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First published in Great Britain in 2011
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The right of George G. Blakey to be identified as the author has been asserted in accordance with the Copyright, Design and Patents
Act 1988.
ISBN: 978-0-85719-292-9
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Registered to a.mudassar88@gmail.com

About the Author

George G. Blakey is a stockbroker of many years experience. In the past he has worked for a number
of banks and investment groups as a financial analyst and was Research Partner with stockbrokers
Lyddon & Co.
Although no longer in the City, George has retained his membership of the Securities Institute and the
Society of Investment Professionals. He has an M.A. in Economics and Law from Trinity College,
Cambridge. He is the author of A History of the London Stock Market 1945-2009 (9781906659622),
World Financial Markets in 2010 (9780857190987) and World Financial Markets in 2012
(9780857192936).
Registered to a.mudassar88@gmail.com

World stock indices in 2011

I have included price charts the major international stock indices for reference.
Figure 1 FTSE100

Figure 2 FTSE250

Figure 3 Standard & Poors (S&P) 500

Figure 4 NASDAQ

Figure 5 Hang Seng

Figure 6 Nikkei 225

Registered to a.mudassar88@gmail.com

Quarter one, January to March

The Way Back
The break above 6000 for the FTSE100 on Christmas Eve 2010 seemed to have confirmed the best
hopes of the bulls, as did the rapid reversal of the hundred points loss in the closing days of the year
with a 150 points gain in the first two trading days of 2011. A 6% surge in the price of BP, taking it
back to almost 500p, helped the FTSE higher. The index of the 100 leading UK shares also benefited
from gains on Wall Street after a dramatic improvement in US jobs data as private sector hiring
recorded a much higher than forecast increase.
However, a statement from the US Federal Reserve (Fed) to the effect that it was not convinced that
the recovery was sufficiently established to scale back its $600 billion bond purchase operation,
coupled with disappointing non-farm payroll figures for December, were enough to halt the New
Year rally.
More cautious commentators welcomed the pause, seeing it as a confirmation of their view that the
rampant bullish sentiment so evident at the turn of the year was yet another case of irrational
exuberance on the part of investors. These investors had apparently come to regard a near-zero
monetary policy backdrop as normal interest rates remained at 0.5% in the UK and between the
range of 0% to 0.25% in the USA throughout the quarter simply because it had been in place for so
long. Misplaced enthusiasm had powered stock markets back to their pre-Lehman levels but given
that such artificial and deceptively benign conditions could not continue indefinitely, investors were
failing to price in the consequences of a return to the real normal of market-set interest rates.

Inflation Fears Increase

By mid-January, the FTSE100 was clearly having difficulty hanging on to 6000 plus territory,
unsettled by the December inflation figure of 3.7% which had sent sterling to a two-month high of
$1.60 on counter-inflationary rate rise expectations. Semi-official pronouncements that core inflation
remained subdued and that volatile food and energy price increases would soon drop out of the
headline calculation were not very convincing for consumers, all of whom were affected by such
allegedly transitory factors.
Furthermore, the oil price was back to almost $100 again, even in the earliest stages of economic
recovery, and the extraordinary rises in soft commodity prices over the past year showed no sign of
going into reverse in the face of rising demand from the vast and growing populations of the
developing world. In any case, to claim that inflation was more of the cost/push variety than
demand/pull was no consolation for consumers unable to negotiate wage increases to maintain their
living standards. Just to complicate matters, a much worse than expected GDP figure for the fourth
quarter of 2010 of -0.5% raised double dip fears and weakened the case for a rate rise.
In the euro zone, inflation had risen above the ECBs target for the first time in more than two years.

Despite this, markets took heart from evidence of the broadening economic recovery in Germany and
its beneficial effect on France (the two countries are each others biggest export markets), and the
region as a whole. The euro responded positively to this performance by its core economies,
regaining the $1.36 level for the first time since November 2010. Hopes of a resolution of the
sovereign debt crisis were boosted, with Germany, Atlas-like, playing a supportive role.
Confidence over the sovereign debt issue had ebbed and flowed in preceding months, and a contrary
view held that the German public had no stomach for their country playing such a role. This camp
were of the opinion that the ECBs bail-outs to date had both compromised its integrity and exhausted
its firepower, and the weakest of the peripheral states would find it impossible to power their way
back to growth while instituting austerity programmes at the same time as paying well over the odds
for funding.

Banks In Limbo
US markets fared better than their European counterparts, helped more by good earnings reports from
big name companies like GE, IBM and Apple (the last named now with a market capitalisation of
$320 billion, making it the second biggest company in the world after Exxon Mobil) than by economic
data on employment and housing, which remained inconclusive.
Banks lagged the rest of the market, depressed by a sharp drop in fourth-quarter trading revenue at
Goldman Sachs and raising fears that regulatory changes would mean that US banks no longer
possessed a licence to print money a privilege now strictly reserved for the Fed. Bumper results
from JP Morgan made no difference to this gloomy outlook for the banks, argued Lex in the FT, and
the column branded CEO Jamie Dimons accompanying statement that the future was extremely
bright as delusional at a time when policy rates were zero, a state of affairs that could not continue
indefinitely.
Management changes among the giants of the technology sector, namely Hewlett Packard, Google and
most notably Apple, whose founder and presiding genius, Steve Jobs, announced that he was taking
indefinite leave of absence on medical grounds, saw these companies stock prices trimmed back.
That left the NASDAQ Composite at the end of January some 70 points shy of its peak for the month
at 2685 while the S&P500 remained just short of the 1300 mark and the Dow held steady at just
below 12,000.
London markets also limped towards the closing days of January, hobbled by the banks, which were
now threatened by the proposals of the Independent Commission on Banking. The Commission was
chaired by the outspoken Sir John Vickers, who seemed to have called the bluff of the banking lobby
by saying that that the financial crisis had exposed a damagingly rickety structure at the heart of the
financial system. The Commissions key proposals were to split customers savings and loans away
from high risk investment banking operations and thus obviate the need for the taxpayer to provide a
generous safety net when things go wrong.
The unexpected fall in fourth-quarter GDP continued to raise problems for the UKs coalition

government by giving weight to the argument that its proposed austerity programme was certain to
stifle growth. The well-respected outgoing chairman of the CBI, Sir Richard Lambert, then added his
voice to those of the opposition by claiming that the government lacked a policy for growth. Against
such a barrage of criticism, the FTSE100 was considered to have done well to stay close to the 6000
level, but some justification for this resilience was demonstrated in the first days of February with the
release of Purchasing Managers Index (PMI) data for the manufacturing sector showing the sharpest
increase since the series began in 1992.
A similar jump in the data for the services sector, coupled with a better than expected run of results
from leading companies like BT, Vodafone, Unilever and Compass, generated a dramatic boost to
investor sentiment and 6000 now began to look more like a floor than a ceiling for the FTSE100.
Backed by the seemingly unstoppable rise in metal prices, mining stocks were responsible for a good
proportion of the rise in the index, in the company of mega-cap multinationals. BP failed to add its
weight to the rise, with its price pulling back from the 500p line as commentators expressed doubts
about the wisdom of the companys decision to throw in its lot with Russia on the Arctic exploration
venture.

