BlackRock favors U.S. growth stocks and quality U.S. bonds. GMO recommends cash rather than other forms of “tail-risk” protection. In Russell survey, bullish sentiment for U.S. large cap growth stocks dropped but still a majority view. Barclays expects that central banks will ignore recommendation by Bank of International Settlements to act against inflation.

Bob Doll and Peter Fisher, BlackRock

Asset Allocation Overview

With the soft patch of weaker US economic growth, increased risks in Europe, negative aftermath of

the Japan earthquake and conclusion of the Federal Reserve’s QE2 bond buying program, volatility in equity and fixed income markets will be elevated in the near term. At present, markets are currently  demonstrating uncertainty and risk-averse sentiment, and we would urge continued caution. However, as the third quarter progresses, we believe market risks should recede and buying opportunities should accelerate, allowing investors to consider a shift back toward risk assets.


Investment Themes


Equity market weakness presents buying opportunities: Equities continue to be fundamentally strong, with profits and cash flow driving growth. We continue to believe the cyclical recovery  continues and that price weakness presents a buying opportunity. 


Remain cautious in fixed income: With softening economic data and the conclusion of QE2, we believe volatility and illiquidity will remain high but rates will remain low or drift marginally higher.  Investors should increase quality within each sector allocation, and reduce interest rate risk.


Municipal bonds market seeing positive supply/demand dynamics: While the fundamental credit backdrop for states and cities is showing some improvement, the best value remains in  certain revenue sectors like healthcare, transportation and education.


Equity Market Outlook

As the second quarter draws to a close, markets are in a period of uncertainty. Stocks have been drifting sideways or lower for the last couple of months in the face of weaker economic data and ongoing concerns over the European sovereign debt crisis, policy tightening in China and the ending of the QE2 program in the United States.


Despite the recent weak market performance, however, the reality is that the world remains in a global cyclical recovery mode (albeit a subpar one). The fact that markets have not been focusing on the positives of the recovery is, in many ways, due to investor psychology. After the worst financial crisis of a generation and a tepid economic recovery, it should not be surprising that investor sentiment levels are depressed and that investors remain quite risk averse. In the current environment, investors have been reacting quickly and negatively to any bad news and have been shrugging off positive news.  We believe that stock valuations will soon settle at a point at which investors will decide that the risks inherent in equities are worth taking. The combination of still-strong corporate earnings and a downturn in equity prices has made stocks more attractive. To us, this scenario represents a potential buying opportunity, particularly for those who share our view that the economy should see a reacceleration in the months ahead. We would caution that volatility levels will likely remain elevated and that additional corrective or sideways action could persist, but we also believe this could be an appropriate time for investors to take on more risk in their portfolios.


Equity Views


As has been the case for some time, we continue to believe that US stocks are more attractive than their developed market counterparts. Regarding styles, we are beginning to favor growth over value given the ongoing relative weakness of economic growth.


From a sector perspective, healthcare remains our favorite area of the market. We are also upgrading our forecast on technology given better growth prospects in the coming months.  We remain cautious on utilities and still list the financials sector as our least favorite.


Taxable Fixed Income Market Outlook

In the current economic environment of moderate economic growth and less liquidity after the conclusion of QE2, volatility will be elevated. But with the structural headwinds of unemployment, depressed housing and a dynamic of increased demand/moderate supply of fixed income keeping a cap on rates, we expect that yields could drift slowly higher by year-end. In this environment, Treasuries may, in fact, become a safe haven for investors in a flight-to-quality trade.  In the near term, the market environment after the end of QE2 remains an unknown given the multiple significant global monetary crosscurrents, including the removal of massive Fed liquidity, the flood of liquidity from Japan, austerity measures in Europe and tightening policy in emerging markets. This environment calls for a cautious approach and an increase in quality within each sector allocation. At the same time, these dynamics are causing some market aberrations across sectors, which may provide opportunity for carefully researched and selected investments.  Beyond this expected period of short-term volatility, however, we believe investors will need to focus on income and yield in the medium to long term. We believe there are attractive opportunities in high  yield corporates, commercial mortgage-backed securities (CMBS) and parts of the asset-backed market. The investment-grade credit sector, in contrast, has seen considerable appreciation and we believe holds less opportunity for returns. We continue to recommend a focus on risk management and careful selection of securities. 


