Research Dept. News
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Monthly Report, num 349 - September 2011
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Financial markets - Monetary and capital markets
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The storm becomes a gale
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The slowdown in growth affects market performance.
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Since the beginning of the second quarter, the international financial situation has been determined by the convergence of several factors whose repercussions on the markets are characterized by a brusque movement of «flight to quality» on the part of investors, with sharp falls in the stock markets. Of note among these factors is, firstly, the slowdown in economic growth, mainly in the United States. Secondly, the restrictive nature of economic policy in the emerging countries given the risk of overheating. Thirdly, the persistence of the sovereign debt crisis of peripheral Europe, both in terms of time and in the number of countries affected. And lastly, the unfinished process of regulating the financial sector.
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In August, these disturbances become more intense, at times reminiscent of the drama of autumn 2008. Without doubt, the effects of these factors and the different actions carried out to handle them will continue to set the pace for the financial markets for some time yet; but it seems reasonable to expect them to gradually fade, so that the medium and long term outlook should see a return to positive expansion rates and investor confidence restored.
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The Federal Reserve and the ECB, two different ways of tackling the crisis
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Monetary policy strategies differ depending on the geographical area.
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In the last two months, several symptoms have been noted that confirm the moderation in the pace of growth of the economy at a global level. The adverse shocks occurring in March (such as Japan's earthquake and the socio-political unrest in the Middle East) helped to trigger a phase of moderation in activity, although this should be temporary in principle. Given that this process differs depending on the geographical area, as is happening with inflationary risks linked to rising commodity prices, the decisions of monetary authorities have also been disparate depending on the country. For example, while the Federal Reserve has guaranteed that its monetary policy will remain lax for the next two years, the European Central Bank has once again opted to raise the official rate, like the People's Bank of China and the central banks of other emerging countries.
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Bernanke admits that the rate of growth has slowed up more than expected.
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In the United States, after the Monetary Policy Committee's meeting held on 9 August, the Federal Reserve (Fed) explained in no uncertain terms the main conclusions of its analysis of the current economic scenario and the guidelines agreed for monetary policy strategy. Under the shadow of the poor growth figures published in July, the Fed chairman, Ben Bernanke, admitted that the extent of the slowdown in the economy throughout this year was greater than initially expected. Relevant indicators, such as household consumption and non-residential investment, have been showing weakness and the activity of some sectors, such as residential, remains decrepit. Within this context, the Fed believes that the prospects for the labour market are still very fragile and this is basically why it has decided to keep the official interest rate as low as possible (0%-0.25%).
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The Fed announces it will keep interest rates at their current level for the next two years.
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Regarding future monetary policy strategy, the Fed made an extraordinary announcement: according to its economic estimates for the coming quarters, and taking into account the possible impact on growth of applying the fiscal deficit reduction plan approved in Congress (whose aim is to reduce the deficit by 2.8 trillion dollars), the monetary authority promised to keep official rates within the minimum range of 0% and 0.25% until mid-2013. In the words of Bernanke, the purpose of this unusual decision is for the Fed to do all it can to ensure economic recovery, given that the risks of inflation are believed to be limited. The Fed will also continue to reinvest the interest and principal of public debt and the mortgage bonds it holds in portfolio. Regarding the issue of possible additional measures of quantitative monetary policy (the so-called Quantitative Easing 3 or QE3), although he did not explicitly mention such measures, Bernanke did state that the Fed was prepared to act decisively should it believe the economic and financial conditions required such action. In short, the bulk of the evidence available suggests that, in the short term, the Fed's focus is to provide extremely lax conditions and that the debate on the «exit strategy» has once again been put on the back burner.
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Bernanke does not rule out a new quantitative easing programme (QE3).