Power To The People

With markets in London and New York apparently poised to continue their advance, it was the cue for
geopolitical factors to come into play and induce at least a pause. The trigger was provided by events
in Tunisia where a popular uprising, as distinct from a politically-inspired one or a military coup,
managed to overthrow a long-established authoritarian regime. Given that the conditions that
provoked the uprising namely high unemployment, especially among the young, widespread poverty,
political repression and blatant corruption in the ruling elite obtained in countries throughout North
Africa and the Near and Middle East, many commentators believed that Tunisians had created an
example to be followed by oppressed masses elsewhere in the region, major oil-producing countries
included.
Such foreboding soon appeared to be fully justified when within days protestors took to the streets of
Cairo and all the major cities of Egypt, calling for the resignation of President Mubarak and the
dismantling of his regime. Efforts to quell the uprising failed and with international opinion fully
behind the protestors, the President was left with little option but to bow to their demands and hand
over interim control of the country to the army.
Western stock markets initially saw this as a satisfactory end to a potentially dangerous crisis and
edged up to new highs, but unrest spread like wildfire across the region affecting Algeria, Libya,
Oman, Yemen, Jordan and Bahrain. Ironically Irans President Ahmadinajad, who had praised the
Egyptians for toppling their pro-American, pro-Israeli leader, now found himself facing the same
demands as his political opponents flooded onto the streets. Thus far from ending the crisis, the
success of the Tunisian and Egyptian protesters had encouraged others to take the same course and
raised uncertainty in the region to a new and much higher level.

Oil Prices On The Rise

One certainty to come out of the turbulence in the Middle East was a rise in the price of oil, with its
concomitant impact on inflation. In the UK, petrol prices surged to new highs as Brent crude topped
$104 a barrel, helping the CPI to record a 4% rise in January (twice the Bank of Englands target
figure) and apparently confirming predictions that the rate would reach 5% later in the year. The
timing of the Banks first increase in base rates from the level of 0.5%, where they had been for two
years, now became the big question following the Governors cryptic comment that inflation would
fall to 2% in 2012 if interest rates rose in line with market expectations.
The doves on the Monetary Policy Committee still outnumbered the hawks and while downgraded
growth forecasts for 2011, together with rising unemployment, supported their reluctance to raise
rates, their assertion that rising food and energy prices were a passing phase continued to be less than
convincing. The ECB took a similar view and calmed rate-rise expectations by saying that the price
increases that had pushed the euro zone inflation rate up to 2.4% were essentially short term and
would soon abate.
Stock markets seemed content to go along with this recipe of interest rates being kept at exceptionally
low levels until such time as growth was seen to be firmly established. As for inflation, the official
view was that it would remain subdued while growth was modest and could be countered by rate
rises in due course as it picked up in line with growth. As Chuck Prince of Citigroup might have put
it, While the music is still playing, equity investors can keep dancing.
Emerging markets, with their near-double digit growth rates, took inflation much more seriously.
China, in particular, had manifested its concern by raising bank reserve requirements five times in
2010 and interest rates twice in February 2011. A number of commentators questioned how Western
markets would react to the withdrawal of stimulus and the imposition of austerity programmes
which their governments insisted was necessary if their countries were to lay the foundations for a
return to sustainable growth paths. The implementation of similar restrictive measures in the BRICs
and other emerging markets had led to their underperformance in recent months in relation to the
markets of the developed world, sparking a massive outflow of funds from the former to the latter.

Time For Reflection

By the beginning of March even the most convinced of bulls were ready to admit that the bull market
that had seen the S&P500 actually double from its low point of two years ago was due for at least a
pause and even a sizeable reaction. The bears were less hesitant in their view of where the markets
were headed. Their key argument continued to be that the economic recovery to date had been a
stimulus-induced pick-up from a low base and that the rising stock market associated with it was
largely liquidity-driven and influenced by the absence of acceptable returns in any other investment
medium.
As long as ultra-accommodative monetary policies continued the bears agreed that stocks could keep
rising, but the soaring oil price had now put a cap on market levels just as it had on a fragile

recovery. Furthermore, now that the post-colonial winds of change had spread to Libya and Bahrain,
there was every prospect they would engulf the whole region.

Dj Vu All Over Again

The situation in the Near and Middle East led to comparisons with 1973, when Arab oil producers
wrested control of oil production and pricing away from Western companies, precipitating a global
economic crisis and the collapse of stock markets everywhere. Colonel Gaddafi had been a key
player at the time, having nationalised all BPs interests in Libya in 1972 and then expropriated 51%
of US oil companies assets in May 1973, prior to leading the embargo on oil exports to the West on
the outbreak of war with Israel in October. It was argued that the situation in 2011 had the potential to
be much more serious.
In the 1970s the oil producing states, imbued with anti-Western, anti-Israeli fervour, had presented a
united front against what they saw as the exploitation of their principal resource, but at least Western
consumers knew that even at sharply higher prices, oil would continue to flow. Coups in the region
came and went but if one authoritarian ruler was replaced by another, it would be one guaranteed to
give continuity to a political system and a sectarian balance that had endured for centuries, thus
ensuring a stability of sorts.
This time around, it was argued, things could work out very differently. The masses of the street were
rebelling not against their former colonial masters and Western domination but against their own
rulers who had kept them in ignorance, poverty and servitude for centuries. Earlier generations had
seemingly accepted their fate but dramatic technological advances mean that citizens of these
countries in the 2011 have been made aware of life in the outside world by satellite television and the
internet as well as being given the means to unite and communicate their discontent via mobile phones
and social networks.
The result could easily be the disintegration of the traditional social and political order in the area,
which would mean the inevitable introduction of a new era of uncertainty and instability in a region
that provides 30% of global oil supplies and contains 60% of the worlds proven reserves.

