The ECB Changes Tactics 14 Aug 2012 Market movements This week, the tone in financial markets was set by policy. We saw a positive response to important policy changes announced by the European Central Bank (ECB) President, Mario Draghi. ECB President Mario Draghi is going a long way to re-establishing the ECB as a monetary operation, rather than a fiscal bailout organisation. Over the course of the week, peripheral bond spreads narrowed compared to spreads on German bonds. European and global equities rose, and despite an uninspiring set of company profit announcements – particularly in the retail sector – investors saw a rise of 2-3% over the week. For the week, the Dow Jones Industrial Average climbed 2.0% to 13,207, the S&P 500 Index advanced 1.7% to 1,405 and the Nasdaq Composite rose 1.1%to 2,958. With these gains, US stocks are now up comfortably into double-digit territory for the year, with lower risk, higher quality, large caps and growth styles leading the way. ECB changes tactics The ECB has decided to act as a monetary organisation rather than a fiscal one. It has looked at spreads, which are the difference between yields on short-term European bonds, and has understood that it is a situation that isn’t working. Essentially, anything anyone does to buy bonds is doomed to fail as long as there are big spreads at the front end. The ECB has committed to a series of monetary policy mechanisms with the explicit aim of providing unlimited support to short-term European bonds. This is important because it recreates the single money system in Europe and gives investors the opportunity to use short-term funding to buy longterm bonds, which will bring down yields in a number of peripheral countries. The issues of Europe are still present, but the ECB action has taken us a big step forward to deal with the monetary situation and the extreme risks reflected in the pricing of European assets. Throughout the financial crisis, the opposition to fiscal bail outs was led by the countries which have to pay for it. So, Germany and the Bundesbank have been very strong in their opposition to the ECB using its balance sheet to buy bonds. Short duration focus By focusing on short-duration assets, the ECB is arguing that it should be concerned with monetary policy. This is clever positioning by Draghi, and goes a long way to re-establishing the ECB as a monetary operation, rather than a fiscal bailout organisation. It is also important to set fiscal trends
in the European financial system. In the US, we are seeing some signs of bottoming of momentum. We have seen some disappointing earnings results from a number of companies, particularly in the retail sector.
All of that said equities have performed surprisingly well, both recently and for the year as a whole. Economies are perilously poised, but appear to be bottoming out. The global financial system continues to deleverage, and central banks are supporting this. Policy mixes in emerging markets continue to weaken. This is a position where equities are condiered a good option, with a bias towards dividend or dividend growth. In the equity space this is essentially a bet on quality. While there will be rallies in lower quality stocks, ignore these in favour of high quality businesses with a focus on good cash flow. We should be positive on high-yield because interest rates should remain close to 0% for a very long time.
Currencies On currency markets, the euro weakened against the dollar for the first time in three weeks, as growth concerns and the plan to ease Europe’s debt crisis worried investors, increasing demand for the world’s safest currency. The €/$ rate ended the week at €1.23. Oil
Oil prices pared gains towards the end of the week, on the back of the weak Chinese data and the International Energy Agency’s cutting ofits estimate of 2012 world consumption by 250,000 barrels a day. Oil prices finished the week at $93 a barrel. The gold price strengthened on speculation of measures being taken to support global economic growth. It rose by 1% over the week.
Bonds Spanish and Italian two-year bond prices fell for the first time in three weeks amid concern that a plan by the ECB to cap the nations’ borrowing costs, by buying their debt, may not succeed. This fear boosted demand for the region’s safest debt, helping German 1-year bond prices rise over the week. The Merrill Lynch over 5 year government bond index ended the week 0.6% higher.