Taxable Fixed Income Views

The more volatile environment following the conclusion of QE2 calls for a tactical near-term increase in quality as a defensive step.


As long as the yield curve remains steep, we believe holding shorter duration higher-yielding assets is  the best way to generate long-term returns in an environment of only modest inflation and high levels of  rate volatility.  


Municipal Market Outlook

As the year progresses, the dire default predictions made late in 2010 appear increasingly less likely to come to fruition. In fact, favorable news has prevailed recently, with states reporting positive revenue growth for five consecutive quarters, and the second quarter seemingly on pace to continue the trend. After a difficult first quarter, the tax-exempt market performed well through the second quarter as new issuance remained low and total supply appears likely to remain scarce for the remainder of the year. The market should also benefit from the wave of cash expected from maturing bonds during the summer rollover season. In June and July alone, that amounts to $78 billion in cash that will need to be reinvested during a period of limited supply.


Municipal Market Views


We favor a barbell approach to yield curve positioning, with exposure to short and long maturities and continue to favor state tax-backed and essential service bonds, particularly the Southwest,  Plains and Southeast regions. We like dedicated-tax bonds and housing bonds backed by state agencies as well as certain revenue sectors like healthcare, transportation and education.


Our least favorite sectors include land-secured bonds, senior living bonds, tobacco bonds,

student loans and local tax-backed issue. 


James Montier, GMO


A Value Investor’s Perspective on Tail Risk Protection:

An Ode to the Joy of Cash


Long ago, Keynes argued that the “central principle of investment is to go contrary to general opinion, on the grounds  that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.” This powerful statement of the need for contrarianism is frequently ignored, with disturbing alacrity, by many investors.  The latest example in the long line of such behavior may well be the general enthusiasm for so-called tail risk protection. The range of tail risk protection products seems to be exploding. Investment banks are offering “solutions”  (investment bank speak for high-fee products) to investors and fund management companies are launching “black swan” funds. There can be little doubt that tail risk protection is certainly an investment topic du jour.  I can’t help but wonder if much of the desire for tail risk protection stems from greed rather than fear. By which I mean that it seems one of the common reasons for wanting tail risk protection is to allow investors to continue to  “harvest risk premium” even when those risk premiums are too narrow. This flies in the face of sensible investing. A  safer and less costly (in terms of price, although perhaps not in terms of career risk) approach is simply to step away  from markets when risk premiums become narrow, and wait until they widen before returning.  The very popularity of the tail risk protection alone should spell caution to investors. Keynes’s edict with which we opened would suggest that the degree of popularity of tail risk protection helps to undermine its benefits. Effectively, you should seek to buy insurance when nobody wants it, rather than when everyone is excited about the idea. An alternative way of phrasing this is to say that insurance (and that is exactly what tail risk protection is) is as much of a value proposition as any other element of investing.


As always, a comparison between price and value is required. One of the nice aspects of insurance in an investment sense is that it is generally cheap when its value is highest (although this may no longer be the case given the rise of so many tail risk products). That is to say, because most market participants appear to price everything based on extrapolation, they ignore the influence of the cycle. Thus they demand little payment for insurance during the good times because they never see those times ending. Conversely, during the bad times, the average participants seem willing to overpay for insurance as they think the bad times will never cease.


The “What” of Tail Risk

It should be noted that tail risk protection is a very vague, if not actually a poorly defined, term. In order for tail risk protection to make any sense at all, it is vital to define the tail you are seeking to protect against. There is a plethora of potential tail risks one might seek insurance against, but which one (or ones) do you have in mind? As one of my logic teachers reminded us almost weekly and Voltaire advised, “Define your terms.”  We suspect that at the most general level, the tail risk the majority of investors are concerned about is a systemic illiquidity risk/drawdown risk (as was experienced during the 2008 crisis). Of course, this ignores another of Keynes’s insights. “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” But, for the time being, let us assume that systemic illiquidity problems are the tail risk that most investors are seeking to offset. 


