Research Dept. News
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Monthly Report, num 345 - April 2011
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Financial markets - Monetary and capital markets
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Calm in spite of the shocks
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The outbreak of conflict in Arab countries and the earthquake in Japan grab the attention of global investors.
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While, in February, the financial markets were disturbed by the socio-political conflict of the countries in North Africa and the Middle East, unfortunately in March the natural catastrophe suffered in Japan was added to the mix. Internationally, the effect of these factors has been passed on via two fundamental channels. Firstly, by rising commodity prices (mainly crude), significant due to the related risks of inflation and global growth. Secondly, the fact that both events are subject to a large amount of doubt, given that they are difficult to quantify, constitutes a threat to investor confidence and financial stability.
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However, the financial markets' performance observed during the first quarter of 2011 has been reasonably satisfactory compared with the same period a year ago. This is due to the positive trend in the macroeconomic variables of each region, as well as to coordinated action between monetary authorities and governments. Everything suggests that agents, when making their investments, are assuming that world economic growth will continue to consolidate, with contained levels of inflation and relatively comfortable liquidity levels. In the medium term, the bulk of the evidence available suggests that the progressive consolidation of this economic scenario should be accompanied by a normalization of monetary policy, which should not undermine the rises in stock market indices.
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Greater prospects for economic growth boost investor confidence.
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However, once again we must highlight the nuances generated by cyclical and structural differences between the different economic regions, given that unequal growth rates entail different monetary policy decisions, with a range of reactions in the foreign exchange, bond and equity markets.
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With regard to the euro area, we cannot ignore the fact that the development of the sovereign debt crisis in the periphery zone is now in at a key stage in its resolution, after the different summits held by top political leaders. Specifically, the progress made in the functions and operations of the European Financial Stability Fund, as well as the approval of the Euro Plus Pact, together with fiscal discipline, are managing to restore investor confidence in Spanish assets.
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The Fed focuses on growth while the ECB is concerned about inflation
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The development of the sovereign debt crisis in the periphery of Europe enters a key stage in its resolution.
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The world economy continues to advance apace, led by the emerging countries and supported by the progressive recovery both in the United States and Europe. However, recent politico-military and natural events negatively distort the balance of risk, a situation that makes it difficult to take economic decisions, particularly those regarding monetary policy. On the one hand is the growing geopolitical risk in the Middle East and North Africa, which has a direct impact on oil prices and, by extension, inflation and the economic activity of the different countries, of an uncertain and varying extent. Since mid-2010, oil prices have risen by almost 40%. The consensus of economic analysts estimates that this rise could deduct between 0.2% and 0.4% from the GDP of developed countries (the G-7) for the coming quarters, but we will have to wait and see how long and to what extent tension grows in the crude market. On the other hand is the negative impact that might result from the tsunami that shook Japan and the subsequent nuclear accident at Fukushima. In principle, most analysts limit any significant effects to Japan. However, and although it may be difficult to measure, we must not underestimate the impact of these events on investor confidence.
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The Fed continues to commit to lax monetary policy and quantitative easing but without forgetting inflation.
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Within this global environment, the Federal Reserve (Fed) is starting to present a slightly more optimistic view regarding the relevant variables that would determine the time to start changing its conventional and unconventional monetary policy. Regarding activity, the institution has pointed out that the recovery «is on a firmer footing», at the same time stressing that conditions in the labour market «seem to be improving gradually». We must remember that, in January this year, the reserve bank classified activity as «insufficient» to boost job creation in any sustained way. Regarding general inflation, the Fed believes that second-round effects will not occur after the rise in energy commodity prices over the last few months, but that a close eye will have to be kept on this factor. Given this scenario, the Fed announced that it is keeping its quantitative easing scheme in place in order to consolidate and boost the improvement. Most economists support the view that the institution presided over by Ben Bernanke will maintain its status quo in terms of official interest rates and balance management for a few more months, and will continue to resort to communication policy as a key tool to guide the markets. We will have to wait and see, in the coming summer, whether the institution sets out the lines of action it will adopt once the recovery is consolidated, which should include a route map for the gradual withdrawal of the stimuli currently in place.
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On the other hand, the ECB announces possible hikes in official interest rates in order to stabilize prices.
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In the euro area, the European Central Bank (ECB), by means of its President, Jean-Claude Trichet, surprised the markets at the press conference after the meeting of the Governing Council on 3 March. Trichet explicitly commented on the institution's unease regarding the low level of official interest rates and the need to get them back to normal. The main reason for the ECB's resounding change in tone is to keep inflation expectations firmly anchored at a suitable level in the medium and long term. These statements led to a radical change in investor forecasts, which now expect the central bank to start raising official interest rates in the spring. Moreover, Trichet, supporting himself with the «separation principle» between the mandate of maintaining price stability (whose instrument is interest rates) and the need to ensure financial markets work appropriately (by providing liquidity), confirmed that the full allotment policy will be maintained for another quarter in the seven-day, one-month and three-month loan auctions.
