Current thoughts

We seem to be getting nearer to an inflection point in financial markets.

This suggests expectations of a policy response are becoming increasingly relevant.  In fact, we already have a first concrete sign, with the People’s Bank of China (PBOC) cutting its benchmark rate for the first time since 2008.

Europe, US, China

Let us take what I call the three ‘pillars’ of the global economy, in turn.

1. Europe: concern remains elevated, both on ‘governance’ issues (Greece, Spain, euro breakup talk) as well as the economic growth front, with economic data implying stagnation, at best, with the exception of Germany (but for how much longer..?)

2. US: macro data has come out on the softer side recently, signaling that recovery may be losing momentum. The employment numbers, to which the Fed is particularly sensitive, appear to be on a deteriorating trend, missing expectations by a wide margin for May.

3. The Chinese economy has been exhibiting signs of persistent weakness. Soft data, such as the manufacturing PMI are indicating growth problems, also evident in ‘harder’ data such as industrial production growth. Further, indicators like electricity production and iron ore demand have not been encouraging.

The Chinese authorities’ concern about rising inflation has led to an aggressive clampdown on the property market with some success, as inflation has stabilized/turned lower. However, the Chinese economic growth model remains substantially dependent on investment/real estate development, and this cannot change overnight.

Today’s rate cut by the PBOC suggests the government’s line in the sand has been crossed.

Unlike previous occasions, when the PBOC started easing policy first through  a series of reserve requirement ratio reductions, this time a rate cut arrived ‘too fast’, potentially illustrating a sense of urgency.

The rate decision came before a raft of data to be announced this coming weekend, including industrial production and retail sales, suggesting numbers may be on the soft side. Furthermore, the Chinese may be getting increasingly pessimistic about the future course of the Eurozone.

The question here is whether to welcome this move at face value, OR see it as confirmation that ‘something is really not going well’ in China. Commodity price behaviour certainly seems to be suggesting the latter for a while now.

4.Other monetary authorities around the world have recently been ‘erring on the side of caution’ by opting to be more accommodative than otherwise, as a result of concern that another ‘Lehman’ event springs from the Eurozone.  For example, the Reserve Bank of Australia, the Banco Central do Brazil and the Reserve Bank of India have all reduced rates in recent weeks, explicitly citing the external uncertainty in their rationales.

Market stress and the coming response

Risk sentiment has been seriously hurt in the last month or so.

Equities have shed most of their year-to-date gains and 'safe haven' sovereign bond yields have reached extremely low levels.

Elements of a policy response are starting to fall into place.

The ECB stands ready to act, as president Draghi mentioned yesterday. Europeans usually take a bit longer before launching ‘solutions’, but a customized package for Spain and its banks appears to be on the cards.

Chairman Bernanke has also mentioned the Fed is ready to act if the US economy becomes ‘threatened’ by Europe. Rhetoric from other Fed officials has also in recent days highlighted alertness and left the door open for further stimulus, should the economic recovery show signs of exhaustion. Importantly, declining energy prices are giving more ‘room’ to the Fed, should it decide on acting.

Nevertheless, the ‘QE glass’ may still be half- empty and the Fed probably needs to see more before acting.

Such ‘readiness’ by monetary authorities may constitute a necessary, but cannot be a sufficient condition for addressing structural issues that require political will.

Three points worth making here:

First, it is once again to central banks that everyone looks to for ‘support’. The vacuum of fiscal presence is remarkable.

What is more, I am worried about China’swillingness or ability to deliver another ‘2008’. While China’s debt situation is probably much better than in most of the developed world, it is not exactly ‘healthy’, which makes it unlikely that the authorities have the appetite for another huge fiscal stimulus package. Furthermore, even if they did, it would in all probability act towards ‘undoing’ most of the progress made in tackling inflationary pressures (and expectations thereof). In addition, a fiscal package, almost certainly geared toward infrastructure investment, would not be entirely consistent with rebalancing towards a more sustainable, consumption-driven economic model. And let us not forget that there is a Party leader handover next year, hence one would expect the current authorities to not aim at major new policy initiatives in the meantime.

Second, notwithstanding the monetary authorities’ readiness to act, one should remember that such interventions merely ‘buy time’. 
More importantly, key developments/sources of uncertainty are still ahead of us.

In the case of Europe, there is ‘can-kicking’ until politicians get their act together. Chancellor Merkel is now talking about a ‘two-speed’ Europe…this can only add to market nervousness if not clarified / backed up by concrete proposals. Also, the Greek election is only ten days away.

In the case of the US, the ‘fiscal cliff’ approaching towards year end, the debt ceiling is bound to be reached again and there is an election coming, with all the associated uncertainty/political gridlock this could bring.

Third, central bankers may be standing ready, but not in an unqualified sense. Inflation remains a key concern and, as illustrated by the Bank of England’s decision today, monetary authorities still aim to keep a delicate balance.

The market has been ‘sniffing’ the policy response. Equities have bounced back from oversold levels, 'safe' sovereign bond yields have edged up a bit, gold and silver have moved higher since the US non-farm payrolls number, while the USD has shed some ground.

However, the rally that followed China’s rate cut did not last, or was not as strong as one would expect. Lack of hints for imminent QE from Bernanke today may have also dented the initial enthusiasm, something evident in gold's move lower.

Unless Europe miraculously and decisively resolves its issues in the next few weeks, the policy response will get more and more necessary and will likely not be denied by the monetary authorities. 
This is a sentiment/event-driven market, so reasonable valuations (esp. Europe) are getting trumped by the macro. We are likely heading to a very interesting summer for financial markets. 
Let us hope that uncertainty does not give rise to a 'Lehman' scenario materializing, as even central bank response has its limits.