Download Capital Markets Briefing (Lothar Mentel, CIO)

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