Monday, 8 August 2011

Markets to look to policy-makers after dramatic week

Last week turned out to be a highly eventful one. It started out with the United States government establishing a deficit-reduction plan and raising its debt ceiling and ended, ironically, with Standard & Poor's cutting the US government's credit rating.

In between, US stock markets plunged. Instead of a relief rally following the resolution of the US debt ceiling impasse, investors chose to sell stocks, culminating in a 4.8-percent drop in the Standard & Poor's 500 Index on Thursday. The S&P 500 ended the week down 7.2 percent and closed on Friday at 1199.38, 12.0 percent below its peak on 29 April.

The fall in US stocks dragged the rest of the world's stocks down as well. The STOXX Europe 600 Index plunged 9.9 percent to 238.88 last week, the lowest level in 13 months and 18.0 percent below its peak on 17 February. The MSCI Asia Pacific Index fell 7.8 percent to 126.08 and is now 10.5 percent below its peak on 2 May.

The flight from stocks benefitted bonds. Prices of US Treasuries rose last week, resulting in the 10-year note yield falling 24 basis points to 2.56 percent and the 30-year bond yield falling 27 basis points to 3.85 percent.

Economic reports last week clearly damaged risk appetite.

Surveys of purchasing managers in July showed a significant deterioration in business activity in the US and Europe.

In the US, the Institute for Supply Management's manufacturing PMI fell from 55.3 in June to 50.9 in July, indicating little growth in the sector. Its non-manufacturing index fell from 53.3 to 52.7.

For the euro area, Markit's manufacturing PMI fell from 52.0 in June to 50.4 in July, again indicating little growth in the sector. The services PMI fell from 53.7 to 51.6.

The slowing growth in Europe is a particular concern because of the on-going sovereign debt concerns there. While initial concerns had mostly been over Greece's debts, the focus has recently shifted to Spain and Italy, especially the latter. Italy's 10-year government bonds now yield over 6 percent. They had yielded less than 5 percent at the start of the year.

European Commission President Jose Manuel Barroso acknowledged last week that "it is clear that we are no longer managing a crisis just in the euro-area periphery". A default in either Spain or Italy would obviously have greater consequences on the European and global economies than one in some of the smaller peripheral eurozone economies.

The European Central Bank, though, may be coming to the rescue. Following an emergency teleconference on Sunday, the ECB declared that it "welcomes the announcements made by the governments of Italy and Spain concerning new measures and reforms in the areas of fiscal and structural policies". It concluded "on the basis of the above assessments that the ECB will actively implement its Securities Markets Programme".

The ECB announcement did not specify that it would be buying Italian and Spanish bonds. Nevertheless, this appears likely, since it would be about the only action that would calm current market concerns.

The next policy move that might calm markets could be from the Federal Reserve. The Federal Open Market Committee will meet on Tuesday and announce its latest monetary policy stance. After the recent economic data and last week's market turmoil, many analysts are speculating on the possible announcement of another round of quantitative easing.

There is reason to hope that another round of quantitative easing would boost stocks. The Fed's first round of quantitative easing in 2009 launched the latest cyclical bull market. A second round of quantitative easing last year kept the bull market going.

Still, these moves cannot guarantee that markets will not continue to fall. In 2001, the Fed cut interest rates aggressively in the last few months of the year; the then on-going bear market persisted for another year. In 2007, the Fed shifted towards easier monetary policy by cutting interest rates in August as the then on-going bull market started to look shaky; stocks entered a bear market two months later.

Nevertheless, if the cyclical bull market that started in March 2009 is to continue, a more market-friendly policy stance from one or more of the major central banks is virtually a necessity.

The next week or so could be crucial in determining whether we are at a major turning point for stocks.

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