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Octopus Weekly Markets Update. Lothar Mentel, Octopus Chief Investment Officer. We’ve experienced another roller-coaster ride in global capital markets this week. However, compared to previous weeks, what’s been evident is just how much the markets want to go up. After closing at new lows on Tuesday, they rallied strongly through to Friday merely on the potential for good news, before the rise faltered on the back of further banking sector downgrades. Greek tragedy turning to farce Investors began the week in bad humour, after unsurprising news emerged that Greece was unlikely to be able to cut its budget deficit to 7.5% of GDP, a target that it needed to meet in order to receive its next tranche of bailout funds. We say unsurprising because the Greek government feels it cannot risk further deficit cuts at a time when it is trying to stave off widespread general strikes from public sector works and its youth population threatening to descend into anarchy. For their part, leaders within the Eurozone cannot bring themselves to release Greece into some form of debt default, but equally they are unable to provide the sort of financial ‘New Deal’ support that’s needed to break the vicious downward spiral. Anyone who’s seen the film ‘Groundhog Day’ will recognise the sensation of waking up to the unbearably familiar, and feeling doomed to repeat the same pattern over. So it’s been with Greece and the European sovereign debt crisis over the last few weeks and months. Rumours that European finance ministers were pushing for a further write-down (or ‘haircut’) of the value of Greek debt (from the proposed 21% to 50-60%, so more of a scalping than a trim) also added to the negative sentiment on Tuesday. But then, in the last few hours of trading in the US, markets staged a sharp recovery rally of around 4%. One explanation for the sudden turnaround in sentiment was that the FT reported in its web edition that European policymakers were considering a ‘troubled asset relief programme’ to help ease the European sovereign debt/banking sector crisis. Markets continued to rally, as more political support for a European banking recapitalisation program emerged. It was also announced that a further set of stress tests for banks would take into account the reduction in value of their European sovereign debt holdings. However, on Friday the UK’s banking sector was rocked by the announcement from credit ratings agency Moody’s that it was lowering its ratings for 12 British banks, based on Moody’s belief that it was looking less likely that the UK government would provide support to financial institutions if needed. Dexia: The first European bank to fall on sovereign debt exposure? Speaking of stress tests, back in July the French/Belgian bank Dexia passed its tests with flying colours, coming 12th out of 91 institutions in terms of core tier one capital ratios. But that was when European authorities still insisted that European sovereign bonds would remain a secure store of value. This week Dexia entered into discussions to agree how the bank would be broken up, unable to raise enough cash via the markets because of its €3.4bn exposure to Greek debt. It is a grotesque irony to see banks in crisis precisely because they implemented the regulatory measures (namely using European sovereign debt to meet larger reserve requirements) that came into force to prevent another banking crisis from happening. Calculations that European banks require €200-400 billion to be properly recapitalised are all based on the assumption of major haircuts on sovereign bond debt from nations which now include Italy, the world’s third largest debt issuer. So this time around it may not be so much ‘greedy bankers’ but incompetent politicians to blame for this crisis. Bank of England pumps another £75bn of quantitative easing into the system It was Monetary Policy Committee (MPC) meeting time again on Thursday, and although the base rate again remained unchanged at 0.5%, the MPC announced it would be pumping a further £75 billion into the economy via quantitative easing (QE). This money will be used to buy UK government bonds and other assets from financial institutions and hopefully free up some liquidity within financial markets. Most analysts, including us, had been expecting a decision on QE to be delayed until November, when there would be further forecasts available for growth and inflation into 2012. But it seems that the Bank of England recognises the need for greater urgency and perhaps wishes to avoid being labelled as indecisive as the European Central Bank when it comes to assertive monetary policy. We welcome this renewed package of QE, although feel it would be so much more potent if the UK government complemented it with a decisive plan for growth. Outlook – the divergence of global sentiment Investors continue to struggle to piece together any reasons to be optimistic, and although markets rallied strongly for much of the week, it was based on measures designed only to deal with the symptoms. Within Europe, sentiment remains close to the bottom, but persistent expectations that politicians can, in fact, solve the European debt crisis have prevented equity markets from capitulating. Yet even if the politicians can pull a magic rabbit out of the hat (and everything so far suggests they are too polarised to achieve anything approaching the level of ‘shock and awe’ that markets are hoping for), investors will need to get used to the aftermath, which will likely be at best a lengthy period of low growth, or at worst, a formidable recession. But it is worth remembering that emerging markets are still expanding, and it’s encouraging to note that in the US, sentiment is improving (this week’s jobs data showing that the private sector added 91,000 in August came in better than expected). The fall of commodity prices (and a lower oil price – always a boost for US consumers) should lead to improved economic activity later down the line. So, depending on your time zone, the glass is either half full or half empty. Lothar Mentel, 7 October 2011