Wall Street Journal
Markets may be getting their mojo back. Buoyed by central-bank action, better-than-expected global economic data and receding fears of an imminent disaster, investors are increasingly putting idle cash to work. European stocks are up 4.9% this year, and credit spreads are tightening.
Markets are pricing in a lot of bad news already. A euro-zone recession for 2012 is now the consensus view—but isn’t expected to cause recessions elsewhere. By December, European corporate-bond yields were anticipating default rates far in excess of the worst case seen in the past 40 years, even assuming zero recovery rates, according to Deutsche Bank. The Stoxx Europe 600 index is trading at 10.2 times next year’s earnings, well below the 13 times long-run average.
But markets may have initially underestimated the significance of the European Central Bank’s offer of three-year loans to banks. The first Long-Term Refinancing Operation in December injected €193 billion ($248.3 billion) of net new liquidity into the euro-zone financial system, enough to take care of short-term bank-funding needs, reducing the risk of a systemic crisis and easing pressure on banks to shrink their balance sheets and cut domestic lending.
Further relief is coming: Banks could borrow up to €400 billion more at a second LTRO in February, reckons Morgan Stanley. With the European Banking Association explicitly promising not to repeat last year’s stress-test exercise, which forced banks to mark sovereign bonds to market, banks could be more willing to use the new ECB money to buy government bonds, taking advantage of higher yields to rebuild their profitability.
Of course, the LTRO isn’t a magic bullet. Greece remains an ever-present risk: Failure to agree on its debt swap could still trigger a disorderly default. Portugal may need further assistance. Italy and Spain can’t count on banks to buy longer-dated bonds and may also need support; the euro zone still doesn’t have a fully credible firewall. Further sovereign downgrades are likely and could trigger second-order effects. Bank deleveraging and fiscal austerity will bear down on growth. Any signs that governments are failing to achieve structural reforms could damage confidence.
But these may be problems for another day, once the sugar rush of the LTRO has passed. In the meantime, fund managers can’t justify keeping their powder dry: Investors don’t pay fees to sit in cash. For the cautious investor, corporate bonds may offer the best way back into the market: Investment-grade yields are still three percentage points over government bonds. For the time being, equities may be best left to the true euro believers.