The “How” of Tail Risk Protection


We are aware of three general groups of tail risk protection from which investors may choose.

1. Cash

This is perhaps the oldest, easiest, and most underrated source of tail risk protection. If one is worried about systemic

Illiquidity events or drawdown risks, then what better way to help than keeping some dry powder in the form of cash  – the most liquid of all assets. (There is much more on the joy of cash to come shortly.)


2. Options/contingent claims

Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases. A  prime example was the credit default swaps that were a result of the demand for collateralized debt obligations.  These instruments were priced on the assumption that there would be no nation-wide decline in house prices, and thus offered a great opportunity (even without the benefit of hindsight) for those who were concerned that such an outcome was more plausible than the market thought.  Here, one caveat stands out above all others: one must be cautious of the dangers of over-engineering in this area of tail risk protection. It is too easy to construct an option that pays out under a very specific set of circumstances, and to do so relatively cheaply. But, of course, such an instrument tautologically only pays off under the realization of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk  protection.


3. Strategies that are negatively correlated with tail risk

For the specific type of tail risk (illiquidity events) under consideration here, long volatility strategies are often said to be negatively correlated. The simplest example of such a strategy is just to buy volatility contracts (bearing in mind  the roll return will be negative given the upward-sloping term structure of volatility). In the recent crisis, a dollarneutral long quality/short junk portfolio acted very much like a long volatility strategy (with the added benefit of an expected positive return, in contrast to most insurance options).    However, if investors are concerned with other tail risks, say, such as inflation, then it is less obvious that these  strategies are appropriate. This is one of the failings with many products being marketed as tail risk protection; they  are long volatility strategies rather than “general” tail risk protection portfolios.  But, sticking with our tail risk defined as an illiquidity event, Exhibits 2 and 3 show the performance of several possible strategies. Strategy 1 is a simple long S&P 500 position. This represents a benchmark for comparison and, as the global financial crisis revealed, is not a bad proxy for more complex portfolios. Strategy 2 seeks to emulate those portfolios I referred to earlier as being driven by greed. This strategy maintains a 100% investment in the S&P  500 and adds a 10% long volatility position (using short-term VIX futures as above), financed by shorting cash.  Strategy 3, a 75% S&P 500/25% cash portfolio, represents an alternative to the greedy approach, which is to run a more conservative portfolio. The final strategy represents an answer to the question: how much tail risk protection would one have needed to have had a flat performance in 2008 and early 2009? The answer is: a 70% S&P 500/30% long volatility strategy.


One thing becomes obvious from this illustrative example: tail risk protection is not a magic bullet. The cost of tail risk insurance becomes very evident when compared to the more conservative equities plus cash strategy considered in the sample above. This highlights one of the most important lessons of the exercise: tail risk protection requires timing … the “when” of tail risk protection, if you will. In the sample above, running permanent tail risk insurance similar to that of Strategy 4 leads to what might be called deferred drawdowns, made clear in Exhibit 3.  Also of note is the limited impact of tail risk protection in the “greedy” strategy, run with 100% exposure to the equity market and borrowed cash to buy tail risk protection. The tail risk protection doesn’t really protect the portfolio from a drawdown, but has a significant impact on returns. Whether one can tell the difference between a drawdown of 55% or 48% is arguable. However, the return drag from buying overpriced volatility (VIX futures) in the aftermath of the crisis is marked, reducing the return from 3.4% to 1.6%.  This cautions against one of the prevailing attitudes with respect to tail risk protection, which seems to go along the lines of investors dedicating X% of their assets (where X is less than double digits) and thinking they are protected against bad outcomes. As Strategy 4 shows, substantial levels of tail risk protection are actually needed in the portfolio in order to have any meaningful impact, but this creates its own issues as the example amply demonstrates.


