Research Dept. News
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Monthly Report, num 352 - December 2011
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Financial markets
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Monetary and capital markets
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A road full of potholes
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The global financial scenario is facing the end of the year with several risks hovering over it.
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In this final stretch of the year, the financial scenario has worsened due to the uncertain trend in some of the essential factors for global markets. Firstly, the activity figures for the world's main economies are suffering a greater decline than expected. Secondly, the euro area's sovereign debt crisis is going through a series of new and unexpected bad patches that are hindering the decision-making process required to put a stop to the crisis. This situation is also feeding fears of the crisis spreading to other economies. And lastly, the negotiations to reduce the fiscal deficit in the United States do not seem to be achieving the desired outcome, suggesting a less than brilliant future for the growth of its economy. On the whole, developments in these factors are increasing, if indeed this is possible, the risk aversion of investors and the volatility of the main risk asset indices.
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The central banks are starting to be less restrictive
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Central banks are attempting to avoid recession in their economies.
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Over the last few months we have seen the rate of growth in the world economy slow up. The reasons for this still ongoing process, as well as its implications, differ depending on the geographical area, although the following can be included among the common elements in most cases: a drop in aggregate demand, rising commodity prices and greater financing difficulties. According to the opinion of the consensus of economists, the risk of a double dip recession for the world's economy has lessened thanks to the crucial action taken by central banks. As is logical, the decisions taken by monetary authorities vary depending on the country and each institution's chosen goal for its monetary policy, but we can state with all certainty that most central banks have started to shift their policies towards a more expansionary focus in order to avoid any risk of a double dip recession.
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The US economy is growing very slowly.
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In the United States, the Federal Reserve (Fed), after its Monetary Policy Committee meeting in November, presented the conclusions of its analysis of the state of the economy. In the words of its chairman, Ben Bernanke, and based on the information obtained from various indicators for activity, there was some improvement in the economy's growth in the third quarter. This change in trend, observed in household consumption and capital goods investment, has largely been boosted by the reduction of some obstacles of a temporary nature that, since the beginning of the year, were stopping growth from developing normally. However, and in spite of this advance, the chairman acknowledged that the US rate of growth was still showing clear signs of weakness. It's because of this, and because significant risks of a downturn still exist for the economy, that the Fed has modified its growth prospects for 2012, reducing the estimates made in June (3.3%-3.7%) to a more adjusted range of 2.5%-2.9%. Similarly, the expectations for the labour market, already not very optimistic in the short term, have also been rectified along the lines of a more modest growth scenario. It predicts that the unemployment rate might improve slightly from its current level of 9%, reaching between 8.5% and 8.7% by the end of 2012.
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The Fed keeps to an expansionary monetary strategy in order to boost the economy.
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Given this situation, the Federal Reserve, continuing with its dual proposal to encourage sustained growth of the economy and keep prices stable, has repeated its commitment to keep interest rates within the minimum range of 0%-0.25% and has confirmed that its programme of exceptional monetary policy measures will continue. Among these measures, of note is the programme to lengthen the average maturity of the debt it holds (Operation Twist) and the reinvestment of the principal and of the interest on public debt and mortgage-backed securities, also in its portfolio. In the last few months, financial forums have speculated whether the Fed might carry out another bond purchase programme within the previous rounds of quantitative easing. In this respect, the institution, far from refuting any kind of rumour, specified that it is constantly on the alert and ready to modify its assets portfolio whenever necessary.
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The ECB cuts the official interest rate to 1.25%...
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In the euro area, the European Central Bank cut the official interest rate by 25 basis points to 1.25% at its November meeting. According to the institution's new president, the Italian Mario Draghi, this turnabout in monetary policy was decided unanimously, this being the first cut in interest rates since May 2009.
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...although confirming that inflation will remain higher than it wishes.
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He also said that this decision was taken due to continued pressure in financial markets that is affecting the stability of the euro area, as well as the persistence of the current risks related to the delicate financial situation of the peripheral countries and the slowdown in global activity. He also suggested that this situation might lead to a slight recession in the region's economy for the last part of the year. However, the decision to cut the official rates has been taken within a scenario where the euro area's harmonized inflation rate is at 3%, the highest level for the last three years. Due to these changes in the region's economic context, the ECB stated that it might revise downwards its growth forecast for the euro area and that it would provide more information on this point at the next meeting on 8 December.