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In the euro area, the European Central Bank (ECB), as part of its normalization strategy started in April, increased its reference interest rate by 25 basis points to 1.5% at its meeting in July, subsequently keeping it the same at its meeting in August. This movement, which had already been hinted at by the EBC chairman, Jean-Claude Trichet, was justified as a response to persistent and significant inflationary risks in the medium term. In fact, the bias of the message in both meetings was clearly dominated, as in previous months, by the objective of ensuring price stabilization in the region, considering that, in the opinion of the ECB, the underlying economic fundamentals warranted a progressive normalization of monetary conditions. However, in the last few weeks, and given the moderation in growth and falling commodity prices, market expectations regarding future actions by the ECB have undergone a dramatic change to the extent that no more interest rate hikes are expected during the rest of the year.
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The ECB buys the sovereign debt of countries in the periphery of the euro area.
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With regard to unconventional monetary measures, the ECB decided to keep the existing measures (unlimited liquidity facilities at 1 and 3 months). In its meeting on 4 August, the ECB extended these with a liquidity auction with the same characteristics as previous ones but maturing at 6 months, in response to the difficulties being encountered by some of the region's banks in securing funding due to the sovereign credit crisis. The ECB has adopted a very active role in attempting to resolve the sovereign debt crisis, always with the aim of reducing tension in the credit markets and sustaining investor confidence. On the one hand, the ECB suspended the application of the minimum rating threshold for assets issued by the government of Portugal at the same time as receiving them as collateral for its loans. On the other hand, it took part in negotiating the second financial bail-out for Greece and in the agreement to make the powers of the European Financial Stability Fund more flexible. In the first few weeks of August, and given growing uncertainty due to contagion of the sovereign debt crisis, once again the ECB resolutely started buying up bonds of countries in difficulty, specifically those issued by the Treasuries of Spain and Italy.
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Emerging countries continue to restrict their monetary policy.
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For its part, the tone of the monetary policy of emerging countries continues to be restrictive, in response to the advanced phase of the economic cycle they currently find themselves in. The fast pace of activity achieved over the last two years has given rise to signs of economic overheating. Elements such as increased inflationary pressure on basic consumer products, excess credit and the formation of bubbles with some assets are more than enough for the monetary authorities of these countries to continue to adopt restrictive monetary policy measures. The most representative example has been the People's Bank of China, which agreed its fifth rise in interest rates in eight months (raising the official rate by 25 basis points to 6.56%), as a measure to slow up an inflation rate that had gone too high. However, in the last few months some moderation has already started to be seen in the expansion of credit and activity, which would be compatible with the start of a «soft landing» and, possibly, the end of the monetary tightening phase.
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Europe's interbank market suffers a modest outbreak of tension.
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Within this situation of disparate monetary policy strategies between the United States and the euro area, interest rates in the interbank markets have developed in line with investors' expectations regarding the actions by the respective monetary authorities, as well as according to the events taking place in the sovereign debt crisis and the repercussions for bank funding.
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In the case of the US market, interbank rates rose slightly between July and August as a result of the uncertainty regarding negotiations on the debt ceiling and due to concern for the health of the international banking sector. But this increase, attributable to risk premia, has been very modest when compared with what happened in autumn 2008 after the collapse of the Lehman Brothers. In this respect, the Fed's announcement that it would delay any interest rate hike for two years is key to preserving stability in this market.
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Developments have been somewhat more agitated in the case of the European interbank market. The one-year Euribor interest rate moderated its rise in July, coming close to 2.20%, as a result of the increasingly clearer signs of moderation in world growth. During August, it fell for the first time this year, a movement that also hides notable divergence between the different components of this interest rate. On the one hand, the risk-free component fell considerably in response to investors' expectations that the global slowdown would end up affecting Europe and would lead the ECB to halting its strategy of gradually raising the official interest rate. On the other hand, risk premia (of credit and liquidity) rose notably, as an increase in the deterioration of the sovereign debt crisis was confirmed and due to a certain lack of confidence among financial institutions when lending each other funds. At the same time, this circumstance led to banks demanding more funding from the central bank.
