The European Central Banks’s (ECB’s) new three-year long term refinancing operation (LTRO) has lessened the chance of a euro area-wide bank run, which will benefit risk assets in the near-term. However, the underlying structural problems in Europe remain unresolved, and the increase in Portugal’s long-term borrowing rates to fresh highs suggests that the firewall around Greece might not hold. Investors may see another bout of market weakness by the middle of the year.
The euro is technically oversold and is poised for a near term bounce. That said the need for the ECB to continue to expand its balance sheet implies that the euro will drift lower over the remainder of the year. The dollar is likely to appreciate against the euro over a 12-month horizon, but weaken against a wider basket of currencies.
The U.S. economy will avoid a recession, but the strong pace of growth seen in the fourth quarter will not be sustained. The housing market appears to have bottomed in many areas, but expect market sentiment to rise and fall with moves by the Obama administration to aid mortgage refinancing. The labor market has perked up, but a large unemployment overhang will continue, possibly for years. Unfortunately, the consumer saving rate has fallen to unsustainably low levels, which suggests that consumer spending growth will decelerate over the next few quarters.
China’s controlled economy is poised for a soft landing, but concern will remain high and risk is to the downside. Unlike much of the developed world, China still has plenty of ammunition in its policy arsenal to deal with domestic and external headwinds. Better than expected growth news from China and other emerging markets will benefit the commodity complex. Chinese equities may outperform in the short-term as the central bank lowers interest rates and eases recent credit constraints. Ultimately, if a hard landing does not occur in 2012 and cleanse out the system, China may be proverbially kicking the can down the road and setting up for a larger economic hiccup in a couple years.
For 2012, an uplift in risk assets will hinge on three key questions:
- Will the euro crisis be resolved?
- Will the recent strong performance of the U.S. economy be sustained?
- Will China suffer a hard landing?
The rally in risk assets, while underpinned by a number of factors that could sustain positive momentum for the next few months also could run out of steam by summer. The sugar high from the ECB’s liquidity injections should not be understated, and could power a rally in risk assets over the coming months.
Michael Ashley Schulman, CFA