Black Swans Rising

As March wore on, the 6000 level on the FTSE100, that of 12,000 on the Dow and 1300 on the
S&P500 began to look like battle lines. The bull forces were supported by the positives of strong
corporate earnings (for now), mergers and acquisitions and share buybacks, and some evidence that
the recovery was gaining a foothold. The bears countered with the negatives of sharply rising prices
for oil and practically every other commodity, continuing sovereign debt problems in the euro zone as
bond yields crept ever higher, and the impending exit from a uniquely artificial monetary and fiscal
framework.
Ongoing turmoil in the Arab world and a downgrading of Portugals credit standing by the ratings
agencies seemed to support the arguments of the bears and by mid-March the aforementioned battleline levels had been breached, taking the FTSE to 5775, the Dow to 11,993 and the S&P500 to 1296.

If this was not enough to shake bullish confidence, Japan was rocked by a category 9 earthquake,
resulting in a tsunami that devastated the countrys north-east coast, swamping a nuclear reactor in the
process and causing a radiation leak.
Given that Japan is the worlds third largest economy (only recently pushed out of second position by
China), the disaster was regarded as dealing a major blow to global recovery prospects and stock
markets everywhere plunged, taking their cue from a record 10.5% drop in the Nikkei. Instant action
by the Bank of Japan in the form of a $225 billion cash injection for the economy and massive
intervention by the central banks of the G7 to drive the yen lower it had risen sharply on
expectations that Japanese insurance companies and other institutions would have to repatriate funds
to meet claims and reconstruction costs were enough to reassure investors and markets rallied.
Even the declaration of a no-fly zone over Libya and the accompanying military action failed to dent
investor confidence and by the end of the third week of March, markets had recovered nearly all the
losses incurred amid the tumult of the week previous.

Heads In The Sand

Since all the bearish factors that had precipitated the market falls were still present in spades, this
resilience was seen as surprising by even the most ardent bulls. After all, it was universally agreed
that a rise in oil prices posed a major threat to economic recovery and now with the Japanese disaster
boosting the anti-nuclear lobby and prompting the shelving of nuclear plant construction plans across
the world, dependence on oil had been hugely increased. Furthermore, natural disasters and
revolutions in faraway countries were matched by worsening difficulties on the home front relating to
tackling unsustainable budget deficits.
Thus, in the US, the inability of Congress to agree over the vital spending cuts needed to meet the
administrations deficit reduction targets was having a knock-on effect at local levels as federal
agencies were forced to curtail work already in progress, freeze hiring plans and withhold grants,
none of which was doing anything for the all-important employment numbers.
In the UK, the Chancellor was in receipt of criticism from all sides for delivering a budget that
ignored the warning lights flashing in the economy and for sticking to his plan to cut public sector
borrowing while simultaneously trying to promote private sector growth, a policy considered by the
Office for Budget Responsibility to have no likely impact on long-term growth potential. The failure
of the Portuguese government to gain parliamentary support for its proposed austerity measures and
the protest march through central London on 26 March were also seen as warning lights, reminding
the coalition government that proposals are one thing and the ability to implement them quite another.
In the final week of March, equity markets continued to rate the importance of mildly encouraging
manufacturing, service industry and employment data, and strong (but historic) corporate earnings
reports, more highly than the possible, even probable, fallout from revolutions in the Middle East,
natural disasters in Japan, and renewed sovereign debt crises in the euro zone. As a result, the
FTSE100, after being down 5% two weeks earlier, ended the first quarter virtually unchanged at

5903, a performance matched closely by the FTSE250 at 11,591.

On Wall Street, the Dow, which had dipped below 11,600 intraday in mid-March, recovered by the
end of the month to 12,319, gaining 6.5% since the beginning of the year while the S&P500 was up
5.6% at 1325, and the NASDAQ Composite was up 4.8% at 2781. The bulls looked forward to
180,000 or more US monthly job gains being reported on 1 April, which would serve to confirm that
the recovery was slowly but surely underway and get the second quarter off to a good start. The bears
remained convinced that the markets failed to see the big picture and were pricing in a lot of good
things that were not going to happen.
Registered to a.mudassar88@gmail.com

Quarter two, April to June

Against the wind
In response to the US monthly job gains for March coming in well above best expectations at 216,000
and a fall in the unemployment rate from 8.9% to 8.8%, stock markets around the world made
significant gains, following the lead of Wall Street. The Dow plussed 57 points to 12,376 and the
S&P500 was up 7 to 1332, while in London the FTSE100 rose 101 points to top 6000 again, reaching
6009.
Most market commentators appeared to believe that the mid-March slide had been the expected
correction and the advance was now ready to continue. More cautious observers, however, pointed
out that if the contributing factors to the nightmare week in early March were not still making the
headlines, that did not mean they had lost their potential to seriously damage the global economy and
their stock markets. The oil price, in particular, at $108 a barrel for West Texas Intermediate (WTI)
and $122 for Brent crude, was now at a two and a half year high, which meant that the cost of
production was rising for practically every commodity and manufacture. This made stock market
upticks on the release of mildly encouraging industrial and employment data almost irrelevant.
Consumers in the UK were already being hit by inflated fuel and food prices resulting in major
retailers like Marks & Spencer, Mothercare and Dixons downgrading their outlook for the rest of the
year as disposable incomes shrank. This situation could only get worse as austerity measures began to
bite and tax and spending changes took effect in the new financial year.
Against such a background, a rising stock market seemed to make little sense unless, of course,
investors were looking for further doses of QE and an indefinite postponement of interest rate rises,
with politics continuing to trump economics. The ECB (European Central Bank) now complicated the
picture by breaking ranks with the Fed and the Bank of England by raising rates from 1% where
they had been since May 2009 to 1.25% in response to the Eurozones inflation figure for March
coming in at 2.6% compared with the 2% target.
The move inevitably attracted some criticism for making life more difficult for the struggling
peripheral countries of the area, especially now that Portugal had joined the bail-out queue.
However, most serious commentators welcomed the rate rise as the first sign of a return to normal
monetary policy by a leading Western central bank at a time when the Fed and the Bank of England
were still flying blind with practically zero interest rate levels and hoping for a happy landing. Even
with inflation at 4.4% in March, more than twice the Bank of Englands target, the MPC still left rates
unchanged at 0.5% on the same day that the ECB had decided to raise its policy rate, while in
Washington the administrations obsession with not taking any action that could threaten a fragile
recovery had pushed the prospect of any boost from a practically zero interest rate to the end of the
year and even into 2012.
Indeed, it now looked as if for simple reasons of political acceptability, the perpetuation of a low

interest rate environment was a necessary accompaniment for the imposition of unpopular austerity
measures. Unfortunately, a side effect of this strategy was that investors with access to cheap funding
were only too ready to take risks in pursuit of a decent return, all too often targeting commodities as
the ideal inflation and dollar hedge.
Thus, correlations between asset classes went out of the window with hot money flowing into
equities, oil, gold and silver, and industrial metals, as investors placed their bets on the red and the
black. That such an investment strategy should be successful today argued for the adoption of one
winning formula put forward in the eighties by a veteran stockbroker who had seen it all: Carefully
weigh every factor influencing your decision to buy or sell, make up your mind as to the only logical
course of action to follow and then do precisely the opposite.

