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Dollars & Sense: Politics Continue to Drive Volatility Print E-mail
Long Term Forecasts | Written by TD Bank Financial Group | Nov 22 11 16:58 GMT

Dollars & Sense: Politics Continue to Drive Volatility

Highlights

  • Contagion in the European sovereign debt crisis has spread in the past few weeks. Yields on Italian and Spanish government bonds have ratcheted up, and even the spread between French and German government bonds has widened on concerns about a potential French downgrade.
  • Fiscal uncertainty in the U.S. has also soured market sentiment as the bi-partisan super committee failed to reach an agreement on fiscal restraint in Washington by the deadline set last summer.
  • Over the near term we expect the high level of uncertainty in markets to continue, setting the stage for only moderate growth in corporate profits, continued low interest rates, and a softening in commodity prices and the Canadian dollar in the near term.

Unfortunately for investors, Europe remains the bad news that won't go away. Since our last issue of Dollars & Sense where we outlined the euro zone's latest “plan” to help address the sovereign debt crisis, contagion has only worsened, with Italian yields breaching the critical 7% level last week (see Chart 1). To top it off the world's other fiscal crisis - the U.S. super committee's deficit reduction plan - has missed the “deadline” for reaching an agreement, further weighing on market sentiment. This one-two punch has knocked the wind out of market sentiment lately, and has kept volatility elevated. All this uncertainty has taken equity markets lower (see table page 3) and increased flight- to-safety flows; strengthening Treasuries and the U.S. dollar, and weakening riskier assets, like the Canadian dollar. With faint hope for a resolution on either fiscal front in the near term, heightened market volatility is likely to persist in the coming months.

The Sack in Rome

The most worrying development in the European sovereign debt saga in recent weeks has been an increase in the yields of Italian and Spanish government bonds to levels that had triggered bailouts elsewhere. In the face of spiking yields the ECB has been buying Spanish and Italian bonds in the secondary market helping to keep a lid on yields. Italy is the third largest bond market in the world - after the U.S. and Japan - and markets' increased fears surrounding the Italian government's ability to make much needed progress on its debt ultimately triggered the sack of Prime Minister Silvio Berlusconi.

Political change has been a major theme in Europe with three governments changing hands in as many weeks. In Spain a center-right political party won a strong majority in its recent general election, and must now undertake major reforms while facing over 20% unemployment. Markets will be watching the new leaders of Greece, Italy and Spain closely to see if they are up to the herculean task. There is no question that Europe is the number one risk to the global economic and financial outlook. (For a more detailed discussion on the events in Europe please see Europe's Slow Moving Train Wreck Still Moving Down The Tracks).

Good Economic News in North American Could Be For Naught

On this side of the pond, the economic news has been largely positive over the past couple of weeks. The U.S. economy grew at a 2% pace in Q3, and early indications are pointing towards a 3% showing in Q4. October retail sales were healthy, and initial jobless claims are signaling improved hiring ahead. At least for now, there is little sign of a double dip recession stateside. The Canadian economy has also rebounded from its Q2 soft patch, albeit with more modest growth prospects beyond Q3.

But these positive indicators could come to naught if policymakers in the U.S. and Europe cannot act decisively to restore confidence to financial markets. Unfortunately in the U.S., exactly the opposite is the case. The bi-partisan super committee has failed to meet its deadline for a plan to save $1.2 trillion over the next 10 years, in theory triggering automatic expenditure cuts. If the full force of the fiscal restraint from those “automatic” cuts is felt, it could derail the economic recovery. However, with the deadline set last summer being self-created, an alternate path will hopefully be worked out by legislators. In the meantime the uncertainty has contributed to souring sentiment in markets, undermining the U.S. recovery at a time when it just looks to be picking up steam.

Where Do We Go From Here?

Barring a banking crisis in Europe, the data we have seen since our last issue are pointing to continued growth. The question becomes; where are financial markets headed? At the risk of sounding like a broken record, there is a particularly high degree of uncertainty at the moment.

Let's address the scenarios for our two chief risks: European sovereign debt, and U.S. fiscal brinksmanship. If there is a European fiscal crisis that causes a European banking crisis, the financial environment would be like late 2008. There would be a big drop in equities and commodities, a rally in bonds, a shift to cash and strength in the U.S. dollar. If the U.S. government cannot make progress on fiscal challenges, the impact will be more muted, but there is a risk of increased market fears of the economy faltering and the possibility of another downgrade of U.S. sovereign credit rating.

However, if Europe and the U.S. can show decisive leadership there is a huge upside potential for the economy and financial markets. Reduced consumer and business confidence is currently constraining economic growth. Nonfinancial corporations are currently sitting on record levels of cash (see chart 2). If these idle funds were put to work they could create investment and jobs. They would also fuel a strong rally in equities and lead to higher bond yields.

Neither of the extreme outcomes is the most likely. Europe is expected to muddle along with the constant feeling of a financial crisis motivating politicians to do what is necessary to avoid financial Armageddon. The U.S. political system will come up with some fiscal rebalancing, but not a grand deal that fully addresses the longer-term challenges. And, while economic growth has bounced back in the second half of 2011, it is likely to remain modest in the advanced world.

We also expect a further slowing of emerging market growth, reflecting the impact of past tightening of fiscal and monetary policy as well as soft demand growth for exports to the advanced world. Given this backdrop we expect only moderate growth in corporate profits, continued low interest rates, and a softening in commodity prices in the near term (see Commodity Prices to Pick Up Steam in 2012). But, as we said in the last issue, the name of the game in financial markets will be volatility, volatility, volatility.

 

About the Author

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.

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