One Step Beyond

So the question now becomes how we should think about the timing of tail risk protection, putting aside the manner of implementation for the time being. This is where the value discipline comes into its own.  Value investing is the only risk-averse way of investing that I know of. It comes with a ready-made framework for assessing (tail) risk: it demands that we focus upon the risk of the permanent impairment of capital. Furthermore, we can identify three possible paths that could result in this undesirable endpoint. I have written of these many times before, but they bear repeating.    1. Valuation risk  This is the risk that is involved in buying overvalued assets. Adopting a valuation-driven approach to asset selection helps mitigate this risk. As implied future returns drop (i.e., the market becomes more expensive), a value investor sells those overpriced assets, thus raising cash. Hence, this approach explicitly takes account of valuation vulnerabilities and the “tail risk” resulting from them.  The idea behind Exhibit 4 came from my friend; John Hussman.1 It neatly illustrates the dangers inherent in running valuation risk. The horizontal axis plots the level of real return forecast,2 the vertical axis shows the subsequent  deepest drawdown from the point of that forecast over the next three years.  The exhibit clearly illustrates the risk-averse nature of value investing. The worst of the market’s drawdowns occur  when forecast returns are below 5% real, and this risk grows as the forecast return drops to zero and below. Indeed,  at forecasts of zero and below, investors run the risk of seeing their investment halve over the next three years! (N.B.  GMO’s current S&P 500 forecast is 0% annually.)


Summary Statistics

Conversely, when the forecast return is 10% or higher, the risk of deep drawdown over the subsequent three years is  relatively muted, limited as it is to around 20%. Thus, as valuations become more and more attractive, the downside  becomes less and less – the margin of safety at work.  Given the link between low forecast returns and subsequent drawdowns, the dry-powder value of cash should be  obvious. Holding cash allows one to invest when the opportunity set looks much better (i.e., after the drawdown). As  Seth Klarman3 notes, “Why should the immediate opportunity set be the only one considered, when tomorrow’s may  well be considerably more fertile than today’s?” 


One oft-cited argument currently is that with the return on cash at close to zero, one should stay in overvalued assets.  This is, of course, exactly what the Fed would like you to do. Bernanke, et al., have made no secret of the fact that  they have encouraged speculation on a massive scale. However, in our view it is better to hold cash and deal with the  limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent  impairment of capital. As Warren Buffett has said, holding cash is uncomfortable, but not as uncomfortable as doing  something stupid.


2. Fundamental risk

This is the “danger of a loss of quality and earnings power through economic changes or deterioration in management” as Ben Graham put it. Essentially, fundamental risk represents write-downs to intrinsic value (i.e., the risk of a value  trap).  Thinking about fundamental risk allows us to help define the tails we may be worried about, beyond those covered by  valuation risk. What are the risks to intrinsic value (or, indeed, our estimates thereof) and how can we seek to protect  ourselves against these outcomes, and at what cost?  For instance, if we are worried about inflation or, indeed, deflation (or are even unsure of which of the two we face),  then thinking about how this impacts fundamental value is a useful exercise. As is incorporating protection against  the event (or our uncertainty) into the portfolios (as long as it can be done cheaply, of course).  As an aside, on inflation and deflation and protecting portfolios, cash once again has benefits. In order to generate  optimal portfolios we would need a perfect macroeconomic crystal ball. That is to say, if we knew for certain that  deflation was in the future, then bonds would make sense. Conversely, if we knew that inflation was a sure thing, then  cash would make sense.  But optimal solutions often aren’t robust. They work under one scenario, which can only be known ex post. When  constructing portfolios ex ante, the aim should be robustness, not optimality. Cash is a more robust asset than bonds,  inasmuch as it responds better under a wider range of outcomes. Cash also has the pleasant feature that, when starting  from a position of disequilibrium (i.e., a level away from fair value), it doesn’t impair your capital as it travels down  the road of mean reversion to fair value (unlike most other assets).    Because of its zero duration, cash fares better than bonds in an inflationary environment. (This assumes that central banks seek to raise cash rates in response to inflation – an assumption, admittedly, that may be less valid at the current juncture than ever before.)  Cash is also a pretty good deflation hedge. Obviously, as prices fall, cash gains in real terms. Of course, all else being  equal, bonds with a higher duration do better. Take the Japanese example shown in Exhibit 7. Cash does well in the  initial stages of the bubble bursting (as per the valuation risk analysis above). In 1995, Japan’s CPI enters deflation  (albeit mild) and remains flat for the next decade and a half, give or take. Cash maintains purchasing power in real  terms. Of course, bonds do better than cash over this period, but to know that ex ante would require perfect foresight  regarding the path of Japanese inflation – something beyond our ken.  Thinking about fundamental risk also reduces the “black swan” element of investing. Nassim Taleb4 defines a black  swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive  impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than  it was. 


