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Global Markets: Once More Unto the Breach, Dear Risk

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Timed from the trough in equity markets, we are now one year out from the start of the recovery. The context of the story has gyrated from bailouts of banks to governments, but the overall story remains the ebb and flow of risk appetite. There is a feeling from the market that risk is being put back on as a sluggish start for tightening from the major central banks is now the status quo and Greek debt concerns are no longer a driver. Our focus this spring remains on signs that the handoff from official support of the economy to the private sector - which is taking place right now - goes off smoothly. The near-term signs are positive for the market and our worries on the fiscal front remain centred on the implications for years down the road.

From March through October of last year, we were able to enjoy upward revisions to economic growth expectations while keeping central bank rate expectations at bay - a win/win situation for reflating risky assets like equities. We can see one of the results - an inverted relationship between data surprises and the USD - in the chart on the cover. Stronger data surprises in the U.S. relative to others in the world were associated with USD depreciation as the flight to safety was unwound and asset reflation ensued.

Then in October came the thunder from down under, as the RBA scared everyone into realizing that enough slack had been taken up that exit strategies were not only considered but actually executed. Monetary exit strategies brought attention back onto fiscal positions and the surprise/USD relationship switched. The surprises tended to be weaker in the U.S. relative to some other markets. And, from this point forward, relatively stronger currencies went with relatively stronger national data.

The interesting divergence since the end of February of this year may support some other signs - such as renewed life in carry trades - that risk is being put back on. The momentum behind the national surprise indicators also suggests a bit more strength outside of the U.S. over the next month. This would strengthen the sign of another flip in the correlation and/or possibly push currency swings to keep up and support taking on risk.

This can be supported by more clarity over major central bank plans. The BoJ will almost definitely be easing further. The BoE is still worried about an uneven recovery and hasn't yet taken the QE tool off the table. The ECB is moving quickly to remove liquidity support by year-end, but this has still moved back rate hike expectations. And the Fed rate expectations seem to be moving out more and more in line with our long held view of no rate hikes in 2010. It is only the smaller, commodity driven economies - Norway, Australia, and now Canada - that have been and/or will soon begin raising rates. With fiscal policy now a spent force for countercyclical demand management, there is a lot of pressure on monetary policy to get it right.

This recent divergence in data patterns also coincides with the apparent resolution of Greek financing issues. The market is likely to remain patchy in spots over the coming year and highlight that confidence is the razor's edge between status quo and cash flow woe. The reported European agreement to use debt guarantees in order to entice private market appetite did lead to strong bids for EUR5bn in Greek debt. But Greek debt management needs confidence more than it needs a bailout, and an implicit guarantee that is thrice-denied every other day is likely to leave sentiment choppy. The near-term looks much better for Greece than it did in February, but if the rumoured support from other E.U. members will only be forthcoming in the wake of an actual market shortfall in auction demand, there will have to be a step back before we can move forward.

National issues, such as elections that must be called before June in the U.K., could leave crosses such as the GBP choppy for now. But admittedly, much of the above swings in the USD crosses have much more to do with U.S. data than they do data strength elsewhere. So the transition in the U.S. economy from official support to private sector demand is crucial to sustaining any global rally.

On this account, the early signs are very promising. The chart here on U.S. stimulus and jobs helps to tell the tale (though clearly some explanation is in order). The orange line accumulates our estimate of the impact of the major impulses that have worked through the U.S. economy over the last two years: the freeze in housing and dislocations in credit markets; the spike, collapse, and recovery in oil prices; the lift to GDP from fiscal stimulus that should last through the first half of 2010; and the actual easing from the Fed. These serve as stylized facts and suggest that all told, they were responsible for subtracting nearly 5 percentage points from the annualized quarterly growth rate of U.S. GDP in the first quarter of 2009. At that point, the impulse sign reversed, and we have had a push from the net impulse, but one which fades after 2010Q2.

This does not mean the economy will contract. But, merely any net positive impact from past shocks and responses will be gone and GDP growth will rise or fall based on its own merits. There are still risks for a choppy transition as measures such as the home purchase credit are scaled back starting in April.

At the same time, there is evidence of growing supports for the economy. By overlaying a model for U.S. payrolls, we are reminded that the first quarter of 2009 also coincided with the worst of the U.S. job losses. The value from this model is it includes the lagged impact of credit tightness, and the improvement seen in reported commercial and industrial lending tightness since early in 2009 is poised to feed through into job creation. So, even if all of the economic data were to come in unchanged from their current levels through year-end, we should still see quarterly job growth in the U.S. for the rest of 2010. The onus on the data is now to take away from job growth momentum, rather than add to it.

Nonetheless, the forecasted strength in hiring we foresee is weak compared to the downturn, but we should not underestimate the positive effect a few consecutive positive prints on U.S. payrolls will have in bolstering investor confidence in their ability to sustain risk. There is still a tactical risk to be managed in the overall investor strategy. Yield curves remain steeply sloped throughout advanced markets and must flatten at some point. However, without sufficient upward momentum in rates, the negative carry involved in making a flattening play can wipe out any returns. Investors need to carefully assess timing therefore, and also prepare themselves for the likely shake-out in market positioning when we finally do get that first big positive U.S. payrolls report.

Yesterday's financial crisis has the potential to be tomorrow's fiscal crisis. But we should differentiate between the three degrees of fiscal concern. Liquidity issues can be overcome with financing as long as there is market demand or a lender of last resort. Solvency can be masked behind a near-term liquidity squeeze and connotes that even with financing and adjustment, debt repayments will continue to rise beyond the capacity of the borrower to ever meet their obligations. These are the existential worries.

Less dire but with longer-term implications is the drag on potential economic growth rates and loss of competitiveness from high government debt levels. This has a tendency to increase interest rates and borrowing costs and depress the discounted cash flows of firms, crowd out private investment as it competes with government issuance, and restrain other government spending as more and more of the budget is committed to interest payments. It could also mute the pace of central bank tightening in countries that tackle their deficit particularly aggressively. But those that fall into the “net drag” camp need not have a near-death experience, as current net debt levels in Japan (105% of GDP) and Italy (113% of GDP) demonstrate. But this is the less exciting and more intransigent issue advanced economies are dealing with.

However, we risk mistaking symptoms for disease in diagnosing the larger global concerns that should be front and center among investors. High government spending for 2010 remains a given at this point. It will come down in 2011 as stimulus comes off the books and governments look to cut costs here and there.

But the revenue side of government ledgers remains captive to improvements in the underlying economy. The U.S. Federal government will take in $810bn less in total receipts in 2009 and 2010 using CBO forecasts than it brought in during 2007 and 2008. Those same CBO forecasts assume a $350bn decrease in the deficit in each of the next two years fuelled by a $400bn increase in tax receipts in each of those years. If the economy does not grow as quickly as forecast, the government revenue shortfall will predominantly be shifted to new borrowing requirements rather than spending cuts.

The same cold, hard fact can be laid at the feet of Greece, the U.K., and every other market now under the fiscal microscope. Advanced markets can't grow their way out of the long-run drag high debt levels will exert. They can, however, grow their way out of the existential liquidity and solvency concerns still bubbling to the surface. Investors would be wise to focus on the incoming data and prospects for economic growth rather than obsessing on the aggregate borrowing requirements for 2010 when gauging the tolerance for more risk seeking going forward.

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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