Friday, 18 February 2011

On markets and monetary policy

Seen as an asset class, equities continue to rally on the familiar background of ample central bank liquidity and a surprisingly late rotation into equities by institutional and private investors alike. A major reason for this rotation appears to be that the return on bonds is unattractive – to say the least.

 However, in the background several trends are quietly working to change the dynamics of the financial markets. We have already described the fact that monetary policies are being tightened at different speeds in different countries. The relative performance of the stock markets shows this clearly. The countries that have already started tightening experience underperforming stock markets.

Apart from Japan – who increasingly looks like a total basketcase – USA is the laggard among the large economies and the main culprit in flooding the markets with central bank liquidity. Recent data from the US Loan Officers Survey indicate that things are changing. Banks are resuming lending activity, albeit on a small scale.

This is important news for the financial markets. It is an early indication that event the US will at some point in time begin to tighten. The discussions whether Federal Reserve will be “behind the curve” are interesting, but irrelevant in this context.

The conclusion is that the dynamics in the financial markets increasingly will be determined by the timing of monetary tightening, and this movement will reach a crescendo once the US Fed decides to rein in liquidity.
For investors it means that we cannot any longer rely on just buying stocks and commodities when the market mood is for increased risk. Or buying bonds when the market mood is for decreasing risk.

The markets/asset classes will have to be bought and sold on their individual merits. And exactly the same goes for currencies.

As an example, take Sweden. The SEK plunged in 2008 as the Riksbanken lowered interest rates aggressively. Sweden – like Germany – is a strong manufacturer and exporter of industrial goods. Sweden therefore profited nicely when the European demand began to pick up.

Now the SEK has appreciated and seems set to continue. Exports are strong. Unemployment is falling and predictably, Riksbanken is tightening as it should be. Having been one of the strongest performers in 2010, Swedish stocks are now underperforming, as the market is discounting the combined effect of higher interest rates and a stronger currency.

Take this story and compare with recent developments in China, Norway, Australia, Canada, and several other countries. The stories may differ in their details, but the main tenet is the same.

Does all of this sound way too simple? Maybe it is. But it is a clear sign that after nearly 3 years of turmoil in the markets, we are returning to some kind of normalcy.

There is, however, one European aspect that should not be overlooked. Germany is the leader inside the Euro zone. Guess who are the laggards. Just look south.

It can be argued that for a long period, Europe had too low interest rates because of sluggish German growth. Maybe we will now have a period of too high rates because of strong German growth. Creating a one-size-fits-all monetary policy is not as easy as it seems. We will hear more about this.

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