Looking back on the past few weeks, the ECB has introduced its Outright Monetary Transactions (OMTs) and the European Stability Mechanism (ESM) has been given the all-clear to pursue its mandate ‘to safeguard the financial stability of the euro area as a whole and of its Member States.’ Until last week, that might have sounded vacuous but the ESM is expected to start life next month and be fully able to offer support for the eurozone banks and for sovereign states by early next year. In Spain’s case, support for the banks has already begun (with the European Financial Stability Facility).
Overcoming a hurdle that helps stabilise and improve the financial position of the banks must help to reduce the prevailing uncertainties reflected over the past few years in the volatility of equity markets, the flight to safety in quality government bond markets and this year’s loss of momentum underlying the recovery in the global economy. It remains to be seen how operationally effective the programme of ‘request, conditionality and assistance’ will be. However, a big step forward has been taken and this should improve the tone for equity markets.
It should also lessen the need for the flight to safety in quality bond markets, especially if you think QE3 is inflationary. But with unemployment being what it is and the risks already on the downside for the economy, any inflation coming through via commodity markets will merely squeeze real incomes and spending, and depress output and employment.
Still, the FOMC was right in coming forward with QE3 for a number of reasons. First, the Fed reckons the economy is growing at a pace that prevents the unemployment rate from falling in a satisfactory manner towards its long run objective. Also, inflation is below the 2 percent level it associates with long run price stability. QE3 is not because the Fed thinks a recession is coming. It is because it thinks the pace of growth is just too slow to be of help for the ‘stagnant labour market’ and it worries that, with the prevailing uncertainties over US fiscal policy and also Europe, the risks for the economy are on the downside.
Second, an open-ended QE3 programme focusing on mortgage-backed securities should help keep mortgage rates down at their historical lows for a long time, so helping to nurture a recovery in the housing market and thus helping to boost aggregate demand. Operation Twist will be maintained to the end of the year so this should help to keep yields at the long end of the Treasury market down. Operation Twist might even be extended.
Third, and allied to the second, the Fed believes that non-traditional policies work and that output and employment would be lower without them. Such measures have mitigated deflationary risks. Without them, the housing market might not be stabilising and nor might the S&P/Case-Shiller home price index be stabilising and maybe on the turn.
And then there is the ‘fiscal cliff’ of spending cuts and tax rises. According to the Congressional Budget Office (CBO), output would fall by about half a percent from the fourth quarter of this year to the fourth quarter of 2013. The CBO expects that the US economy would be badly hit in the first half of next year and that the unemployment rate would shoot up to over 9 percent.
On the face of it, the markets reckon that Congress will postpone it all, at least temporarily, and sort something out next year. But the Fed still sees the uncertainty of it, which is bad for the economy and bad for jobs.
But what are markets without risks? In the here and now one can point to several; the oil price for one, China’s prospective landing for another, the loss of earnings momentum for a third, not to mention the risk associated with monetary policy itself as the Fed reminds us.
Yet aside from the Fed’s reliably solid commitment to supporting the US economy, a change in the eurozone is underway for the better. Whatever might be said, progress is being made towards the ultimate objective of debt sustainability and full integration. It is to that end, and within its mandate, that the ECB intends to help. The risk to the financial system has diminished – the crisis has been subdued – and the uncertainty that reflects on the outlook for the global economy has lessened.
All other things equal, that alone is worthy not only of a modest re-rating in equity markets and a more supportive tone than has been seen for a while but also of a little more of what has been seen very recently, namely a modest shift towards the second liners, smaller companies and the associated move towards cyclicals.
However, as indicated at the outset, the major markets are overbought and if the technical condition for the UK, as shown in the following chart (next page), is any guide, a bout of consolidation is now likely. This might set the stage for the change in market dynamics that has helped to push the second liners and smaller companies in the US to new all-time highs and to new highs for the year in the UK.
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