It should be noted that some black swans are a matter of perspective. Taleb asks us to think of turkeys in the run-up  to Thanksgiving. From the turkeys’ perspective, each day a kindly human arrives and treats them to fresh water and  feed. Then, suddenly, a few days before Thanksgiving, the very same human massacres all of the turkeys. Clearly,  from the turkeys’ point of view, this was a complete black swan event. But from the farmer’s perspective, this was  anything but a black swan.  Rather than genuine black swans, most financial implosions are the result of “predictable surprises” (a term coined  by Michael Watkins and Max Bazerman5). Like black swans, predictable surprises have three characteristics: 1) at  least some people are aware of the problem; 2) the problem gets worse over time; and 3) eventually the problem  explodes into a crisis, much to the shock of most. As Bazerman says, “The nature of predictable surprises is that while  uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.”


This  speaks to the requirement of patience when it comes to dealing with bubbles.  So, in essence, fundamental risk appraisal helps us identify which tail risks we should be worried about, provides  context for the decisions that we have to take, and allows for the construction of more robust portfolios.


3.. Financial risk

This risk covers such elements as leverage and endogenous factors (e.g., crowded trades). Forsaking the use of  leverage obviously removes a large part of the problem, as does having a contrarian bent because this greatly reduces  the risk of over-crowded trades. However, in a world of mark to market, one still needs to be cognizant that the  behavior of other market participants can impact one’s portfolio.  Thus, the multifaceted approach to risk that is embodied within the value approach seems to naturally minimize  some elements of tail risk (those associated with valuation risk), and leads to a focus on other aspects of tail risk  (fundamental risk and financing risk).



Tail risk protection appears to be one of many investment fads du jour. All too often those seeking tail risk protection  appear to be motivated by the fear of missing out (not fear at all, but greed). However, the surge of tail risk products  may well not be the hoped-for panacea. Indeed, they may even contain the seeds of their own destruction (something  we often encounter in finance – witness portfolio insurance, etc). If the price of tail risk insurance is driven up too  high, it simply won’t benefit its purchasers.  When considering tail risk protection, investors must start by defining the tail risk they are seeking to protect  themselves against. This sounds obvious, but often seems to get scant attention in the tail risk discussion. Once you  have identified the risk, you can start to think about how you would like to protect yourself against that risk. In many situations, cash is a severely underappreciated tail risk hedge. The hardest element of tail risk protection is likely to be timing. It is clear that a permanent allocation is likely to do more harm than good in many situations. When it comes to timing tail risk protection, a long-term value-based approach and an emphasis on absolute standards  of value, coupled with a broad mandate (a wide opportunity set, or, investment flexibility, if you prefer) seems to offer  the best hope.   


Russell survey: Most managers unconcerned about end of QE2 but optimism tempered for U.S. equities and bonds

Three quarters (75 percent) of investment managers surveyed in the latest Investment Manager Outlook <>  (IMO), a quarterly survey conducted by Russell Investments <> , say that they are not concerned about the scheduled conclusion of the U.S. Federal Reserve’s second round of quantitative easing (QE2).

More than half of the survey respondents (54 percent) indicated that they believe the end of QE2 will have no impact because the financial markets have already priced in this event, and 21 percent said there will be no negative effects because the economic recovery in the U.S. is self-sustaining.

Despite this apparent confidence around the end of QE2, manager optimism regarding U.S. equities and bonds fell across the board in the latest IMO survey, trending toward survey average levels. Bullish sentiment for U.S. large cap growth stocks dropped from 70 percent in March 2011 to 60 percent in June, and managers remained bearish regarding U.S. corporate bonds (eight percentage point increase in bearishness since March to 57 percent) and U.S. Treasuries (two percentage point increase in bearishness since March to 82 percent).