Faites vos jeaux

If this continuation of an ultra-accommodative monetary policy was considered to be a more than
adequate explanation and justification for rising stock markets, then rising prices for oil and other key
commodities, for which such a policy was in part responsible, ran counter to this trend. Not only
were they bad for business but their inflationary impact would in time pressure governments to revise
the interest rate policy. However, this apparent contradiction was one which investors seemed
content to live with and stock markets forged ahead throughout April, largely under the influence of
strong earnings and outlook statements for major US companies.
By the end of April the Dow at 12,810 and the S&P500 at 1363 were standing at their best levels
since June 2008 while the FTSE100 had reached 6069, a performance the bulls interpreted as
indicative of all the known knowns of negative news being priced in. The bears, on the other hand,
maintained that the continuing flow of easy money was floating all ships and that with oil at $114
(WTI) and $126 (Brent crude), gold at a new nominal high of $1570 and silver at $50, in the context
of the dollar at a three-year low, stock markets were riding for a fall.
The bears acknowledged that the markets had staged an impressive recovery from a sharp setback
earlier in the month after Standard & Poors had downgraded the outlook for US debt to negative,
seemingly when the move was seen as strengthening the chances of the administration being able to
implement a realistic deficit reduction strategy. However, at the same time, the bears believed that the
recovery owed more to an over-optimistic bias on the part of investors convinced that the Fed would
keep the party going, come what may. They also interpreted the equally rapid rebound after the
dramatic one-day collapse in the price of oil and a broad range of commodities as likely to be shortlived, given that it was attributed to a recovery in these prices and thus hardly a cause for investors to
celebrate.
Similarly, while the April job gains coming in well above expectations was a plus for the markets in
that it bolstered economic recovery hopes, the slide over the past month of 40 basis points in the US
10-year T-bond yield to 3.15% was hardly a vote of confidence in the return to growth story of the
worlds number one economy. And since, by contrast, bond yields in the peripheral Eurozone
countries were going through the roof, it was difficult to avoid the conclusion that deficit problems in

the developed world were simply a matter of scale. We are all Greeks now but some of us are more
Greek than others; a dollar-denominated Treasury bond was seen by many as the only safe port in a
likely coming storm.
If rising US bond prices appeared to have wrong footed outspoken bond bear Bill Gross of PIMCO,
he was not dissuaded from continuing to build up his short position, convinced that the US
government had no politically acceptable option save to eventually inflate its way out of its selfimposed debt trap. A renewed slide in commodity prices in the second week of May ensured that
investors remained nervous and the markets were in no mood to resume their advance. Indeed, after a
brief flurry over 6000 again, a move attributed to the lessening of contagion fears on the news that
Greece was to get another 60 billion from the ECBs emergency fund, the FTSE100 fell back on
second thoughts that more money for Greece meant that the problems for the PIIGS (Portugal, Italy,
Ireland, Greece and Spain) were even worse than originally believed.
Furthermore, the London market received no encouragement from the Bank of England when it
announced a revision of its growth forecast for the current year to just below 2% and to 2.5% in
2012. In the context of the April inflation figure coming in at a higher than expected 4.5%, this put the
UK economy in a poor light when compared with Germany, reporting first-quarter growth of 1.5%,
and France, which reported first-quarter growth of 1%.

Commodities on the rack

Meanwhile, a marked revival in the dollar in tandem with Treasury bond prices in response to the
shadow cast over the Euro by ongoing sovereign debt problems of the weaker members of the single
currency was wrecking the risk-on strategy of traders and speculators who had stocked up on
commodities as a dollar and inflation hedge. By mid-May, falls in mines and oils in the wake of the
slump in commodity prices had pulled the Dow below 12,500 and the FTSE100 back to around 5900.
Both indices rallied strongly though thanks to their weighting in resource stocks, which recovered in
line with rebounding oil and metal prices.
If institutional investors had any doubts about the durability of the commodities boom, they were not
evident in the IPO of Swiss-based mining and commodity colossus, Glencore, which enjoyed a fourfold oversubscription for the 6.7 billion tranche on offer at 530p, the top end of the indicated price
range. Financial columnists were much more critical, citing the buccaneering reputation of the
directors and the politically-unstable areas of the world in which it operated, but the sheer size of the
company at some 40 billion, ensuring its instant entry into the FTSE100, simply made it too big for
the institutions to ignore. However, after an initial surge the shares ended their first week of trading at
a small discount to the offer price, a performance sparking comment that such a major launch often
marks the high point in an industrys fortunes.
Just as high profile and engendering as much enthusiasm but even more scepticism than Glencore was
the IPO of LinkedIn (www.linkedin.com), the business-oriented social network group described by
one City writer as populated by business people who one has no interest in making friends with.
Nevertheless, placed at $45, the shares soared to $122 on the first day of dealing before settling at

$93, giving the company a valuation of nearly $9 billion. The fact that such numbers represented a
multiple of 40 times revenues and 200 times earnings in 2010 invoked comparisons with the worst
excesses of the internet bubble of 1999/2000. However, LinkedIns fans saw its share price
performance indicating the reception likely to be accorded to other social media groups planning to
come to market, namely Facebook (www.facebook.com), Groupon (www.groupon.com) and Twitter
(www.twitter.com).
The FTs Long View column saw this wild enthusiasm for internet offerings as of the same nature as
the startling rise and fall in the price of silver up 63% in less than five months and then falling 35%
in a matter of days and linked this sort of investor behaviour with the significant decline in a broad
range of commodity prices in recent weeks which cast doubt on the prospects for economic growth.
They interpreted this as a sign that investors were finding it ever harder to make money and were
getting a little desperate.

