The current market environment is such that investment-specific analysis is rendered, at least temporarily, redundant. The overarching driver of pretty much all asset prices on a day-to-day basis at present is the macroeconomic news flow and the prognostications of the major central banks, principally the US Federal Reserve and the European Central Bank. We then have the supranational bodies such as the International Monetary Fund and the European Commission to muddy the water still further.

In what has to be one of the least surprising outcomes of the year given previous acrimony, the US Congressional Super Committee has failed to agree on the mandated deficit reduction. This triggers an automatic reduction in key program spending such as Medicare and Defence. The threat this in theory poses is somewhat neutralised by timing; the cuts don’t come in until summer 2013 by which time a newly constituted Congress and a new/re-elected President will be in the White House and thus be in a position to override this with more legislation. The ongoing saga should ensure however that dealing with the budget deficit will be high up on the agenda when ‘real’ campaigning starts with a vengeance in 2012. President Obama’s idealistic dream of cross-party consensus in Congress has been well and truly shattered and the two major parties appear further apart than ever.

We have talked regularly in recent months about how quick some investors are to react to news, or even just rumours, and then stop to ask questions later. This increases the risk of an erroneous conclusion because so many feel under pressure to react quickest or, in a world of instant communication, to be the first with a comment. We can’t be the only ones who think it is worth reading something for more than ten seconds before making a judgment and this rush must increase the likelihood that the market’s initial reaction is incorrect.

After steady losses for several weeks, the first signs of life for markets came following an unexpected relaxing of monetary policy by the Chinese, something we previously flagged up as being likely in the wake of waning inflationary pressures. Hot on the heels of this, the world’s leading central banks recently announced that the cross-border cost of borrowing US Dollars (via swap lines) would be reduced in a pre-emptive action intended to prevent the global financial system seizing up as it did in 2008. The sharp market bounce in the wake of this announcement is perhaps more of an indictment of how pessimistic investors have become and/or how desperate they are to recoup losses before year end. However, this liquidity ‘backstop’ is no panacea for the world’s troubles and investors are perhaps letting hope override their better judgment.

In last month’s News and Views we tried to get across the important distinction between liquidity and solvency. The announcement with respect to swap lines goes some way to alleviating concerns on the liquidity front but it does nothing to tackle the fundamental solvency problems. All the major Euro nations are now facing a more challenging environment for refinancing maturing debt and/or issuing new debt by way of some combination of higher yields, shorter maturities or smaller issue sizes. The unprecedented failure of a recent German Bund auction should perhaps be seen as a warning that no Euro nation is safe from this silent contagion.

Is Germany really bullet-proof?

We believe that investors’ nervousness with respect to Bunds is well founded. Even if we ignore the fact that so many investors have retrenched from government bonds across the Eurozone to hold Bunds - a trend that can equally reverse - there are perhaps two key points to consider. Firstly, as the roll call of sick patients gets longer,Germanyis increasingly standing alone as the source of a solution and this is a big ask indeed. Secondly, Bund yields of close to 2% for a 10-year bond leave very little rational incentive to hold them whilst the downside if sentiment towardsGermanycrumbles is material.

The upshot of all of this is that the UK is starting to resemble the most plausible safe haven outside the US which itself is only a safe haven because the US Dollar is, and will remain for the foreseeable future, the world’s only true reserve currency. It is sobering to recall that not that long ago commentators were sounding the death knell of the US Dollar and people were flocking to the Euro as the new reserve currency; you are not supposed to worry about the world’s reserve currency disappearing!

The Coalition Government has outscored their rivals by acknowledging the problem and setting the UK on the long road to dealing with that problem through a combination of tax increases and public spending ‘cuts’ (overall spending is still rising in nominal terms). A result of this is that whilst there is a lot of pessimism around the country, something that the press seems keen to propagate, financial markets have given theUKthe benefit of the doubt. This means that whilst other sovereign nations are being dictated to by the investors who buy the debt they issue, the UK is in full control of its own agenda. Those who think that retrenching from this ‘reformist’ agenda is the best approach as it might boost economic data in the short-term would do well to consider the potential for the UK to become an investor’s pariah. Like it or not, when you are spending more than you earn, you rely on the goodwill of your creditors and thus you need to be mindful of their concerns even if you think them misplaced.

It is rare to find a popular government these days but it seems a little curious that a bit more ‘credit’ is not accruing to the Coalition for having steered us from the edge of the abyss around the spring 2010 election to a situation where the country’s cost of borrowing is dropping almost daily. Whilst the ostrich-like approach favoured by many others would undoubtedly be more ‘populist’, we firmly believe that the ultimate path would be far more damaging.

This takes us back to the solvency issue and the fact that too many governments have debts that are too high and still growing yet have no credible plan to deal with this. The day-to-day focus on whether governments can issue bonds and if so in what amount and at what cost is unsurprisingly hogging the short-term limelight but we must not lose sight of the need for cohesive, credible long-term plans to be put together. Equally, these not need be a ‘one size fits all’ kind of approach as the appropriate balance between tax rises and expenditure cuts is likely to depend on the overall prevailing tax burden.

A ‘Santa Claus’ rally?

Unless something occurs to derail the current positive mood (which may have disappeared by the time you read this), there is a relatively high likelihood of the traditional end-of year rally occurring.

2011 has been an exhausting year for most market participants and we are sure many investors feel similarly jaded and are looking forward to some festive cheer. News and Views will be back in February 2012 and before then we will have published our in-depth 2012 Global Investment Strategy Report. Please speak to your usual contact if you would like a copy.