In-between the lines

Frankfurt am Main, (PresseBox) - .
- Aggregated policy stimulus is lifting asset prices and growth prospects
- But four risk areas persist
1) Insufficient private sector response
2) Trouble with Greece and Spain
3) US fiscal tensions after election
4) Conflict between Iran and Israel

The last two weeks have been more of the same: soft economic data and bullish markets. The economic data has improved a tiny bit in the sense that conditions failed to deteriorate further, but the level of global activity remains sluggish. The best news comes from business sentiment indicators, which point to some improvement in orders versus inventories and hiring intensions. Asset prices, on the other hand, especially global equity markets, have remained buoyant. This week has started weaker, but there is a sense that underlying sentiment remains optimistic. The market rally has been fueled by central bank action around the globe. Some fear that this liquidity induced rally will not last long and have little impact on real growth. There are notable risks, but we believe that the aggregated impact of the global monetary action is still underestimated.

At the start of the year, we put out a DAX target of 7500 for this year. We came close to the target in the first quarter and are even closer now. Looking ahead, the fundamentals are in place for further upside in 2013. However, volatility is also high as we had predicted and there are several risk factors that could lead to a temporary correction in the fourth quarter.

Uncoordinated policy impatience

To an outside observer it may seem that the series of monetary measures over the last few weeks by central banks in both industrialized and emerging economies was coordinated. That was probably not the case. Instead, each central bank seems to be responding with growing impatience (and in some cases concern) to its own domestic economic conditions. And with interest rates near zero in the major industrialized economies, that easing is coming through unconventional "quantitative" measures. To the extent that there is a link between central bank actions, this is more a sign of defense than coordination. A good case in point is Brazil, which drastically cut reserve requirements to boost liquidity and prevent currency appreciation. The easing is probably also not yet over. We expect the ECB to lower the refi rate by at least 50bps. China has revived credit growth, but a further stimulus push is likely to follow soon after the leadership change in October.

Finally, not just monetary policy is pushing for growth.

The most prominent case is last week's Swedish fiscal stimulus package. In the Euro area, fiscal policy is not turning around, but the degree of tightening seems to be easing, especially in the crisis economies. The aggregated impact of all these monetary and fiscal actions is probably underestimated by both policy makers and markets. The result is likely to be stronger financial and economic performance. However, four key risks remain.

1) Battling the liquidity trap

The most general risk is that the easing fails to trigger an adequate private-sector response. Output and business sentiment indicators exhibit a downward bias. This needs to be reversed. There are some positive demand indicators, like car sales, but they are not yet strong enough. The impact of policy action is less of a concern for emerging markets, since they are not in a deleveraging mode and have enough room to ease via conventional policy tools. The concern applies mostly to the major industrial central banks (Fed, ECB, BoE, BoJ). Some argue that the quantitative easing only creates asset bubbles. However, asset markets are the main transmission channel through which monetary policy can affect the real economy (wealth effect and sentiment). So far, the track record has been mixed. Especially the BoJ has struggled to gain traction. Halfway measures are likely to fail. The Fed and the ECB have learned that lesson. Their actions leave little doubt about their intensions and are likely to have a significant impact.

2) Recurring Euro-area tensions

In the Euro area, the main concern is about risks outside of the direct control of monetary policy. Markets are currently impressed by the ECB announcement, but events can change this quickly.

- One event risk is Greece. The Troika report will probably fail to make a clear recommendation. Realistically, Greece needs a third package with a second restructuring. This is very unlikely to happen. On the other hand, Greece will probably not leave the Euro voluntarily. It could get pushed, but this is not the most likely scenario either. In particular, Germany's chancellor Merkel fears the behavioral response of depositors in other crisis countries. Thus, most likely is another fudge (front-loading of the current program with some other EU aid), which only postpones the tough issues.

- The second event risk is Spain. This could be triggered by Greece or emerge separately (banking issues, regional issues, market impatience). Ideally, Spain should apply for a precautionary credit line from the EFSF/ESM as soon as possible to get ECB support when needed. However, that seems not to be happening. Whether the reluctance is pride or a tactical maneuver is not clear. Also unhelpful is that Germany is not encouraging Spain as it tries to avoid another debate in the Bundestag for domestic political reasons (especially as voting for a Spanish program means giving the ECB the green light). In our judgment, neither Spain nor Greece will trigger a full-blown crisis. In particular, Spain will eventually request and get a precautionary credit line and with it ECB support. However, the process to that outcome is likely to be pumpy and could result in a significant (albeit temporary) market correction.

3) US fiscal tensions after the election

Another concern is that markets have become very sanguine about US election and fiscal risks. Consensus growth forecasts for 2012 and 2013 imply no significant change in the fiscal policy stance following the election, especially no automatic implementation of the fiscal "cliff". Indeed, the fiscal "cliff" becoming just a "speed pump" is the most likely outcome. But the risks are biased to the downside if the election outcome is an emboldened second Obama administration and a strong Republican majority in the house. We have no insight how likely such an outcome is, but view this scenario as an underestimated risk, which could soon after the election lead to a conflict between the administration and the house over both the handling of the fiscal "cliff" as well as the approaching debt ceiling. The result could be a similar impasse as in mid 2011 and whether the Fed's new QE program is sufficient to overcome this is not clear.

4) Escalating conflict in Middle East Another area where markets seem to have become complacent is the Middle East, especially the tensions with Iran. Again, we have no particular insight, but clear is that Israel believes that the situation has come to the point of no return. In other words, the question of an Israeli airstrike against Iranian nuclear facilities is probably when and not if. And with an airstrike for military reasons unlikely in the winter months, the timing could be either in the next two months or later next year. A second risk is the deployment of chemical weapons by the Assad regime against the Syrian opposition and the likely military response by both the US and Israel.

To be sure, our underlying scenario is positive. We believe that the aggregated policy actions around the world will have a positive impact on asset markets and growth prospects. In the transition before these measures have an impact, however, we see substantial risks for a correction, especially in the fourth quarter.


This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 27 September 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.

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