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The top monetary authority maintains liquidity facilities for banks.
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Regarding the action taken by the ECB in the sovereign debt crisis of the region's periphery, the institution has always appeared willing to act in order to resolve the tensions in financial markets, restore agent confidence and especially try to lessen the disastrous effects on nations of the lack of financing in international capital markets. In this area, the ECB has started to implement quite significant unconventional measures over the last few quarters. Specifically, these are the wide range of unlimited liquidity auctions at different maturities (1, 3 and 6 months) at a fixed interest rate, the long-term refinancing operations (LTRO) at 12 and 13 months, with the same characteristics as the liquidity facilities, and finally the purchase of covered bonds. By using these instruments, the monetary authority hopes to help banks in the euro area to access funding, as they are encountering greater difficulties in the capital markets as a consequence of the credit crisis.
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The ECB buys up the public debt of Spain and Italy with the aim of reducing tension in the bond markets.
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The ECB's participation is also crucial in aspects related to negotiations between the euro area members affected by the crisis, to supervision (together with the European Commission and the IMF), and to regulation in creating the European Financial Stability Fund (EFSF). But where it's truly playing a decisive role is in buying up the public bonds of countries in difficulty. By making purchases in secondary bond markets, the ECB is trying to lessen the effects of investor nervousness, which are unjustifiably pushing up the yields for bonds from these countries, specifically Italian and Spanish bonds. Moreover, in the last few weeks there has been open debate among euro area countries as to whether the ECB should be the lender of last resort for the member states or whether there should be other ways of resolving credit tensions.
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Interbank markets reflect the tensions generated by the European crisis.
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For their part, the framework of the emerging countries' monetary policies is currently shifting towards less restrictive strategies. Although, in the first part of the year, these countries' central banks were battling to avoid the effects of high levels of growth, in the second half of the year a slowdown in activity indicators has highlighted the fact that their restrictive interest rates were out of synch with the moderation in the rates of economic growth. Since then, many central banks have modified their lines of action to avoid a sharp decrease in growth expectations. The main instrument used to make the shift towards a more expansionary policy has been cuts in official interest rates. The most representative example of this situation is occurring in Brazil, where the central bank has adopted a policy of gradual interest rate cuts (currently at 11.0%) to boost economic growth, relegating the inflation target to second place, currently at 7%. It has also started to withdraw some quantitative measures of a restrictive nature.
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Yields on high quality debt remain low.
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Another environment where interest rates are gaining in importance is in the interbank markets. It is precisely through interest rates where agents' expectations are expressed regarding the possible decisions of central banks. But, moreover, in situations of financial adversity such as the present, interest rates reflect the degree of tension and mistrust between some credit institutions and others when competing in the capital markets. In the case of the United States, the reference for the interbank market is the Libor interest rate (in dollars). As has been happening since the summer, the overall trend in the Libor interest rates throughout November has remained upward. Far from being a reflection of tougher monetary policies by the Federal Reserve (which has confirmed that its lax monetary policy will continue), the rise in interest rate seems to be more related to the increase in uncertainty caused by developments in Europe's sovereign debt crisis. On the other hand, in the euro area the Euribor interest rate references have fallen slightly due to the lowering of the official interest rate for the region and the action taken by the ECB to buy debt from Spain and Italy.
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US debt heads investor preferences
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The Fed's actions in secondary markets encourage a drop in long-term yields.
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The internal return rates (IRR or yield) for the public debt of the two main developed economies, the United States and Germany, have once again fallen slightly throughout November, placing them back at historically low levels. The main reason for this movement is investors valuing this kind of asset as a safe haven given the high volatility generated by the sovereign crisis in the euro area. Specifically, in the United States, this could be seen in the yield for 10-year bonds, which broke through the barrier of 2% while the IRR of 2-year bonds remained stable. In addition to the effect of abundant capital flows in search of quality, the rise in price (and fall in yield) of long-term debt also occurred due to two reasons. The first, because of the Fed's intervention in the debt markets via the Operation Twist, leading to a drop in long-term interest rates and more flexible financing conditions for the private sector. And the second, because of the pessimism regarding negotiations for an effective plan to reduce the US deficit in terms of GDP over the coming decade. The absence of agreement would lead to an automatic programme of fiscal cuts being activated that would hinder future growth prospects for the economy.