After a 20 percentage point tumble in bullish sentiment in the March survey, bullishness for emerging market equities increased in the latest survey, up eight percentage points from March to 59 percent. Bullishness for non-U.S. (developed market) equities also rose four percentage points from March to 53 percent.

“Managers may not be citing concern about the end of QE2 specifically, but they certainly appear uneasy about the U.S. economic environment overall, and they are showing caution and moving toward a more defensive investment posture,” said Rachel Carroll, client portfolio manager at Russell Investments. “Recent U.S. economic data, including the unexpected increase in unemployment numbers, challenged previously held growth-rate expectations, and this quarter’s growth in optimism for non-U.S. and emerging market equities is an indicator of increased nervousness related to the path of the U.S. economic recovery.”

With respect to concern about QE2’s conclusion, 19 percent of the managers surveyed say they believe the economy is still weak and the end of QE2 will be harmful to capital spending and employment. Fifteen (15) percent believe the end of QE2 will require the Fed to raise the federal funds rate before the end of 2011 to keep inflation in check and 10 percent believe the end of QE2 will derail the economic recovery.

Additional findings from the latest Investment Manager Outlook include:
Managers continue to see markets as fairly valued
In the latest survey, the majority of managers (61 percent) see the U.S. equity market as fairly valued, representing a drop of 11 percentage points from the all-time survey high in March at 72 percent. Currently, 26 percent of respondents believe the market is undervalued and 13 percent believe the market is overvalued.
Manager nervousness regarding overall strength of the economy appears to have affected sentiment across several industries
Bullishness for the “safe haven” consumer staples sector rose eight percentage points since last quarter to 40 percent in the latest survey.

The financial services sector also saw a 10 percentage point increase in bearishness and according to Carroll, “If investors are worried that the economy is slowing, then financials may seem too risky. The ongoing uncertainty regarding loan losses and the changing regulatory environment for financial companies is likely weighing on this outlook. Additionally, the April earnings season was not particularly strong for many financial companies, which could have had a negative impact on bullish sentiment.”

Bullishness for the energy sector dropped 14 percentage points from March to June, against a backdrop of falling oil prices and nervousness about a potential economic pullback. Of note, the energy sector of the Russell 1000 Index® had the strongest one-year returns of any sector through May 2011, but has been one of the worst performers recently, down approximately 10.5 percent since the end of April 2011.  

“Managers’ bullishness for the energy sector seems to be dwindling after seeing strong gains through the first quarter of the year,” said Carroll. “Though this has been an area of strength in the market, and we believe that there are many growth drivers going forward, it is also an area of uncertainty. Managers may be moving away from energy and toward traditionally defensive sectors such as consumer staples and utilities in anticipation of a potential economic pullback.”

The technology sector saw a nine percentage point drop in bullishness quarter-over-quarter, and a four percentage point drop year-over-year. That said, this sector continues to lead all sectors – for the tenth survey in a row – in terms of bullishness, with 65 percent of managers expressing bullish sentiment.

Simon Hayes, Barclays Capital


The inflationary bias remains

This week, the Bank for International Settlements (BIS) highlighted a collective action problem among central banks. The BIS argued that monetary authorities were collectively underestimating global inflationary pressures and that a tighter global monetary stance was  needed to keep inflation under control. However, in our view, this attempt to achieve greater  coordination of global monetary policy is likely to prove ineffective and the inflationary bias  in the global monetary system is likely to persist. Building evidence of slowing global activity  – as seen in the June PMIs, for example – is likely to temper central banks’ enthusiasm for  tackling inflation, in our view.  The BIS argued that central banks were too narrowly focused on domestic wages as an  inflation gauge and too ready to ascribe commodity price rises to one-off external shocks.


