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VOL. 36 | NO. 37 | Friday, September 14, 2012

Backstop may ease Europe’s fiscal woes

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Our most recent musings in this space have focused on the political and fiscal dynamics here at home.

While those dynamics are vital and will continue to come more into focus as the calendar turns the page to the fourth quarter, the more pressing short-term focus in the financial markets has been to the east across the Atlantic Ocean.

The ECB in general and Mario Draghi specifically landed a powerful counterpunch last week. Draghi said “we have a fully effective backstop” as he announced a program for the ECB to make unlimited bond market purchases.

The program will focus on issues with short-term maturities (one to three years). The access to the spigot does come with conditions, as participating countries will be required to agree to still-to-be determined economic reforms.

Those economic reforms are needed, as the Eurozone is basically in a recession. GDP contracted by 0.7 percent in the second quarter, and the ECB forecasted a GDP contraction of 0.4 percent for the full 2012 calendar year. Printing money can lead to longer-term inflation problems, and that is one reason the Germans continue to voice opposition.

In a nod to their concerns, the ECB announced that any bond buying would be sterilized, essentially keeping the money supply effect neutral. Whether the sterilization move truly does keep inflation in check over the longer-term remains to be seen.

Inflation and a slow, plodding economic recovery are longer-term issues, but equity and bond markets in Europe have feared a short-term Lehman-type financial collapse, not just a slow recovery.

As the ECB’s moves continue to dim the prospects of such a collapse, below-average valuations are too attractive to resist.

Spain’s equity market rallied 5 percent on Thursday, while Italy’s surged by 4 percent. Furthermore, even though the ECB program will focus on short-term maturities, the longer end of the yield curve immediately benefited as Spanish 10-year bond yields fell to 6 percent, and Italian 10-year yields dropped to 5.3 percent, their lowest level since April. The U.S. markets also were pulled into the party, as the DJIA, Nasdaq and S&P 500 all closed at multi-year highs.

Overnight on Thursday, Asian equity markets were poised to rally anyway on the heels of the ECB announcement. However, the markets received an extra boost as the Chinese government opened its vast arsenal and announced aggressive stimulus efforts, including funding for 1,254 miles of road, various warehouse projects, waterway upgrades and subway projects.

Yes, this is investment and development expansion, rather than direct consumer stimulation, so overcapacity issues remain a concern, but markets were stimulated anyway as the Shanghai Composite Index woke up out of its doldrums and surged nearly 4 percent; the broad MSCI Asia Pacific Index posted its biggest one-day gain since December.

By no means will it be smooth sailing from here, as many land mines remain, and even the ECB measures could prove to be ineffective.

In the meantime, don’t fight a committed central bank!

Mark Sorgenfrei Jr. is vice president and investment analyst for Waddell & Associates Inc.

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