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Investors look for a safe haven in the debt of the United States and Germany
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Yields on United States and German debt fall again.
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Domestic yields for the public debt of the main western economies, in particular the United States and Germany, were still immersed in their downward slide that started in the spring. Very low rates have been reached in historical terms. In the case of the United States the yield for two and ten-year bonds fell to 0.20% and 2.10%, respectively. Among those factors that lie behind this new episode of falling yields is, above all, the gradual deterioration in the main macroeconomic indicators and a drop in consensus expectations of growth. In addition, the new budgetary adjustment plan agreed in the US Congress has reduced the possibility of a «technical default». The plan includes the reduction of public deficit by 2.8 trillion dollars over the next decade. One event that made a lot of noise in the media but had little impact on the market was the downgrading of US debt by Standard & Poor's. The agency withdrew its AAA rating and replaced it with AA+, given that it believes the agreement to reduce the deficit agreed by Congress is not enough and it has reservations regarding the high level of debt the country must face in the medium term. However, it seems that investors are still completely confident in US debt and its risk premium remains at a low level. Another factor that has not prevented a fall in yields has been the end of the Fed's second Quantitative Easing programme (QE2). The active presence of the central bank provided some support to the debt market but it's true that, since it withdrew on the last day of July, the ten-year bond's yield has fallen further and the rise in volatility has not been too intense.
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German sovereign debt is benefitting from being seen as a safe haven.
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In the case of the euro area, the yield on German sovereign debt has performed similarly to that of the United States. The yields on German two and ten-year bonds fell to 0.60% and 2.12%, respectively. Once again, the deterioration in the peripheral sovereign debt crisis and fear of contagion to other economies in the region has led to a change in investor preference, choosing assets with a lower risk or higher quality, as is the case of German debt. Although this has been happening since the spring, it should be temporary if notice is taken of the favourable information coming from a fundamental economic analysis of the area.
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The dollar's exchange rate continues to be highly volatile.
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For their part, the risk premia of the peripheral countries have performed extremely erratically and unevenly. Once the agreement was signed for Greece's second bail-out between the EU, ECB and the IMF (which will provide financing of 109 billion euros, including the participation of the private sector to the tune of 37 billion) and after having agreed to improve the effectiveness of stabilization instruments (European Financial Stability Fund), the sovereign risk premia of those countries in difficulty climbed back down. This truce did not last long, however, as uncertainty regarding the effective implementation of these agreements led to the fear of contagion once again taking hold of market sentiment, with all eyes on Italy and Spain. In both cases, the gradual increase in financing costs in international markets (exceeding 6% for ten-year bonds) led the ECB to intervene in the secondary markets, buying up the bonds of both countries. Thanks to this action, and to the additional structural measures taken by governments, the high level of tension in the debt markets fell in the second half of August, although the situation is still far from normal.
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Lack of definition continues to reign in the dollar-euro exchange rate
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The Chinese yuan speeds up its appreciation.
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Under the scenario described in previous sections, the exchange rate between the dollar and the euro has continued to be highly volatile and lacking in any clear direction. The range of fluctuation throughout the summer has been 5%, the maximum being 1.47 dollars and the minimum 1.40. Several factors lie behind this volatile behaviour. Throughout July, the euro benefitted from the approval of the second financial bail-out for Greece, the ECB's interest rate hike and fierce debate regarding the debt ceiling in the United States. Subsequently, the resurgence of fears regarding the contagion of the debt crisis to other European economies and the US reaching an agreement to raise its debt ceiling provided a shot in the arm for the dollar's recovery. After this fluctuation, the final variation was small. In the short term, this erratic performance by the dollar exchange rate will surely continue, caused by factors related to the perception of risks affecting one area or the other. But in the medium term, the key factor that is appearing will be how the macroeconomic situation develops in the United States: as it is expected to avoid a double dip recession, the dollar will probably be more solid than in the recent past.
