Perspectives - February 2012

As a result, one of the major risks pinpointed for 2012, the danger of accelerated downsizing and deleveraging of eurozone bank balance sheets, has been dispelled. Nevertheless, there is a key difference from the Fed's quantitative easing, which has involved buying assets on the open market, directly pumping in liquidity to underpin the pricing of financial assets. Market operators are faced with a considerable unknown: what use will eurozone banks make of all this liquidity? They have a number of options: they could replenish already existing lines of financing, buy short-term sovereign debt or even grant new loans if solvent borrowers apply for credit. In other words, although a rough estimate of the likely impact of the Fed's quantitative easing on the S&P 500 could reasonably be made, we have little idea of the likely extent of the indirect effects of the ECB's quantitative easing. It has clearly had a positive impact as suggested by declining premiums for banking risks priced into spreads (see the chart on page 2). The key question is whether, beyond this one-off impact, the fresh liquidity will feed eventually through to have genuine benefits for the real economy. If that does happen, we would expect to see share prices rise, all other things being equal, by an extra 10% to 15%.

In any event, the ECB's liquidity injection does give eurozone governments a welcome breathing-space to press ahead with redressing peripheral eurozone countries' finances and introduce mechanisms to prevent the crisis spreading and culminating in a cascade of chaos-creating defaults. The credit crunch risk has been temporarily shelved, but the issues of insolvency remain, as the woes of Portugal's sovereign debt show. The eurozone has so far only reached one of a succession of crossroads in the crisis; it has not yet successfully negotiated the decisive turning-point.

If systemic risk can be kept subdued for the immediate future, which would help to push volatility back comfortably into its average zone between 15% and 25% on the VIX Index, two key factors should be watched over the coming weeks. The first will be the outcome to talks over the restructuring of Greek debt where, to be blunt, we are struggling to comprehend why the ECB is digging its heels in about its holdings of Greek bonds on which the loss would work out at roughly an estimated 20 billion euro. The whole process could still escalate out of control. The implications are hard to quantify, but they would undoubtedly be nasty and painful. Second, as liquidity issues appear to have been tackled, it will not be long before the markets refocus on matters of insolvency, turning the spotlight back to growth prospects for over-indebted countries. Economic statistics for the eurozone overall, but particularly those member states on the periphery, are going to be crucial: remember, the dramatic slide on Italy's sovereign debt in early July last year was triggered by the leading economic indicator for Italy going into freefall.