Global Markets Weekly 

22 November 2010

• The market’s broad-based decline suggests speculative ‘bullish’ positions were cut
  
  The Irish ‘crisis’ continued to drive a broad correction, but the range of moves points to an unwinding of speculative positions as the main driver. The dollar rally and decline in equities, especially in emerging markets, suggests declining risk appetites. But this was not borne out by a drop in the VIX measure of equity volatility. Similarly, a ‘flight to quality’ rally in the dollar would normally be accompanied by gains in the yen and Swiss franc, yet both fell back against the commodity-linked Australian dollar. Bond yields rose, but commodity prices fell, with some agricultural prices off 10% from their peaks as investors withdrew an estimated $30 billion from commodity futures markets. Overall, we would regard this correction as a healthy venting of speculative ‘froth’ and a buying opportunity.
  
• The market discounts an EU bail-out for Ireland as the political negotiations continue
  
  The markets were clearly discounting some form of Irish bail-out, duly announced this weekend. Irish sovereign bonds and those of similarly troubled member states rallied (as did Irish equities), but bonds of other member states weakened as the debt burden and associated credit risk is effectively being spread across the EU members. Austria provided a timely reminder of how politically contentious bailouts can be, by threatening to force a renegotiation of the support package for Greece, which recently revealed its deficit and outstanding debt were higher than previously thought. This highlights the on-going structural and political issues and supports our long-held stance of reducing exposure to the euro.
  
• Fed is criticised for QE2, but inflation figures point to increasing deflation risk
  
  The Federal Reserve (Fed) was directly criticised by Republican leaders for pursuing a further round of quantitative easing (QE2). But a drop in October core inflation to 0.6%, the lowest since records began in 1957, highlighted what we believe remains the Fed’s key concern - significant risk of deflation next year – which we believe will be decisive in determining the scale and length of QE2. The inflation data coincided with a more-encouraging 1.2% monthly gain in October retail sales and another week of below-trend unemployment claims. If these are the first signs of a more sustainable recovery, QE2 will have been unnecessary, but if this is another false spring, it will show in hindsight to have been a timely and necessary move. Similarly in the UK, while inflation remains stubbornly high at 3.2%, we are still forecasting that the Bank of England embarks on its own QE2 at some point in the next six months as government cuts bite and growth and inflation slows.
  
• China’s inflation problem – some of the cures may be worse than the disease
  
  Last week’s surge in Chinese inflation triggered a wide variety of official responses. The trade-weighted renminbi gained, which we see as broadly positive as it reduces imported commodity prices and encourages a rebalancing towards domestic demand that will be beneficial for China’s longer-term growth as well as reducing current trade tensions. Interest rates were raised and are likely to be raised again, with bank reserve ratios also being hiked. This will dampen growth, but also encourage a more efficient allocation of capital, particularly by reducing excessive speculation in the property market. Finally officials talked about imposing price controls on food and other essentials, which we would regard as poor policy. Holding down prices subsidises demand while reducing returns for producers, and so is likely to aggravate the longer-term mismatch of supply and demand, even if it solves a short-term problem.

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