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In other area of the foreign exchange markets, the appreciation of the Chinese yuan is particularly of note. Its rate of appreciation intensified over the summer in what already seems to be a clear reorientation of economic policy and growth model for the Asian country.
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High quality corporate bonds hold firm, but high yield debt does not
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Investment grade corporate bonds have become a safe haven.
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As has already happened in previous quarters, the investment grade private bond market has shown commendable resistance during the summer given the bad news coming from the economic situation overall and the sovereign risk on both sides of the Atlantic. After the slight dip suffered by the main corporate bond indices in June, these got back on the road to recovery in July and August, thanks to the fact that the rise in risk premia was offset by a drop in reference interest rates. As a result of economic globalization, and given the intensification of the «flight to quality» of capital flows, large areas of the corporate credit markets have become more attractive as safe havens, behind gold and good quality public debt. Specifically, US investment grade corporate bonds and the corporate debt of some emerging economies have seen an increase in demand, pushing down their yields. In the case of the euro area, this phenomenon has occurred to a lesser extent thanks to the strong presence of the financial sector, which continues to suffer from investor mistrust. In fact, the rise of risk premia due to the worsening of the sovereign debt crisis has continued to harm financial sector spreads on the old continent, highly exposed to the sovereign debt of the countries affected. For their part, performance by high yield bonds has been more lacklustre, influenced by the downward revision of economic growth forecasts, mainly in the United States.
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The lower economic growth expectations are putting a brake on issues of high yield bonds.
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Given this financial situation, issuances have remained stable in the emerging markets thanks to the relatively favourable perspectives for economic growth in the medium and long term. On the other hand, in developed markets doubts regarding the European crisis and the pace of economic activity in the United States have put a brake on issuances.
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Setback in international stock markets
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Uncertainty leads to extensive losses on the world's main stock markets.
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The weak tone exhibited by international stock markets since the spring has led to extensive losses in August. The weakening of the world's economic growth prospects and the perception of a vulnerable financial scenario have been reflected in a pronounced rise in volatility indicators and a decreasing «appetite for risk». The tensions dominating the world's financial markets have led to increased doubt among investors, who prefer to go for assets with a less risky profile, such as gold, investment grade corporate bonds and US and German public debt.
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Under the scenario that the current risks in the financial context are going to be gradually and satisfactorily resolved, the stock market outlook for the medium and long term is clearly favourable. The recovery of global economic growth, the continuing expansionary business cycle and a reduction in sovereign credit risk are the main arguments expected to push up the world's stock markets in the future. Unfortunately, in the short term the stock market scene is still subject to the interaction of the aforementioned negative factors which are hindering any potential gains.
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Over the last few months, the worsening of economic indicators in the United States, the downgrade of its credit rating and its political difficulties in negotiating the debt ceiling have relegated to second place the satisfactory corporate earnings season of the second quarter. Specifically, 91% of S&P 500 companies have already published their accounts and 71% of these have exceeded the expectations of the consensus of analysts. Profit per share in the quarter also exceeded the figure reached in the same period last year by 17%.
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The corporate expansionary cycle is a fundamental support for stock market gains in the medium term.
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In the euro area, the growing uncertainty of possible contagion of the crisis to other economies and the difficulty in implementing bail-outs for the countries already affected have continued to weaken investor sentiment. Within this context, the financial sector is the most negatively affected, even though the second stress test carried out in the euro area was more satisfactory than the one carried out last year. Aspects such as banking's high exposure to peripheral debt and the news regarding regulatory reforms (which will lead to bigger solvency and liquidity requirements) are hitting bank shares.
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The sovereign debt crisis weighs heavily on the share prices of Europe's banks.
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Lastly, the stock market indices of the emerging economies have also fallen sharply over the last few weeks. The stock markets of these economies were already immersed in consolidation resulting from the tightening up of their economic policies and now, in August, the world's economic and financial situation has damaged even further the expectations of any gains in the short term.
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