According to the BIS, insufficient account was being taken of tight global supply chains,  with little spare capacity in emerging markets and the risk that output gaps in developed  economies were smaller than supposed. Moreover, the BIS was concerned that advanced  economy central banks may have under-appreciated the extent to which their loose policies  were encouraging capital flows to emerging markets, which, in turn, made the latter  reluctant to tighten monetary policy at an appropriate pace.


The BIS’s conclusion finds some support in our own analysis: on conventional measures, monetary settings appear generally inadequate to contain inflation. However, we expect the BIS’s warning to go largely unheeded. UK MPC member Adam Posen described the prescription as “nonsense”, and although other central bankers may use less direct  language, we continue to believe that many will act with a bias towards nurturing growth,  bringing attendant upside risks to inflation.


The UK, with its notable mix of ultra-loose policy and persistently high inflation, was singled  out by the BIS as being in particular need of monetary tightening. However, this week, we  have pushed out our forecast for the first Bank Rate increase to May 2012, from November  2011 previously. This follows a downward revision to our GDP forecast, which, in turn, reflects evidence of a renewed downturn in consumption (Figure 2). High inflation may  provide an obstacle to further policy loosening – we do not expect further QE in the UK –  but if our growth forecast is correct ,the MPC is likely to be in little rush to tighten.  A similar assessment applies to the US. Again, recent consumption indicators have been  soft: personal spending fell slightly in May following a similar drop in April, and the  Conference Board’s index of consumer confidence continued its recent downward drift. Our  tracking estimate of Q2 real consumption growth now stands at just 1%. Although we  expect an improvement in Q3 – and that this, together with firming core inflation, will likely  lead the Fed to resist a move to further quantitative easing – the prospects for policy  tightening remain distant.


One central bank that appears sympathetic to the BIS’s advice is the ECB. Euro area inflation  was stable in June, according to the flash estimate, but at 2.7% remained well above the  ECB’s target zone. Both ECB President Trichet and Executive Board member Stark this week  reiterated the central bank’s “vigilance” against inflation, supporting our expectation that  the refi rate will be increased by 25bp to 1.5% at next week’s policy meeting. We expect this  move to be the last under Mr Trichet, who steps down at the end of October, although we  still forecast another rate increase in December. However, if this week’s evidence of slowing  household demand – both Germany and France saw unexpected drops in consumption in  May – proves persistent, and if the recent declines in the PMI new orders indices translate  into weaker IP and exports, this may give the ECB pause for thought. Moreover,  nervousness over the strength of demand in core Europe seems likely to moderate the pace  of monetary tightening in EMEA, notwithstanding recent upside inflation news.  The drop in the oil price that was prompted by the International Energy Agency’s (IEA’s)  announcement that it would release oil from its strategic petroleum reserves (SPR) has been  largely maintained, which could be interpreted as a sign of waning global inflationary  pressures. However, although the IEA action should reduce the oil price in the near term, it  is by its nature a reallocation of supply through time, not a permanent increase. Thus, unless there is a material slowing in global demand, when the IEA halts its reserve releases  oil prices should return to their previous level (and may temporarily overshoot it if the SPR is  re-built). Moreover, we have some concern that the IEA announcement is a symptom of  deepening tensions between oil consumers and oil producers that could result in even  higher oil prices in the future. Notwithstanding the recent softening in global activity,  therefore, we remain mindful of upside risks to global inflation.


Greek deal buys time but a more lasting solution is needed  The Greek parliament’s passing of the government’s medium-term fiscal plan has removed  a major source of near-term uncertainty for policymakers and financial markets. Time has  been bought, but how much is unclear and the value of this purchase will depend on how  much progress can be made towards developing a lasting solution to the euro periphery  sovereign debt problem. A favourable momentum appears to be building around private  sector involvement (PSI) in the Greek rescue package, and we expect PSI to form a major  part of the Eurogroup discussion scheduled for Saturday, even if it is probably too early to  finalise terms on its form and size. However, although such measures may help in the short  run we continue to view the Greek problem as one of solvency rather than liquidity, and  without a substantial NPV write-down we find it hard to see a lasting solution. The wider  ramifications of a material restructuring of Greek debt for the European banking system and  sovereign debt markets remain unclear.



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