PIIGS cant fly

Such runaway enthusiasm was not mirrored in the broader market which was more concerned with an
apparently deteriorating sovereign debt situation in the peripheral Eurozone. As Greek ten-year bond
yields soared to a record 16.5% after another ratings agency downgrade of the countrys debt, a
restructuring was widely seen as inevitable with all that it would imply for the rest of the PIIGS.
Spains ten-year bond yields rose to a near record of 5.5% against a background of more antigovernment protests in Madrid and a trouncing for the ruling Socialists in regional elections, and
Standard & Poors then stoked anxieties even further by downgrading the outlook for Italys debt from
stable to negative, much to the annoyance of the countrys finance minister. Contagion was once again
the name of the game as despite the best efforts of the ECB, a renewed sovereign debt crisis in
Greece had put Spain and Italy in the spotlight and their bond yields continued to rise, although with
the offset of falling yields for those countries judged to be at the other end of the stability spectrum.
Stock markets in Europe reacted negatively to these developments with widespread falls of 1% and
more, giving the lead to Wall Street already overshadowed by the failure of the latest round of data
on employment, housing and industrial production to show that the long-awaited recovery was
taking hold before the Feds bond-buying programme expired at the end of June. Asian markets also
fell back, depressed by evidence of a slowdown in China as the governments counter-inflation
measures began to work, and Japan slipping back into recession.
At the start of the final week of May, the Dow had pulled back to 12,381, the S&P500 to 1317 and the
NASDAQ Composite to 2788, while the FTSE100, at 5835, had left 6000 far behind. In Asia,
Japans Nikkei Dow had fallen to 9460 as its run of natural disasters began to reveal their impact on
company profits, and in China the stock indices in Shanghai and Hong Kong continued to erode.
Indian markets were not immune from downward pressures as the authorities run of interest rate
rises to curb inflation took their toll and the BSE Sensex slipped below the 18,000 level. The sole
beneficiaries of this renewed wave of risk-aversion gripping stock markets everywhere were the
standard and supposedly safe havens of the dollar, Treasury bonds, the Swiss franc and gold.

US data disappoint
Just as investors were regretting not having adopted the time-honoured Sell in May strategy,
markets rebounded strongly on the last day of May, taking the Dow up 128 to 12,569 and the S&P500
up 14 to 1345, while the FTSE topped 6000 again before settling at 5990. However, since the
rationale for the rebound reportedly the news that Germany had agreed to extra funding for the
Greek bail-out was carrying more weight with investors than disappointing May readings on US
house prices, regional manufacturing and consumer confidence, this seemed hardly a fair trade-off
and suggested that the rises were likely to be a one-day wonder.
This proved to be the case the very next day, 1 June, when the combination of a well below forecast
drop in the ISM manufacturing index for May, a shockingly weak private sector jobs report and a
string of downbeat outlook statements from Americas leading retailers, saw the Dow slump 279
points to 12,290. And if this was not enough to depress investors, further evidence that the recovery
was stalling was provided by the non-farm jobs number for May showing only one-third of the widely
expected gain and a reversal of the downtrend in the unemployment rate with an uptick to 9.1%.
As a result markets continued to slide and were given a further downward nudge by the Fed
chairmans acknowledgement that the recovery was uneven and frustratingly slow, but with no
mention of a further round of QE. Eurozone sovereign debt problems also weighted on sentiment after
yet another downgrade for Greece and a warning that the ECB itself was at risk of collapse given its
highly-levered exposure to struggling Eurozone economies. This second point was widely reported to
be alarmist but it still raised the question of the source of the ECBs apparently unlimited funding.
The answer was that it was backed by all the central banks in Europe and taxpayers. So, no problem
then.

IMF backs Chancellor

The London market followed Wall Street down, its course unchecked by the IMFs endorsement of
the governments austerity plans. However, the endorsement was complicated by a recommendation
of emergency measures in the form of more QE and tax cuts if weaker growth and higher inflation
persisted, developments which Moodys warned could lead to a loss of the countrys triple-A rating
in the event of any excessive relaxation of the original plans.
One writer thought that Moodys was concerned about the stability and unity of the coalition given
that many of its Liberal Democrat members, cabinet ministers included, appeared to have no stomach
for implementing tough choices and were too unaccustomed to office and the responsibility and
discipline that it required. The intervention of a troublesome priest in the form of the Archbishop of
Canterbury was not considered to be an influential factor.
As the month progressed the downtrend in markets continued, interrupted only briefly by the
occasional half-hearted rally which was almost immediately expunged after another item of
depressing news. Retail sales on both side of the Atlantic in the first quarter came in well below
expectations and accompanied by gloomy forecasts for the rest of the year, and slower growth in

Chinas exports and a fall in Germanys industrial production in April, appeared to confirm
suspicions that the global economic recovery was faltering.
The failure of OPEC to reach agreement over Saudi Arabias proposal to raise oil production quotas
to meet rising demand did not suggest any likely softening of the price and benchmark Brent crude
moved up $1 to $119 a barrel. But the most influential downward pressure on stock markets was the
ongoing disagreement among Eurozone leaders over how to deal with Greeces sovereign debt crisis,
resulting in the cost of insuring against default soaring to record levels, not just for Greek government
debt but for that of the rest of the PIIGS.
The principal concern appeared to be that Germanys insistence that bondholders must share in the
pain involved in any restructuring of Greek debt would alienate holders of the debt of the other
peripheral Eurozone countries who would be tempted to liquidate their positions while they still
could. And since so much of that debt is a core holding of banks, pension funds and insurance
companies across Continental Europe, such an event would precipitate another and much more
damaging financial crisis. Greek ten-year bond yields topping 17% did not augur well for a
satisfactory outcome and official protestations of Eurozone solidarity over the issue were widely
seen as falling into the they would say that, wouldnt they? category.

Six down in a row

By the end of the second week of June and after an unusual six consecutive weeks of losses, the Dow
had slid below 12,000 to 11,951, the S&P500 to 1271 and the NASDAQ Composite to 2643. In
London the FTSE100 had crashed significantly below 5800 to 5766 with mines and banks leading the
way, unsupported by no change bank rate decisions by both the Bank of England and the ECB.
Another unsettling factor for investors as a reminder, in case they had forgotten in times of buoyant
markets, that being a shareholder necessarily involves being a victim of the fallout when things go
wrong at the top. Care home provider, Southern Cross, had come to grief after a business plan
implemented by its private equity owners in preparation for flotation in 2006 with an equity market
valuation of 425 million at an offer price of 225p, turned out to be based on faulty premises. With
the company making huge losses and drowning in debt and the share price below 5p, its survival was
now in doubt.
Another reminder for investors that buying into companies in far away countries with strangesounding names can also carry dangers was provided by Kazakhstan-based Eurasian Natural
Resources (ENRC). Floated in 2007 in accordance with the rules of the London Stock Exchange, the
companys founding and majority shareholders had fired their UK name directors, former Glaxo
chairman and CEO Sir Richard Sykes included, and were running it like a private company again and
in a way more Soviet than City, to quote one of the ex-directors.
On the generous assumption that the Citys code of governance provides some degree of protection
for investors, the lesson from ENRC is that buying shares in any company based in a country
possessed of an alien business culture means signing up to a caveat emptor deal. The Americans were
learning that lesson too after finding serious defects in the accounts of many of the Chinese companies

that had obtained their US listing via reverse takeovers and thus avoided the more rigorous testing
that an IPO would have demanded.

