino Hernández
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Financial Markets Unit, "la Caixa" Research Department
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