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Given the upswing in inflation, the emerging economies' central banks toughen up their economic policies.
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In general, the situation in the emerging countries has not varied substantially and economic authorities are focusing their efforts on containing short-term inflationary pressures resulting from the sharp rise in energy and food commodity prices, and on anchoring medium and long-term inflation expectations. Along these lines, the central banks continue to restrict monetary policy and accept a gradual appreciation of their currencies. In the case of China, the monetary authority has opted to increase the mandatory reserve ratio for commercial banks to 20%, whereas the central banks of India, South Korea, Brazil and Chile, among others, have decided to raise their official rate. Although monetary policy is tightening up gradually, the dominant opinion in the markets is that the strategy adopted by the central banks will manage to contain the second-round effects threatening economic stability. The main underlying risk, especially for China, is the rate of restriction being too moderate and not enough to stop the economy from overheating, not a very desirable situation as it might result in a sharp slowdown in growth.
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Europe's interbank market reflects the greater expectation of interest rate hikes.
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Within this global context, characterized by upward inflationary pressures, the interbank markets in dollars and euros continue to perform disparately. In the case of the Libor dollar interest rate, market expectations indicate that the current stability will continue being the predominant tone in the coming months. The Fed's decision to keep official interest rates very low and the abundant liquidity injected are helping this situation. On the other hand, and given the decisive nature of Trichet's message, the interbank market rates in euros have risen, principally the 12-month Euribor, up from 1.77% at the end of February to above 1.9% in March. The vast majority of analysts have upped their forecasts for European interbank rates. However, the levels reached in March are likely to consolidate for a few months, picking up again in the second half of the year when the central bank's monetary restrictions are in full swing.
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Temporary factors are affecting the government bond markets
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Government bond markets have reacted to the conflict in Arab countries and Japan's earthquake with higher volatility.
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In the last few weeks, sovereign debt has suffered from the geopolitical conflict in the Middle East and the events in Japan. Public debt yields at a global level have recorded strong volatility and a downward trend in March, a consequence of these short-term, temporary factors and not so much due to a change in medium or long-term macroeconomic perspectives. In the case of the United States, the fall in two and ten-year yields, to 0.53% and 3.15% respectively, has occurred over two phases. The first was associated with a mere technical correction after the strong upswing in yields during the end of February and early March. The second is the result of a «flight to quality» by investors, due to the terrible earthquake and tsunami that struck Japan and the intervention of western forces in Libya. This last phase also affected German 2 and 10-year bond yields, falling to 1.47% and 3.09% respectively. At the end of March, the geopolitical and nuclear uncertainty started to dissipate, a situation that boosted the confidence and appetite of investors for higher risk assets and, consequently, pushed up yields on the sovereign debt of central countries, reflecting more precisely the perspectives of solid global growth and moderate increase in inflationary risks.
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In the euro area, the progress made in resolving the sovereign debt crisis is helping Spanish public debt yields to stabilize.
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In the United States, we can expect yields to rise again as the end of the Fed's quantitative easing scheme approaches (planned for June) and the new direction of monetary policy is announced. There are principally two risks within this process that might accentuate this movement. The first is inflation, which the Fed has stated it is keeping a close eye on. The second, crucial to ensure no loss of investor confidence, is carrying out the necessary fiscal consolidation to ensure medium to long-term sustainability.
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In the case of Europe, specifically the central countries, current conditions point towards a consolidation of levels in the spring which, in the second half of the year, will give way to a moderate rise. This would affect both long-term and short-term rates, in line with the ECB's monetary restriction process. Regarding the risk premia of countries such as Spain and Italy, the gradual fall observed indicates that agents are welcoming the European Union's measures to improve economic and financial governance in the region. This new situation will help to reduce the sovereign risk premia of the peripheral countries, although countries such as Spain will do so to a greater extent than others with high debt ratios, such as Greece, Ireland and Portugal.
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International cooperation to slow up the yen's appreciation
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The euro exchange rate appreciates, pushed up by expectations of interest rate hikes.
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As has been typical since the start of the year, the foreign exchange market has continued to show notable stability in general, albeit dotted with some unexpected episodes. At the start of March, the calm was disturbed by statements by the ECB President suggesting impending interest rate hikes, and subsequently by Japan's earthquake. In any case, the dynamic of exchange rates is providing a more balanced reflection of the trends in economic figures among the main economic regions (basically between emerging and developed countries), helping to reduce volatility in these markets.
