“That is not it at all, That is not what I meant, at all” – TS Eliot
Since we last published a blog in late March, stock markets have declined and volatility is up a little. Weak economic data and a sharp rise in Spanish bond yields have led pundits to argue that the ECB’s Long Term Refinancing Operations have failed. They say nothing has changed, and the euro area remains just as risky as it did last year.
We disagree. That doesn’t mean that we expect risk assets to immediately resume their rally. We noted back in March that some correction would not be a surprise, not least because of the strong gains seen over the winter, and it may not yet have run its course. But we think that the ECB’s LTROs are doing what they were meant to.
They weren’t aimed primarily at kick-starting the euro area economy. Even if the funds were to be recycled into wider bank lending (assuming there’s demand for it…) it would take months to have a noticeable effect on corporate orders and output. The central bankers know this, even if the politicians and pundits don’t. Nor were the LTROs intended to remove all volatility from the big peripheral bond markets.
Instead, the ECB was trying first and foremost to insulate the banks from ongoing trauma in the southern periphery (Irelandcontinues slowly to stabilise, as we’d hoped). It has probably done enough to take the worst case, disaster scenario – a banking crisis – off the table. Supporting evidence is the decline in the key interbank spread. It has paused in recent days, but at the lowest levels since early August.
Opinions are also divided on the impact of the Fed’s QE programme. If short-term market moves are any guide, traders can’t make up their minds about whether further action would be good or bad. When the Fed hinted at the start of March that QE3 might not be coming, stocks seemed to respond negatively. But they also responded negatively to the payroll data that will likely have kept a possible QE3 on the FOMC agenda.
The actions of central banks on both sides of the Atlantic have provided cheap insurance for the markets – helping explain the marked decline in the cost of traded options – and this has supported risk assets. We don’t expect them to do much more, but for us this will be good news, even if it’s accompanied by some long-postponed rebound in interest rate expectations.
Our current case for building a bigger than normal weighting in developed equities is that we don’t expect QE3 or another LTRO. We think the big western economies will be standing on their own two feet in the next year or so, keeping their inexpensively-valued quoted sectors firmly profitable, and we’ve seen nothing in the last three weeks to alter that view.
Kevin Gardiner, Head of Investment Strategy EMEA
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