Greece rolls over

As June progressed, Greeces problems came to the fore and moved from the financial pages of the
national press to become the subject of leading articles and main features. The fear was widely
expressed that the ramifications of the Greek default would be so far reaching that it would constitute
another Lehman moment and produce a similar dramatic fallout. Lex in the FT disagreed, pointing out
that this time around markets were not going to be taken by surprise and that exposure to losses was
limited to 25 or so mainly European banks, making it possible to negotiate a much more orderly
default than in the case of Lehman where the products had been so complex and the counterparties so
numerous that the administrators are still working out today who owes what to whom.
At the same time, Lex conceded that the risk of a Lehman moment in the Eurozone remained if Spain
or Italy were in the frame; a possibility, even probability, in the view of many other commentators.
Germanys reluctant agreement that the rejigging of Greeces debt should take the form of a voluntary
rollover, rather than a debt exchange with extended maturities, triggered another rally in US markets
but London and other European markets, with the Greek crisis nearer to home thanks to the
involvement of their 25 or so banks, were less enthusiastic.
In the final week of the second quarter, stock markets sprang into life led by an exuberant Wall Street
as a run of strong earnings reports accompanied by unexpectedly upbeat regional PMI manufacturing
numbers revived hopes that the recovery was gaining traction. Data on housing and employment
remained inconclusive, but while acknowledging a disconnect between the economy and Corporate
America, investors seemed happy to give the economy the benefit of the doubt. Even the downward
revision of the growth forecast for the current year from 3.2% to 2.8%, and no mention of QE3 to
follow the conclusion of the Feds bond buying spree, failed to dampen buyers enthusiasm and the
S&P500 registered a gain of 5.6% over the week taking it to 1339, while the Dow added 647 points
to 12,582. The FTSE100 just failed to top 6000 again but still managed to rise by 5.1% to 5989,
apparently undisturbed by growing evidence of blood on the high street as retailer after retailer
announced sharply falling profits and embarked upon a programme of store closures.

A reprieve for Greece

If such items of news seemed to provide little justification for a one-week rise of over 5% in markets
across the board, there was some further encouragement to be taken from the International Energy
Authoritys (IEA) decision to release an initial 60 million barrels of oil from its stockpile, and from
the Greek governments success in getting parliamentary approval for its five-year austerity plan, thus
ensuring the 12 billion loan tranche would arrive on schedule and head off the threat of default.
However, more sceptical commentators pointed out that after an immediate fall in the oil price to
below $90 on the IEAs announcement, it had rebounded to $95 by the end of the week and, in any
case, the stockpile would have to be replenished. As for the Greek situation, 12 billion was no more

than a sticking plaster; default, however it was structured, was inevitable further down the line. They
also saw the sharp rise in bond yields the US 10-year Treasury had risen over the week from 2.86%
to 3.22% as an overreaction to the ending of the Feds bond buying programme and the Greek bailout. The sovereign debt crisis was still with us, they argued, and a short-term fix for Greece did
nothing to solve it.
Registered to a.mudassar88@gmail.com

Quarter three, July to September

Recovery, what recovery?
The first week of the third quarter raised hopes that the end-June rally was going to develop into a
meaningful advance under the influence of an uptick in US economic data and a solution, if only a
temporary one, to Greeces debt problems. The Dow had topped 12,700 with the S&P500 over 1350,
while the FTSE100 seemed to be keeping its head comfortably above the 6000 level. Even Japan
began to enthuse its ever-patient fans on signs of rising production as the recovery from the
earthquake gained momentum and the Nikkei 225 managed to move above the 10,000 mark again, to
the benefit of the other Asian markets.
Unfortunately for the bulls, this wave of renewed optimism over the prospects for global recovery
was soon to be snuffed out. Shockingly disappointing US jobs gains in June of 18,000 against
confident expectations of around 120,000 and soaring bond yields and spreads among the
peripheral Eurozone countries, as contagion now threatened Italy and Spain, took away the two props
of the June rally.
The disagreements among the Eurozone leaders over how to sort out Greece, coupled with the fact
that even after their bailouts, Ireland and Portugal were clearly still in trouble, suddenly spooked
bond investors. If all the European Central Banks (ECBs) costly efforts had been unable to improve
the lot of these three countries, how could it possibly cope if contagion spread to Italy or Spain? The
answer was that it could not and bond investors started to sell.
Suddenly ten-year bond yields in both Italy and Spain were topping 6% before falling back to 5.5%
for Italy and 5.8% for Spain on talk that the ECB was buying in the market. If Greece, Ireland and
Portugal were the Northern Rock and Bear Stearns of 2011, there was no question that Italy or Spain
could be the Lehman Brothers. Stock markets reacted accordingly and within the space of three days
the FTSE100 lost 300 points and the Dow lost 250 as investors fled to the supposed safe havens of
US Treasuries, German bunds, UK gilts and, of course, to gold.
The sovereign debt crises in the Eurozone had also taken the spotlight off two other situations, neither
of which was doing anything for investor sentiment. One was the Obama administrations battle with
a Republican-dominated House over establishing a mutually agreed deficit reduction plan to allow
the raising of the national debt ceiling and avoid a technical default. Since a spending programme
which would breach that ceiling had already been passed by both houses, the dispute was widely
seen as a party political one inimical to the national interest.
Nevertheless, most observers believed an accord would be reached before the August deadline, after
striking a balance between Democratic tax rises and Republican spending cuts, especially now that
Moodys and Standard & Poors had raised the temperature by threatening to downgrade US debt
removing their triple-A rating if the House failed to reach an agreement. One commentator was
moved to quote Winston Churchills wartime assessment of the Americans, After exhausting every

alternative they always end up doing the right thing, and was confident that what President Obama
had referred to as Armageddon would be averted.

Its The Sun wot won it!

