Weekly Market Commentary - Predicted Policy Positives Priced In, Producing Potential for Precarious Pitfalls

The series of economic policy actions in the United States, China, and Europe have already had a powerful positive impact in the markets. The policy events this week are: Germany's constitutional court ruling, possible aid for Spain, the Fed’s likely announcement of yet another stimulus plan, and inspectors reviewing if Greece’s progress on reforms merits any more aid.

The market is anticipating generally good news from each of these events, so volatility may return if they are mixed.

 

Predicted Policy Positives Priced In, Producing Potential for Precarious Pitfalls

There are many highly anticipated economic policy events this week, primarily in Europe. The markets will debate whether these will finally be enough or if more are required. It is likely there will be more to come. However, the series of policy actions in the United States, China, and Europe have already had a powerful positive impact in the markets:

  • • Federal Reserve (Fed) Chairman Ben Bernanke’s speech on August 31, 2012, from Jackson Hole, WY reaffirmed the market’s expectation for another major policy initiative from the Fed to be unveiled this week. The anticipation of further economic stimulus has helped to lift the U.S. stock market, measured by the S&P 500, back to four-year highs.
  • • Last week, China announced that it approved a large number of infrastructure projects estimated to total nearly a quarter of all the stimulus China put to work during the global Great Recession of 2008-09. On the news, the Shanghai Composite, which had been sliding to near four-year lows, surged nearly 4%.
  • • Even without the European Central Bank (ECB) making a single purchase of the bond-buying program announced last week, it is already working and adding to the backdrop of other potent policy measures. European bank stocks have surged, and 2-year Spanish bond yields have plunged from 6.5% less than two months ago to less than 3% last week.

This week is set up to deliver another week of policy announcements that may drive the markets. The most significant begin on Wednesday and include: Germany's constitutional court ruling and possible aid for Spain, the Fed’s likely announcement of yet another stimulus plan, and inspectors reviewing if Greece’s progress on reforms merits any more aid.

 

• Greece’s Inspection. The troika, made up of members of the European Commission, International Monetary Fund (IMF), and the ECB, are in Greece reviewing progress on a number of delayed reforms and spending cuts. The final report is set for October 8; however, much of the deliberations are transparent. Greece is hoping to convince the inspectors of the commitment to its plans, but a number of provisions run counter to what some of the new government coalition members promised voters just three months ago. If the inspectors sign off on the latest cuts and are convinced of Greece's reform drive, Greece will get 31.5 billion euros next month, without which Greece would likely default and send markets lower.

• German Constitutional Court Ruling. On Wednesday, the German Constitutional Court is due to rule on the legality of the Eurozone’s permanent rescue fund, the European Stability Mechanism (ESM). The ESM is intended to replace the nearly exhausted temporary European Financial Stability Facility (EFSF). The market has priced in the most likely outcome that the judges will let the ESM move forward. However, if the court were to rule the ESM violates the German constitution, it could have a very negative effect on the markets by casting doubt on the rescue of troubled southern European countries. But, even if the court gives its ok, it may complicate rescue efforts by setting limitations or veto powers that may undermine confidence and spook the markets.

• Spain’s Memorandum of Understanding. Following a favorable decision by the German Constitutional Court, Spain may request European assistance in the form of a broader bailout than the banking sector aid received earlier this year. The terms of this bailout, spelled out in a memorandum of understanding, are already being negotiated with Spain attempting to moderate politically unpopular conditions such as cutting public pensions. The markets are sensitive to how long it takes to cut a deal after the German court rules—the sooner the better.

• Netherlands Election. The coalition government that may form could have a high proportion of representation from the parties that are skeptical of further Eurozone integration. This could raise another hurdle to rescue efforts.

• European Banking Union. A proposal for a single banking supervisor based at the ECB—rather than leaving all banks regulated at the national level and risking capital runs from banks in one country to banks in another—will be presented to the European Parliament this week. Most favor broad regulation since problems have spread from smaller institutions to larger ones. However, Germany wants the ECB to supervise only the top-25 systemic cross-border banks and leave the rest to national regulators. This week is set up for a showdown over the future of banking in Europe after European bank stocks have rallied sharply in recent months.

• The Fed’s Quantitative Easing. The Fed is widely expected to announce open-ended quantitative easing at the conclusion of its two-day policy meeting on Thursday. Indications from recent speeches, papers, and economic data failing to meet the Fed’s stated objectives, all point to action. But if the Fed believes it has the time to wait for more data given the recent significant improvement in European markets mitigating a key risk, and providing more time for the extended Operation Twist program to work prior to its end in December, it may put off its decision until after the election. If so, the markets would likely react negatively.

This week ends with European finance ministers meeting in Cyprus to argue over the banking supervision proposal and the terms of aid for Spain and Greece.

The market is anticipating generally good news from each of these events, so volatility may return if they are mixed.

While all of the policy events last week and this week hold significance for the markets, over the next few months, the policy initiatives in China may be the most important. A bigger economic downturn for China would have broad global implications that would be hard for European or U.S. policymakers to offset.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990 with a base value of 100. Index trade volume on Q is scaled down by a factor of 1000.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. "Operation Twist" describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.

This research material has been prepared by LPL Financial.

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