Rallies become ever briefer

Given recent events, a further “relief rally” in stock markets and commodity prices would have seemed likely:

• Even though the Fed has only extended its Operation Twist for now, many investors believe the central bank will announce a new round of quantitative easing sooner or later given its concerns regarding the US economy and lower inflation expectations;
• The outcome of the Greek polls and a probable pro-euro(zone) coalition avoids the doom scenario of a fast Eurozone break-up;
• China has cut interest rates and the authorities are focussing on growth measures;
• The focus of Eurozone leaders (for example during the EU and Eurozone summits this month) will also be on ways to boost growth, and a potential move towards more integration – for example in the form of jointly issues eurobonds;
• Spain is set to receive money (up to €100bn) to recapitalize its troubled banks, and France’s president Hollande is pushing for using the European Stability Mechanism directly to purchase sovereign debt of the weak euro countries to push down respective bond yields. Although Merker is resistant to the idea, hopes are that she will give in under market pressure.

The fact that a sustained rally has not emerged is, in our view, a strong hint that these fiscal and monetary developments are no silver bullets: They will not address the underlying problems. Most importantly, the drive of the peripheral euro countries to implement structural reforms is waning. This is not surprising. A recent IMF study has again shown that such reforms will result in higher growth only after a year or 5. This implies the need for bridge financing for the weak euro countries; otherwise, income-cutting and tax-raising measures will only weaken their economies further. However, the stronger euro countries are reluctant to provide more bridge financing, not in the least because this might, ultimately, weaken their economies as well.

The actual problems that the world economy is facing might well be much graver than most investors believe: not only in the Eurozone, but also in other large economies with China and India clearly slowing and the Fed expecting a slowdown, especially with the fiscal cliff looming). Time to address these issues is running down and investors will come to realize this. As a result relief rallies in the stock and commodity markets are likely to become ever briefer.

As long as no significant steps forward are taken to address the flawed institutional setting in the Eurozone (a non-optimal currency area without crisis resolution mechanism, without a banking, fiscal, and political union), another acute phase in the euro crisis seems all but inevitable. In that case, expect the relief rallies to overshadow the downward corrections in the financial markets.