In the UK, the phone hacking scandal at the News of the World had put Rupert Murdochs News
International media empire in the dock and raised questions over the degree of political influence he
had exercised in the country in recent years. The fallout in stock markets was dramatic with $5 billion
wiped off News Internationals capitalisation on Wall Street. In London the shares of satellite
broadcaster BSkyB collapsed from 850p to below 700p after the government effectively vetoed Mr
Murdochs proposed bid for the company and forced its withdrawal.
But just when things were looking grim for the markets on all fronts, Ben Bernanke threw them a
lifeline by telling a Congressional hearing that the Fed stood ready to respond should economic
developments indicate that an adjustment in the stance of monetary policy was appropriate. In other
words, more stimulus could be on its way and markets responded appropriately enough, led by the
Dow which on 13 July plussed 170 points at the opening before settling at 12,491 to finish up 44.
In London, the FTSE100 added 37 to 5906 although, just like the Dow, it finished well below its high
for the day. The positive statement from Bernanke that had given markets positive impetus was
tempered by an announcement by the Office for Budget Responsibility (OBR) stating that the
Chancellor would have to do a lot more in terms of tax rises and spending cuts if public sector debt
was to avoid continuing along an unsustainable path. Second quarter GDP growing at 0.2% and a
downgrade for the years performance by the Independent Treasury Economic Model (ITEM) to 1.2%
did not suggest the economy was treading the recovery path and of course demand in the countrys
biggest export market was bound to suffer as country after country in the Eurozone embarked upon
austerity measures.
Markets were on the slide again as the second half of July began, disappointed by no sign of the Fed
chairman following through with the idea of further stimulus and by the failure of governments on both
sides of the Atlantic to come up with credible plans to deal with their debt problems. The results
from the new round of stress tests for European banks did nothing for public confidence. Only eight of
the 91 banks tested failed by falling below the 5% core tier one capital ratio (under Basel II) but
since no measure of the banks ability to withstand a sovereign default was incorporated in the tests,
they were widely regarded as a whitewash.
Banks led the markets down on Wall Street, London and the Eurozone capitals with falls in the 5% to
7% range, reflecting their varying degrees of exposure to the crisis. Safe havens took centre stage
again as gold topped $1600, a nominal high, and silver shot ahead to $40. Yields on US Treasuries
and German bunds and UK gilts fell to new lows for the year. On the other side of the coin, peripheral
bond yields soared with those of Italy and Spain moving above 6% again, but this time staying there
and making 7% the next stop a figure judged to be the point of no return in the science of bond
yields. Any country that has to pay that much to find buyers for its bonds is regarded as being stuck in
a permanent debt trap out of which it is impossible to grow.

No way out
The failure of the politicians to come up with a solution to the debt problems that were now having
such a damaging impact upon the daily lives of every citizen in the developed world did nothing for
their standing in the eyes of those who elected them. The political system, in particular the American
one which made it so difficult to agree a vital deficit reduction plan, was seen as dysfunctional even
compared with those of the PIIGS (Portugal, Italy, Ireland, Greece and Spain), all of which had
quickly passed onerous austerity packages through their parliamentary systems. However, since it is
democratic systems which are being discussed, enacting measures in a parliament is one thing but
getting the people to accept them is quite another.
Strangely, despite the frightening backdrop the stock markets, perverse as ever, were ready to
respond to a run of excellent earnings reported by Americas leading companies and to strong
indications from the White House that the Democrats and the Republicans were at last getting together
to do the right thing. The news gave Wall Street its best day of the year as the Dow rose 202 points
with 27 out of its 30 constituents gaining, the NASDAQ Composite added 61 to 2826, with Apple
making a new high, and the S&P500 was up 21 to 1326. Raised hopes for a deal on the deficit
reduction plan calmed nerves considerably and gold went into sharp reverse, falling $20 to $1585.
Significantly though, US Treasury bonds actually rose slightly, pushing the yield down to practically
the lowest point of the year at 2.88%, reflecting diminished default expectations (the yield on the 30year bond fell much more sharply) as opposed to haven considerations.

A stitch in time
Wall Streets performance enthused markets elsewhere; Japans Nikkei 225 topped 10,000 again and
the Hang Seng edged over 22,000, but gains in Europe were much more restrained given that a
solution to sovereign debt problems there seemed as far away as ever. Everything depended on the
meeting of the heads of the 17 member states on 21 July and their decision on whether or not to adopt
a one for all, and all for one approach. Since the very nature of the Eurozone meant that the problem
was not going to be confined to the PIIGS if they made the wrong choice, the pressure on them to do
the right thing was enormous.
In the event, the meeting resulted in a deal that was as good as anyone could have expected. Greece
would get its money with the benefit of a lower interest rate of 3.5% and an extended repayment
schedule from 7.5 years to 15 years, revised terms which were also to apply to the loans made to
Ireland and Portugal. In addition, new powers were to be accorded to the European Financial
Stability Facility (EFSF) to provide precautionary lines of credit to help countries running into
difficulty and to recapitalise any bank in trouble. It was also permitted to buy bonds in the secondary
market in exceptional circumstances and with the agreement of the ECB. One-third of the 159
billion aid package for Greece was to be provided by private sector bondholders i.e. mainly banks
on a voluntary basis and would involve debt swaps, rollovers and the acceptance of a 20%
discount on capital values.
Since this last point was likely to trigger a selective default rating for Greece it was much more

controversial. To allay market fears it was to apply only to Greece as a special case and not to be
extended to any other country finding itself in a similar situation in the future. According to the EU
president the net result of the bailout agreement was to improve Greek debt sustainability, to stop the
risk of contagion and to improve the Eurozones crisis management ability.

One for all and all for one?

The immediate reaction in financial markets was a rebound in the euro and a sharp rise in stock
markets across the Eurozone and in London. This was led by the banks rising between 7% and 10%;
they were relieved by the shelving of the 50 billion tax on them that had been proposed by the
French. Bond yields among the PIIGS fell back to their lowest level in two weeks but still remained
uncomfortably high and the initial favourable reaction was quickly countered by a more sober
appraisal. The consensus was that the deal had contained the crisis, not resolved it, and in the
absence of a credible growth strategy and its implementation, the next crisis was just around the
corner.
With Greeces debt trading at around 50 cents in the euro, a 20% haircut was not going to be very
effective or realistic in reducing its burden. It was also widely noted that there had been no proposed
increase of the 440 billion EFSFs rescue fund which meant that there would be nowhere near
enough in the pot if Italy or Spain got into trouble. And, in any case, the whole deal was still subject
to ratification by all 17 of the parliaments of the Eurozone member states. The conclusion of almost
every commentator was that the Eurozone remained a house divided, and that the Euro as a common
currency could not continue to work without fiscal union and the creation of Eurozone bonds whereby
the debt of every member state was guaranteed. To achieve such a goal would involve a long and
difficult political process and more crises along the way were considered inevitable.

