The rally in risky asset markets fuelled at the start of this year by the European Central Bank’s unlimited provision of long-term liquidity to the region’s banks proved short-lived. It started to fade in March in the face of risks to the global outlook. The escalation of banking and fiscal stresses in Spain soured sentiment towards the euro zone, while a string of disappointing data releases in China kept alive fears of a hard landing in the world’s second-largest economy. Global risk appetite in the rest of 2012 is likely to hinge to a significant degree on whether Greece stays in the euro.
The US equity market held up longer than others, underpinned by good corporate earnings. US bulls took encouragement from 3% GDP growth posted in the final quarter of 2011, the strongest since early 2010, and from the buoyancy of the labour market early in 2012 when the economy was creating upwards of 200,000 jobs a month. But the US market was unable to shrug off the souring mood on global markets for long, and the rally had already lost impetus by the time the Greek elections on May 6th triggered sell-offs in markets across the board.
The script being followed by markets is well rehearsed from previous moments of market stress, most notably following the collapse of Lehman Brothers in September 2008. Assets which are risky or geared to global growth have been sold. These include equities, commodities and emerging-market currencies. Investors have parked the proceeds in the traditional safe havens of US Treasuries, German bunds and the yen. The flight to safety has pushed yields on 10-year US Treasuries below 1.7%. 10-year German bund yields have gone even lower and are currently around 1.2%. These yields are at record lows and below the rate of inflation, so that anyone buying at these prices is locking in negative yields in real terms.
The scale of declines in equity markets has varied. Although the US market has been the clear outperformer in the year to date, it lagged the Japanese market in the first quarter when the Nikkei shot up by 21%, from 8,455 at the start of the year to 10,255 in late March. But the Nikkei’s subsequent fall from grace has been even swifter: by late May it had fallen back to just over 8,600, surrendering nearly all of its first-quarter gains.
In Europe, the Greek market enjoyed a boost in January and February but has since fallen to new lows. It is now trading at levels last seen in the early 1990s, a decade before the country’s ill-fated accession to the single currency. In Spain there has been little relief from the pain caused by worries about the solvency of the banks (and hence the government, through its contingent liabilities). The Bolsa de Madrid barely responded to the ECB-inspired lift at the start of the year and has ground relentlessly lower since mid-February, falling to its lowest level since early 2003. Germany’s Dax index has been the clear outperformer in the region, reflecting Germany’s industrial might and the current resilience of the economy. But most of the Dax’s first-quarter surge has dissipated since April, leaving the Dax clinging to a gain of around 6% year to date.
In emerging-market equity markets the pattern this year has been one of big gains followed by steep declines, leaving markets at similar levels to those at the start of the year. As these markets are driven by risk appetite, they traditionally evince a high degree of correlation. The Chinese market is often an exception because of its closed capital account. But this year its ups and downs have broadly followed global trends. The market is up around 12% year to date, making it one of the world’s better performers. Chinese bulls, in the grips of a protracted bear market, will be betting on the authorities applying more stimulus in the second half of the year to galvanise the economy in the run-up to the once-in-a-decade political transition in the autumn.
In foreign-exchange markets in the first two months of 2012 the US dollar gave up some of the broad-based gains made against developed- and emerging-market currencies in late 2011. But since March, and particularly during May, the dollar has strengthened across the board, against the euro, commodity currencies such as the Australian and Canadian dollars, and most emerging-market currencies.
The dollar has also been strengthening against the Chinese renminbi, one of the few currencies that appreciated against the greenback in late 2011. Chinese policymakers may be reluctant to let the renminbi strengthen while the outlook for the global economy is so uncertain. In Brazil policymakers will welcome a weaker Real as a means of restoring competitiveness to a manufacturing sector struggling in the face of Chinese competition. But the Real’s decline has been so precipitous that the Brazilian central bank decided to intervene in the market in late May, selling dollars to send a warning shot across the bows of speculators. The Indian rupee is another currency that has depreciated rapidly during the current episode of risk aversion. Funding India’s sizeable current-account deficit in this climate is challenging, particularly given concerns about regulation, openness to foreign investment and the policy framework more generally.
The picture for commodity prices is, as usual, more nuanced because of factors affecting the balance of supply and demand of specific markets, particularly soft commodities. But those which are most sensitive to the global economic cycle, such as copper and oil, have displayed similar trends, rising early in the year before subsequently giving back most of those gains. The surge in oil prices in the first quarter was given an extra lift by the toughening of international sanctions against Iran over its nuclear programme. Markets were pricing in not only a reduction in Iranian oil supplies to world markets but also the risk of disruption to supplies from the Persian Gulf in the event of military action against Iran. Having started the year at US$108/barrel, Brent soared to US$128/b in early March only to fall back to around US$104/b today. Prices have fallen as tensions between the West and Iran have eased somewhat. In addition, concerns about growth in China have been exerting downward pressure on prices. The political uncertainty in Greece provided the impetus for another leg down in the oil price in May.
All eyes on Greece
As regards prospects for risky asset markets in the rest of the year, the big question is what happens in Greece. On the one hand, if the June elections set in motion a Greek exit from the euro zone, investors will worry that Greece will set a precedent that other countries will follow. An episode of acute risk aversion would then be in prospect, in which risky assets could fall much further as investors fled to safe havens. Policymakers would presumably respond by flooding the financial system with liquidity with the aim of supporting asset prices. But their arsenals are not as full as they were at the time of the Lehman Brothers collapse, raising doubts about their effectiveness. On the other hand, if Greece elects a government which is committed to meeting the conditions of the EU/IMF loan deal, risky asset markets would enjoy a relief rally. How long this might last is open to question given all the structural problems in Greece and elsewhere in the euro zone periphery, which will remain a source of concern for investors for the foreseeable future.