Global Markets Weekly 13 December 2010

• US tax-cut stimulus package lifts growth forecasts and risk assets

  Risk assets rallied on the back of proposed US fiscal stimulus based on tax cuts. The package, if passed in its present form, would likely mean increasing our 2011 US GDP growth forecast from 2.5% to around 3.0%, with a similar increase to consensus estimates. Growth could easily be higher, depending on just how much of the approximately $300bn of additional cash is spent rather than saved or used to repay debt. Although US economic growth will rise in the short term, the US will face an even greater challenge in dealing with its large and rising public debt. Combined with uncertainty over how the new fiscal stimulus package would affect the Federal Reserve’s (Fed) current $600bn quantitative easing (QE) programme, this produced a mixed reaction in capital markets.

• Stronger US growth outlook triggers jump in yields

  Commodity prices and emerging-market currencies strengthened in response to the US stimulus plans, while Treasuries sold off sharply. The price movements were consistent with a rise in medium-term fiscal concerns. However, the rise in Treasury yields also reflects the boost to economic growth and a reduction in both deflationary pressure and need for the Fed to buy more government bonds. Inflation-linked bonds fell by less, while high-yield debt bucked the trend with a positive return. However, bond yields will continue to be contained by low inflation, with core inflation at a 50-year low. Equities, which represent a claim on earnings in perpetuity and not just next year, had a more ambiguous response to the fiscal stimulus, given its temporary nature. Nevertheless, consensus estimates for 2011 earnings growth of 13% for the MSCI US now look too low, given upgrades in GDP growth forecasts. With earnings forecasts likely to be upgraded, we see US equities breaking above 2010 highs set in April.

• US tax-cutting ‘gridlock’ contrasts with euro-zone austerity ‘gridlock’

  The package is supportive for the dollar against the euro, as it reduces the need for further QE in the second half of next year, once the current programme of $600bn in Treasury purchases is finished, and it will boost the economy in 2011. Given plans for significant fiscal tightening in the euro-zone, the contrast with the US approach of tackling economic weakness by loosening fiscal policy and actively seeking to expand the money supply through aggressive QE could hardly be greater. One of these approaches is going to be proved wrong, and our money is on the Europeans’.

• The advance of emerging equities may be impeded by a shift in investment flows

  Emerging equities were flat over the week, losing ground relative to developed markets. This still leaves emerging equities ahead for the year and should be seen as more of a consolidation than a change of trend. However, there are short-term headwinds, with a hike in bank reserve ratios representing a further shift in China towards a ‘prudent’ monetary policy. It remains to be seen how investment flows will respond to a strong US recovery and, potentially, a reduction of QE and an increase in bond issuance. This would reduce the relative attractiveness of emerging markets and the availability of cheap dollars with which to fund this ‘carry trade’. Returns from other assets, such as gold, are also likely to be affected by this potential change in investment flows.

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