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The price of German bonds reflects the advances made towards solving the European crisis.
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In the case of the euro area, the yield for German public debt also fell both for 2-year and 10-year maturities (0.37% and 2%, respectively) in November. It should be noted that, since the start of the sovereign crisis, the value of these bonds has been related to the different episodes in the crisis. But fear of contagion to other countries (such as Italy, Spain, France and Belgium) and the rapid political changes occurring in Italy and Greece after the agreements adopted in October at the Euro Summit have, if anything, made German bonds even more of a safe haven compared with the sovereign bonds of the rest of the member states. However, towards the end of November this circumstance altered after the bad results of the auction for German 10-year bonds.
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The euro's exchange rate is highly volatile due to the sovereign crisis.
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With regard to the European countries in difficulty, the month of November has been marked by a strong upswing in the risk premia of most of the economies, particularly for Italy and Spain. Although to a lesser extent, the spread of French debt compared with the German bund also widened due to the doubts of some rating agencies regarding France's capacity to meet its deficit targets and the high exposure of the country's banks to debt from other countries in the firing line. Within this context of growing instability, the ECB's purchases of Italian and Spanish debt barely calmed the nerves of investors, witnesses of how market pressure was forcing political changes in Greece and Italy. This situation has now been reflected in the recently issued Italian and Spanish bonds, whose yields rocketed due to greater risk aversion. It is expected that, in addition to the advances being made in the area of governance of the European Union and ECB, the new political leaders of the periphery will quickly implement effective austerity packages to ensure a certain level of financial stability and the achievement of the targets imposed by the Euro group. As these premises come about and a greater degree of stabilization is achieved within the euro area, tension in the debt markets should ease and we should see an improvement in investor confidence.
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Volatility dominates the currency markets
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Within the current economic and financial context, the currency markets are going through a phase of high volatility. Most analysts agree that this situation might continue over the coming months due to the uncertainty in the financial markets and the slowdown in the world's growth prospects. Of note among those factors causing the most movement in these markets are the actions taken by central banks on the exchange rate for their currencies (for protectionist purposes), the change in expectations regarding economic growth and incidents related to the European crisis. This is precisely one of the variables with the most significance for the dollar-euro exchange rate. The unsteady political scenario in southern Europe, fear of the crisis spreading to other countries such as Spain and France and the lack of resolve and speed in implementing austerity measures are sufficient reason for the euro to have lost close to 3% in November against the US currency.
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Corporate bonds suffer from the euro area crisis
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In the current scenario, investors still see investment grade bonds as an attractive safe option.
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To date, corporate bond markets have performed relatively well within the context of the recent financial crisis. Corporate income indices have shown notable resistance to the slowdown in global economic activity and the sovereign debt crisis of the euro area. Thanks to this situation, part of these assets (investment grade bonds) has been chosen by investors as a stable safe haven, together with gold and US long-term debt. But over the last few weeks, political upset in the periphery of the euro area and its effect on the sovereign crisis have unbalanced the risk premia of corporate bonds, mainly in Europe. In the investment grade segment, this situation has merely aggravated the credit risk spreads between the US and European market, making investment in the former more appealing and safer in the eyes of agents. The main signs of the deterioration in risk premia can be found in the bonds of the euro area's financial institutions, under a lot of pressure due to the worsening of the peripheral sovereign debt crisis. In an attempt to ease tension in the market and help banks to access funding, the ECB has restarted its programme to purchase covered bonds. With regard to the high risk and high yield sector, and after the indices had improved in October, uncertainty regarding the European crisis and its implications for global economic growth prospects have made this kind of asset less attractive.
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High yield bonds lose ground due to the slowdown in the world's growth prospects.
