Time to enjoy the lull while the storm looms
The combination of extreme fiscal and monetary policy stances can have significant side effects on markets, warns Newton's Paul Brain
This improved investment environment could be severely challenged if economic growth fails to live up to expectations
The ill health of Greece continues to cast a shadow over the Eurozone
"As we look at the year ahead we continue to see significant risks during this ongoing ‘deleveraging' phase, not least because authorities are being compelled to keep monetary policy extremely loose in order to offset the dramatic fiscal austerity that is being applied," says Brain. "This dangerous cocktail of extreme monetary and fiscal policy stances can have significant side effects which are hard to forecast.
"Indeed, this environment of high risk but loose monetary policy might allow riskier markets, in the absence of any key event, to move higher. Just like commuters who have heard a bad weather forecast, markets will constantly walk around with an extra layer of inclemency protection. We believe this protection and the cheap funding rates could lead to modest risk-taking and decent returns, especially if the ‘Armageddon' forecasters get it wrong," he explains.
"Another consequence of these extreme policy initiatives and the increasing political risk is that markets could become less correlated, in our opinion" says Brain. "Those more vulnerable to liquidity squeezes and government policy changes, such as Hungary, could be picked on while yield-chasers could bid up markets, such as Poland, that don't have the same problems. This better, albeit not great, investment environment will be severely challenged later should economic growth fail to live up to expectations but, for now, while the sun may not be shining at least we are not in the midst of a tornado," he adds.
Eurozone future
"Meanwhile, the potential for the Eurozone to fall apart remains, as fiscal austerity is applied to already weak economies, bringing about recessions and deteriorating government finances as well as increasing banking sector concerns," Brain warns. "We believe the European Central Bank needs to offset this fiscal drag with aggressively loose monetary policy and it can only do this (legally) via the banking system. The three-year repo structures help but their support for the peripheral government bond market may have been overestimated in our view. Peripheral Eurozone government bond supply during the first half of 2012 is likely to provide a constant hurdle, requiring sustained demand from banks.
"We would be more sanguine about the prospects for ‘peripheral' European government bonds should the prospects for economic growth and politics be better," he concludes, "but the spectre of Greece's private sector involvement (PSI) issues and S&P downgrade continues to overshadow the markets and create uncertainty."
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