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In the case of the euro, the change in investor expectations regarding whether the ECB will raise the official interest rates in the near future, fed by repeated statements by important members of the institution, together with the satisfactory developments in the sovereign debt crisis in Europe's periphery, have been the factors behind the euro's appreciation to 1.41 dollars, a rise of more than 2.5% between the ECB's last meeting and the end of the month.
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Credit spreads widen as a result of international instability.
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Regarding the Japanese yen, the country's tragic events led to its currency rising sharply against the dollar, reaching record levels (76.25 yen per dollar). This strong movement was due to increased expectations regarding the repatriation of Japanese savings invested in foreign assets. Given this situation, and as an extraordinary measure, the central banks of the G-7 countries agreed to intervene jointly in the foreign exchange market, the first time in ten years. The mission was to sell yen in order to relieve the sufferings of the Japanese economy. As a result of this action by the G-7, the yen's exchange rate fell by almost 3%, reaching around 80 yen per dollar at the end of the month.
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High yield bonds still shine
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Yields for the high risk bond segment are still immersed in a downward spiral.
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The global private bond market performed well in March, although temporarily (and inevitably) subject to unstable episodes due to the tragic events in Africa and Japan. As has already been mentioned, these factors led to a selective fall in top quality sovereign debt yields and, therefore, an increase in credit spreads. This was a hiatus in the narrowing that has been occurring since spring last year. However, once the possible effects of Japan's natural disaster had been assimilated, credit spreads readily started to narrow again, indicating the strength exhibited by corporate bond markets for the last few months.
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In fact, having at least partially overcome the episodes of instability, the fall in firms' credit risk has continued inexorably, both in the United States and in the euro area. Once again, the greatest reduction has been in the high yield segment, to the point that yields for these corporate bonds were close to record lows. Taking advantage of this circumstance, investors have opted to increase the volume of their portfolios for this kind of asset.
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Agreements to resolve the European sovereign debt crisis make banking sector bonds more attractive.
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From the point of view of issuers, it should be noted that, in the case of the United States, the lassitude that is still being preached by the Federal Reserve is giving companies an opportunity, and one they are making the most of, to issue bonds with weak guarantees and very low interest rates, given that investors are reducing their demands because of the general context of low interest rates in traditionally alternative products (bank deposits and public debt). Nonetheless, managers can still find interesting opportunities within the wide range of corporate bond assets, albeit by being very selective in terms of geographical area and issuer.
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In the case of the euro area, the progress achieved in the last few meetings of central government heads regarding the new economic and financial governance framework has led the sovereign debt crisis of the periphery towards a satisfactory resolution, helping corporate credit risk premia to fall. To this we should also add the improvement in investor confidence, overcoming short-term setbacks such as the events in March, so that capital flows have once again increased towards the corporate bond market. In the current phase, a preference can be seen for banking and insurance sector debt in the euro area, severely hit during the harshest moments of the sovereign debt crisis.
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In spite of adversities, the stock market outlook is favourable
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The outlook for economic growth and the business expansionary cycle boost stock markets.
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The global stock market context has not remained unaffected by March's tumultuous international context. However, losses have been limited thanks to the support provided by the consolidation of global economic growth prospects and the boom of the business cycle. Although there has been the odd upswing in volatility, after having weighed up the effects of the risk mentioned above, investors have gradually returned to equity in detriment of other assets with less attractive expected yields.
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Improved expectations for yields from the indices of advanced economies are starting to attract greater investor flows.
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March saw a hiatus in the emerging stock markets performing worse than those of developed countries. Given that the economic conditions surrounding the emerging economies have not changed, this seems to be a one-off occurrence related to the month's tragic events that might not be repeated in the future. We must remember that the need to keep inflationary pressures under control suggests that the normalization of monetary policies in emerging economies will continue and this will hinder any rises in their stock market indices. Moreover, the higher yields expected from the indices of industrialized countries (reflecting the improved economic outlook) should lead to flows being transferred from emerging economies, something that will further accentuate this decoupling. It should be noted that the progress made in the area of fiscal discipline in the euro area, focusing on improving the stability and strength of the region's financial system, is being welcome by investors and analysts, becoming an additional support.
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In the medium term, economic and business factors are making equity more attractive.
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Within this context, the outlook for the world's equity markets looks favourable in the medium term. The forecasts of the vast majority of economists point towards a consolidation in world economic growth, which will restore investor and entrepreneur confidence, help the expansion of the business cycle to continue and lead to a gradual reduction in credit risk. All this should help equity to rise in value. Nonetheless, we must acknowledge the fact that there are short-term risks that might lead to uncertainty and one-off corrections in the direction taken by the main stock markets. Among these elements, of note is the worsening of some of the geopolitical risks, as well as an (unlikely) outbreak of the sovereign debt crisis in the euro area.
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