Fog descended on markets a few weeks ago in the form of anxieties around the US debt ceiling and credit rating and over the lack of a comprehensive response to dealing with the Eurozone debt crisis. Fast forward a few weeks, and the fog remains with us:
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US debt ceiling: although we did get an eleventh hour agreement to increase the debt ceiling and cut some spending, to borrow a ‘European' phrase this just really ‘kicks the can down the road'. It may well have bought some time before ratings agencies move to downgrade the US, but hard decisions still need to be taken and markets will be revisiting this issue before year end.
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Eurozone: Spanish and Italian 10 year bond yields north of 6% are a powerful reminder that liquidity is in the gift of the market, and, in the face of an inadequate response from the EU, the market is extracting a higher price to lend to these countries. Where does it end? The market is looking for a big bang solution: an expanded EFSF, a common Eurobond? The hurdles to both of these remain very high and in the meantime Spanish and Italian yields are likely to head higher.
Far from dissipating, the fog has spread and we can now include a stuttering global economy and stressed FX markets:
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Our proprietary leading and policy indicators continue to decline across the world in both developing and developed economies. Leading indicators are suggesting that central banks should be thinking of reducing, not increasing interest rates. Watch the debate on more quantitative easing in the UK and the US. The hurdle is high, but the debate is likely to intensify and more QE at some point is likely. Especially because, in the context of a slowing global economy, deflation, rather than inflation, is likely to emerge as the key concern over the next few months, removing a key barrier to more QE.
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FX: selected currencies such as the Swiss Franc are, to quote the Swiss National Bank, ‘massively overvalued', and are at unprecedented levels. Ultimately, successful or not, these distortions can lead to policy responses and it could well be that other central banks follow the SNBs lead in intervening to stabilize and weaken currencies.
Where does this leave markets?
Stresses in the global financial system are building, and are spreading across different asset classes and sectors leading to breaking points in certain areas: FX, Italian and Spanish bond yields. Ultimately, and although hurdles for action remain elevated, these stresses are likely to provoke official policy responses.
Is EM a safe haven? The fact that EM equities are one of the worst performing asset classes this year demonstrates that EM has not necessarily decoupled. In the bond world the power of flows, coupled with a declining inflation profile should keep sell offs limited.
What does it mean for portfolios?
This is an environment to be running lower risk positions and we remain content with our reduced allocations to credit and long duration bias. However, the fog will lift, and when it does we are ready to deploy with a large cash pile.
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