Market View - December 2011

As we head into the season of goodwill at the end of another volatile year in global markets, we cling to the hope of another traditional Santa rally (which this year would appear appropriately enough to have begun immediately after Thanksgiving Day on the 24th November!), to drag major stock market indices into positive territory for calendar 2011.

The shortfall to be made up in December is just over 7% for the MSCI World index, with a large discrepancy of individual market variations within this figure ranging from the S&P 500 in the US being less than 1% adrift, the FTSE 100 in the UK off 6.69%, to the FTSE EuroTop in Europe needing to make up 11.60% and the MSCI Emerging Markets index requiring almost 20% this month to break even! In contrast, while the risks of holding the Sovereign debt of several euro-zone countries has increased in 2011, and appears to have been perfectly correlated with each successive failed bailout attempt by European politicians, the yields on US Treasuries (down from almost 4% in January to less than 2% recently) and UK Gilts has continued to fall (resulting in price rises), despite the sovereign debt situation of both countries actually being worse on several measurements than that of the sick euro-zone countries!

The rational explanation for these anomalies lies in market perception, with the market prepared to overlook the US's sizeable budget deficit and future funding predicament (total current debt plus future unfunded liabilities are estimated at $75 trillion) on the premise that because the dollar is the reserve currency of the world, the Federal Reserve can print as much money as it wants to get out of trouble. In the UK's situation, the printing presses (or quantitative easing as policymakers like it to be known) are also being cranked up again, but since sterling is not a reserve currency like the dollar, the UK has only been able to persuade the markets to allow its bonds to continue trading at low interest rates by dint of the British government austerity programme, recently reiterated in the Chancellor's autumn statement.

Sceptics however might argue that the more likely explanation is simply that most investors have not yet realised the American and British Emperors are wearing no clothes, and that when markets finally recognise this, no amount of unlimited printing of fresh $ or £ will assuage ruthless bond markets in the absence of sustained economic growth to reverse the slump and prevent stagflation! Of immediate concern of course as has been the case throughout most of the past year, the euro-zone crisis remains the potential catalyst to widespread disaster in both developed and emerging markets.

The most crucial event during this month will be the euro-zone summit on the 8th and 9th December, at which the markets will hope German Chancellor Angela Merkel and French President Nicolas Sarkozy can confirm a so called "Grand Bargain" arrangement that will finally provide measurable reassurance that the euro in its current format can be saved. Proposals from Italian Prime Minister Mario Monti to reduce Italy's sovereign debt had provided encouragement to global markets that European leaders have at last recognised how late the hour is, and that remedial action is required without further delay!

As George Soros warned at the beginning of December "The world financial system is on the brink of collapse, with developed markets running full speed ahead toward disintegration. Although developing countries are battling a slew of problems themselves, such as corruption and tattered infrastructure, they will likely end up faring better than markets in the big, industrialized nations since developing countries are unscathed by the deflationary debt trap that the developed world is falling into. While the global financial system finds itself sliding down a slope of a self-reinforcing process of disintegration, investors must brace for the worst because the consequences could be quite disastrous. You have to do what you can to stop it developing in that direction"

The potential dangers to the world financial system also become apparent when reading a recent paper from the website of the Bank for International Settlements (often referred to as The Central Bank for Central Banks) titled "The macrofinancial implications of alternative configurations for access to central counterparties in OTC derivatives markets" which states that "The notional principal amount of outstanding OTC derivatives was estimated to be $600 trillion as at December 2010". Is it little wonder the sage of Omaha, Warren Buffet who is often referred to as the world's most successful investor thinks of these financial instruments as Weapons of Mass Destruction!

However before we get too gloomy ahead of our Christmas turkey, it is also worth remembering another famous adage, namely "It is always darkest before the dawn" and one of my favorite Buffettisms "Be fearful when others are greedy and greedy when others are fearful!" Doubtless 2012 regardless of what the markets throw at us will bring some interesting opportunities.

From all of us at Ash-Ridge Asset Management we'd like to take this opportunity to wish you and your loved ones a very merry Christmas!