Sweet Spot

We can trace back the beginning of this equity rally in March to various factors: extreme pessimism about the world economic outlook; G20 reassurances and IMF funding, particularly for Eastern Europe which reduced the risk premium for Emerging Markets as a whole as well as the European banks; cheap valuations; USD weakness (causality here is difficult to gauge though) etc. Clearly all these played an important role turning the markets around. However, what really propelled asset markets was undoubtedly the massive amount of liquidity released into the system by world central banks. We have had a great spectacle of how markets run on liquidity in the short term. As the rally progressed equities moved into the “sweet spot”. On the one hand is huge liquidity and on the other hand the advent of economic recovery – at least this is what the markets wanted to believe in. The severity of the last recession and the spectre of a double dip ensure that central banks around the world will wait to see the white of the eye before shooting i.e. monetary policy will err on the side of keeping policy relaxed. However, come autumn we are likely to see the first signs of “decoupling” but of policy. Given the slew of upward revisions to GDP monetary policy in some parts of the world, particularly in some EM countries, look far too easy. Extraordinary liquidity will be quickly drained and interest rates will be normalised. Although this will not be across the board – as BoE proved it last week -- it will be enough to spook the markets. Just look at how Chinese local markets are performing as the loan growth numbers half from 1H. The irony is that the more markets rejoice the recovery the higher the chances that the most important pillar of this rally – liquidity – will disappear. Some of you will say that earnings will take over and sustain the rally but equity prices already seem to be reflecting the earnings recovery and valuations are not longer particularly attractive. So enjoy the rally while it lasts.... Enter the USD.