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In spite of this, international investors continue to prefer the public debt and corporate bonds of emerging countries. The continual arrival of investor flows to these markets is pushing down yields, both in public and private bonds, to historically low levels. The gradual increase in the amount of capital to these markets is due to the relaxation of the monetary policies in these countries and the improvement in the credit rating of local companies.
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Stock markets have yet to perk up
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Current financial risks are penalizing stock market returns.
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For yet another month, the main international stock markets have been characterised by their weak performance and continually high volatility. The main fears damping the enthusiasm of investors have been the pessimism regarding politicians' ability to negotiate efficient fiscal plans in the United States and, in the euro area, the growing fear that the European sovereign debt crisis will spread to the rest of the world, as well as doubts regarding the rate of growth of the global economy. In fact this has been one of the aspects that have pushed down stock markets the most during November, given the disappointing industrial figures from China and the moderation in growth figures from the United States. Regarding the capacity of political leaders to take resolute decisions in the area of fiscal policy, financial markets and specifically equity markets, for some time now investor decisions have been accompanied by a feeling of exhaustion regarding the slowness of these decisions and their implementation.
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Rising risk premia in the euro area are pushing down stock prices in the banking sector.
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But the factor that is perhaps causing the greatest degree of risk aversion among investors is the delicate situation of the sovereign debt crisis in the euro area. The perception that the measures being adopted are not very effective and too slow, as well as the widening spread between the countries affected and Germany and, above all, the consequent fear of the crisis infecting the rest of the euro area and countries lending funds to Europe are the main arguments weighing heavy on European indices. The sector hardest hit by investors is banking, due to its high exposure to the region's sovereign debt and the limited prospects of gains in the new, more restrictive regulatory environment.
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The medium-term outlook for stock markets is more encouraging.
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However, the medium-term forecasts for stock markets are more encouraging. Assuming that the risk of a global economic recession will be avoided and that political and monetary leaders will manage to lay the foundations for recovery from the European crisis, risk assets might possibly gain in value. The main arguments supporting this scenario would be, on the one hand, an extension of the corporate earnings cycle and, on the other, a reduction in global credit risk.
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The stock market panorama is bleak; a good time to buy?
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In the final days of 2011, four years after the subprime crisis broke out, the conditions under which financial markets are operating are once again looking sombre, especially in Europe. On the one hand, the macroeconomic environment is plagued with hazards and beset by uncertainty. The deleveraging process of numerous agents (be they households, banks or governments) is incomplete, so that there are many threats that could still lead to recession, in particular the debt crisis that's punishing the euro area. Unfortunately, the capacity to act of political and economic authorities is not inspiring enough confidence and the effects of the measures adopted and those that might be adopted are doubtful. On the other hand, and to a large extent as a result of this situation, investors' appetite for risk has decreased while their preference for liquidity has increased.
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In the stock market arena, performance in 2011 has been poor in the United States, bad in the emerging countries and very negative in the euro area, particularly in its financial sector. This has merely lengthened the prolonged period of stagnation and the high volatility experienced by the West's stock markets for several years now. The question is whether, as from the coming year, conditions will tend to improve and thereby boost share prices, or whether the opposite will happen and this downward slide will continue or even get worse.
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In the first instance, the key factors can be found in the world's macroeconomic trends, in the outcome of the European sovereign debt and banking system crises and, for Spain, in its ability to correct its budget and reform the economy. These issues are dealt with in more detail by other sections in this report.(1) However, we should point out here that, with the appropriate provisos, there's good reason to predict a moderately positive scenario on these three fronts, provided the political forces have enough sense, courage and technical know-how. If this is actually what happens throughout 2012, the implications will be favourable for the fundamental decisive factors underlying stock market prices: corporate earnings and the risk premium. Certainly, the contribution of both variables will be significant but, in the singular state of affairs today, with exceptionally high uncertainty, the latter has become particularly relevant.
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(1) See, in particular, the other three Boxes, which review the key elements for each of these issues.
