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Get Ready For Equity Surge If Merkel Gets Her Way On Fiscal Discipline - Brewin Dolphin

Tom Burroughes

6 December 2011

Equities could rise sharply if German chancellor Angela Merkel’s call for more fiscal union in the troubled eurozone is heeded and owing to a number of other positive forces such as lower bond yields and looser monetary policy, argues Brewin Dolphin's chief strategist, Mike Lenhoff.

If Merkel is able to convince French president Nicolas Sarkozy of the need to shift tax and spending sovereignty to the EU, this could be a major step towards convincing markets that the eurozone’s leaders are serious about tackling its debt woes, Lenhoff said in an investment note.

Uncertainty over the eurozone’s fate has acted as a drag on investor sentiment for much of the summer and autumn; in a recent briefing to journalists, Pictet, the Swiss private bank, said it was the greatest source of uncertainty in the world at present.

Lenhoff said a clear move by Merkel is a strong positive signal for equities.

“If Mrs Merkel gets her way with fiscal integration, market sentiment will be dramatically transformed. To say that equity markets, especially the banks, will have something to celebrate understates it. Fuelling the risk-on trade will be a big exit out of bond markets – and we don’t mean Italy’s,” he said.

Already, Lenhoff noted that the Italian bond market has rallied, with yields falling sharply last week and continuing to drop yesterday. (As of midday in the UK yesterday, the yield on the 10-year benchmark Italian bond was 6.16 per cent). Yields above 7 per cent have been regarded as the point at which a country is in a distressed state.

The rally in Italian bond prices, which move in the opposite direction to yields, followed the unveiling of Italian leader Mario Monti’s €30 billion (around $40.4 billion) austerity budget.

“Mrs Merkel has made her mind up and, like that other lady , she’s not for turning! The root of the problem needs tackling with nothing short of a transfer of fiscal sovereignty to the federal level. For Mrs Merkel, and the markets, here lies what is critical to credibly resolving the issue of eurozone debt sustainability and to ensuring budget discipline,” Lenhoff said.

Despite the so-far cool response from Sarkozy, Merkel has allies such as the Dutch, who have floated the idea of a commissioner for budgetary discipline in the eurozone with the role of overseeing national budgets and given powers to enforce fiscal rules, Lenhoff continued.

“It is either fiscal integration or a break-up of the eurozone and if Mrs Merkel succeeds at Friday’s EU summit meeting, much could fall into place,” he said.

“Having been blindsided by the eurozone sovereign debt crisis, a change in sentiment might also encourage the markets to focus on some of what has been going on elsewhere, like in the US where employment is growing, albeit slowly and modestly, but without any sign of faltering. Capacity utilisation is rising across industry,” he said.

Meanwhile, in China, where the country had been tightening policy, in some cases quite sharply, authorities were moving in the other direction, loosening the reserve requirement ratios for banks, said Lenhoff. He noted that Brazil has cut interest rates three times, with the most recent cut coming last week.

Some analysts have disputed the notion that China is loosening monetary controls with its move on reserve requirement ratios. Robin Parbrook, head of Asian equities at Schroders, said that while last week’s RRR cut supported expectations of monetary easing, he thinks markets will be disappointed by the pace of change.