After what has been a frantic month to date in global markets, where heightened risk aversion has led to a sharp selloff in equities and moved AAA government bond yields to record lows, this week it feels more like a typical August trading environment, as investors sit back, reflect on recent events and wait for an address by the most powerful man in global finance.
"If you cast your mind back to this time last year, in the run up to the meeting of global central bankers at Jackson Hole, Wyoming, markets had experienced a summer of deteriorating macroeconomic data, peripheral Europe concerns, falling equities and speculation that the global economy might fall back into recession. Sound familiar? It was at this forum that Ben Bernanke first hinted at a second round of quantitative easing (QE2) to try to kick start the stuttering recovery.
"Friday, central bankers return to Wyoming and all eyes will be on the Fed Chairman to see if he has any tricks up his sleeve to improve market sentiment and get global growth back on track. A lack of initiatives could disappoint an already jittery market, but it is worth remembering that it was only two weeks ago that the FOMC last met and announced their intention to keep rates unchanged for 2 years, so we are not expecting any further guidance, at this time, towards a QE3 program. Previously, the Fed has noted two pre-conditions for undertaking QE: persistent economic weakness and the risk of deflation. Although there is growing evidence to support the first condition, the Fed's favoured measure of inflation expectation, the 5 year forward 5 year breakeven inflation rate is not currently showing any deflationary pressure.
"In Europe, the ECB's Securities Market Program (SMP) has been successful at capping the yield on Italian and Spanish government bonds, around 5%. Although there is a concern that the volume that has been required (€36bn) to achieve this during light trading summer markets is unsustainable. If we assume the recent EFSF amendments do get ratified (no guarantee of this) and if the current run rate of purchases by the ECB is maintained by the EFSF, then the EFSF will be out of fire power within 3 months. This combined, with the Troika starting their Q4 review of Greece, where growth is likely to be significantly less than forecast and the privatisation program set to fall short of expectations, will lead to continued stresses in Europe and we expect the market to significantly test the political will of Core European Governments to continue supporting the Euro project.
"It is not all doom and gloom, however, as the risk off mentality has led to a re-pricing of many fixed income sectors. High Yield spreads have widened out to around 750bps which would imply default rates in the region of 6-8%. Currently default rates are low, at around 1%, and the team would not expect these to increase to more than 2-3%. This makes the asset class look attractive at these levels, but the age old quote of "not wanting to catch a falling knife" is at the back of our minds. So whilst we will look carefully at selective opportunities if they arise, we remain happy sitting on the sidelines and watching how markets react over the next few weeks."
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