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Investors' expectations for corporate earnings and dividends have fallen in the second half of 2011, due to the slowdown in the world's economy and the worsening of the European debt crisis. In fact, as can be seen in the graph below, this decline in expectations(2) has been particularly severe in the euro area, a circumstance attributable to the relative weight of the banking sector in its stock markets (almost 25% in the index selected). In fact, repeated messages that the region's banks need to improve their solvency, if necessary resorting to increasing their capital and curbing the payment of dividends, have been a vital element in this sharp change in prospects.
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In any case, the expectation of a level of dividends per share over the next four years that is around the same size as the figure fifteen years ago is unlikely to be called optimistic or inflated, unless we expect disaster for the euro project, the collapse of banks and a far-reaching and long recession. Insofar as a non-catastrophic scenario is expected for the euro area, earnings and dividends are likely to surprise us and exceed the figures expected by the markets. The situation is different for the United States, however, where investor expectations, although not exaggerated, are more generous and therefore more vulnerable to unexpected setbacks in the economic cycle.
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(2) The graph refers to futures contracts for dividends per share of the companies on the Index Eurostoxx 50, interpreting them as representative of investor expectations as a whole. Estimates by the consensus of professional analysts have also decreased but, in this case, from and to higher levels, given these agents' traditional tendency to overestimate, as well as their inertia.
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What should be noted is that this projection for the euro area assumes, at the index's current levels, a dividend yield in the order of 4%, a level in the upper range of those observed over the last few decades. Once again, the situation is different in the United States, as valuation there is much more demanding, offering only a moderate appeal. Other stock market valuation indicators also show the same for both regions, such as the cyclically adjusted Price/Earnings ratio (CAPE) and Tobin's q.
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The factor underlying the euro area's relatively high dividend yield is, presumably, a rise in the stock market risk premium.(3) This interpretation is in line with the information provided by other indicators, such as sentiment surveys on investors of all types, the level of risk premia for sovereign and corporate bonds, the volatility implicit in stock options, the high correlation between different assets, etc. On the other hand, various academic studies(4) have highlighted that, historically, increases in the dividend yield ratio have mostly been due to rises in the risk premium and, consequently, have generally led to a subsequent improvement in returns in the medium term (through dividend pay-outs and/or stock revaluations).
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Several theoretical explanations have been offered for the causes that increase or decrease the risk premium. Some are based on arguments that assume investors do not behave completely rationally but suffer from cognitive limitations in appreciating the fundamental value of assets, making them succumb to fads, panics(5) and other kinds of psychological bias.(6) Others uphold the paradigm of rationality and even the capacity of agents to appreciate fundamental value, but argue that investors lose their tolerance for risk when, at times of economic crisis and growing unemployment, they feel their income and consumption are threatened.(7) The risk premium has also been related conceptually with the existence of financial frictions (such as liquidity crises) and with imperfect information. Whatever the case, the situation currently being experienced by the euro area contains the whole gamut of these elements.
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(3) This can also be applied to other ratios, such as the P/E ratio or the PBV ratio.
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(4) See J. Cochrane, «Discount Rates», The Journal of Finance, Vol. LXVI, No. 4 2011, and John Campbell, S. Giglio and Ch. Polk, «Hard Times», Harvard University Working Papers, 2011.
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(5) -For example, Andrew Haldane, «Risk Off», Bank of England, Speeches, 2011.
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(6) -For example, U. Malmendier and S. Nagel, «Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?», Quarterly Journal of Economics, Vol. 126 (1), 2011.
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Correctly identifying the causes of fluctuations in the risk premium is important for economic policymakers when designing measures of financial stability, as well as for investors, particularly those operating in the short term and who therefore depend critically on its performance. For those with a more medium or long-term approach, it's important to bear in mind what we have already mentioned: whatever the cause, an increase in the dividend yield associated with an increase in the risk premium ultimately means potentially more attractive returns in the future. Under this premise, and given the events of recent times, investing in a diversified portfolio of European shares is an option that has notably gained in appeal over the medium term; even though there's a small likelihood of 2012 still being disappointing.
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(7) -For example, Cochrane (2011) op.cit.
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This box was prepared by the Financial Markets Unit
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Research Department, "la Caixa"
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