Running for cover

Stock markets took the hint and retreated again, receiving no encouragement from Wall Street, now
depressed by the fading of initial hopes that agreement on a deficit reduction plan had been reached
between the Democrats and Republicans. As a result, the final week of July witnessed a steady
erosion of share prices as investors directed their attention to the supposed safe havens of government
bonds, gold, the Swiss franc and the Yen. Their bearish mood was accentuated by disappointing
second quarter GDP figures of just 0.2% in the UK (and from the US at 1.3%) against expectations of
1.8%. This was accompanied by a downward revision of the first quarters growth figure from 1.9%
to a shock figure of 0.4%. By the last day of the month, the Dow had lost 550 to 12,143, the S&P500
had lost 52 to 1292, while the FTSE100, at 5815, was down 135.
The striking of a deal between the Obama administration and the Republicans over the weekend of 30
and 31 July sparked an initial relief rally of 139 points in the Dow on the first day of August but it
was soon dissipated as a run of below expectations manufacturing data brought the economy sharply
into focus. An austerity package long on spending cuts, even though it was below the Bowles Simpson
$4 trillion plan, would be hitting the economy when it was down, putting the US in the same dilemma
as the one facing the weaker countries of the Eurozone. Namely, how can a realistic deficit reduction

programme be compatible with any sort of growth strategy?

The dawning realisation that overspending and now over-indebted governments in the developed
world had painted themselves into a corner was to give markets their worst week since the depths of
the financial crisis in November 2008. Both the FTSE100 and the Eurofirst 300 plunged 10% to
5247 and 975 respectively. The Dow was down 5.8% at 11,444 and the S&P500 fare even worse as
it fell by 8.7% to 1199. The declines were paralleled in markets everywhere, leaving the FTSE AllWorld index off 7.6% on the week with most indexes recording drops of more than 10% from their
cyclical peaks.
It was now all too clear that the second Greek bail-out two weeks earlier had done nothing to assuage
fears of default in the Eurozone periphery and now Italy and Spain were in the spotlight. Seor
Barroso, the president of the European Commission, did not help the situation when he stated that the
EFSF should be enlarged to boost systematic capacity to respond to an evolving crisis. The
Germans were not happy with the idea and expressed their concern that in embarking upon a bond
buying spree, the ECB was exceeding its authority by doing what the fiscal authorities in individual
countries should be doing. This collectivisation of risk, they believed, posed a threat to monetary
stability and augured a slippery slope towards debt monetisation. Germany had reluctantly agreed to
the ECB buying Irish and Portuguese bonds and the offer of unlimited funds to banks to prevent the
money markets freezing, but Italy and Spain were in a totally different league.

US debt downgraded
Meanwhile on the other side of the Atlantic, Wall Street was in freefall; a downgrade in Americas
triple-A bond rating was anticipated despite the last minute bipartisan agreement over the deficit
reduction plan. Panic took hold on 4 August as the Dow dived 512 points, the S&P500 dropped 60
points and the NASDAQ Composite fell by 136. These performances contrasted with new lows for
yields on Treasuries, UK gilts and German bunds, and gold hitting a new high.
That made the jobs report for July, due the following day, a make or break news item. The 117,000
jobs created in July were comfortably above the estimates of 75,000 to 85,000, but an initial relief
rally of 170 points in the Dow was quickly replaced by a 244 point fall before the index rebounded to
end the day with a 61 point gain, said to be in response to the ECBs decision to extend its bond
buying programme to include Italian and Spanish debt.
The actual downgrade by Standard & Poors by one notch to AA+ came after the close of the US and
European markets but was greeted by sharp falls across Asia in the order of between 2% and 3%;
these performances were thought likely to be mirrored in London and New York on Monday morning.
They were, but in spades. The Dow plunged a near record 634 points to breach the 11,000 level and
end the day at 10,809 while the S&P500 lost 80 to 1119 and the NASDAQ Composite dropped 174
to 2347. In London, the FTSE100 saw its fourth triple digit drop in a row, taking it perilously close to
the 5000 level to close at 5068. The percentage decline of the FTSE250 was greater still it fell 451
points to 9861.

Double jeopardy
With two major crises running in parallel, the level of uncertainty confronting investors was daunting
but some market commentators, albeit a minority, were not downhearted and saw a buying
opportunity. Their argument was that the rating downgrade was inevitable in the circumstances and
therefore had already been priced in by the markets. Likewise for the ECBs decision to start buying
Italian and Spanish bonds. The argument ran that both of these were solutions of a sort and the
markets should see them as such. Furthermore, with bond yields falling, equities were becoming ever
cheaper relative to bonds and earnings were continuing to exceed expectations.
The contrary view held that the rating downgrade was a warning shot across the administrations
bows and that henceforth it would be compelled to implement a credible deficit reduction plan in a
near-Chapter Eleven style restructuring, without too much regard for the adverse impact it would
have on growth. Companies would have no choice but to retrench and adapt to a less benign trading
environment in which earnings would be hard to come by.
As for the ECBs bond buying programme, over 300 billion had already been dispensed buying
some 20% of the bond capital of Portugal, Ireland and Greece, and the bank simply lacked the
firepower to prop up Italy and Spain given the quantity of bonds likely to come on to the market. This
meant that it was no time for taking risks in equities, a view apparently confirmed when, within hours
of the downgrade, the yield on the now officially slightly less trustworthy US Treasury ten-year bonds
dived to a new low for the year of 2.34% (after a short-lived flash rise to 2.56%). This affirmed their
pole position in the world of bonds; the best of a bad lot.
The next couple of days 8 August through 10 August seemed to settle the argument in favour of the
bears as equity markets plunged, led by banks recording double digit percentage losses. Record oneday falls taking the Dow down to 10,719, the S&P500 to 1120 and the FTSE100 to an intraday low of
4791 looked like a re-run of the aftermath of the Lehman collapse until they were succeeded by
record one-day rises as the Federal Reserve pledged to keep interest rates exceptionally low into
2013 in response to slower than expected growth and the deterioration of the labour market. By the
end of the week the markets appeared to have survived everything thrown at them, including the threat
of a downgrade to Frances debt and a run of second quarter growth figures from the US, the UK and
France that made a double dip recession almost a certainty. The Dow was up to 11,269, the S&P500
to 1178 and the FTSE100 had recovered to 5320, apparently heartened by the perpetuation of the
Feds cheap monetary policies and perhaps by the hope of the launch of QE3 hinted at by the use of
the term as appropriate with regard to the employment of additional policy tools.
The other supposedly ameliorating factor in the Eurozone crisis in the form a ban on short selling of
financial stocks was widely seen as not very helpful and even counterproductive in light of the
ineffectual record of this strategy in 2008. As for the full percentage point fall in Italian and Spanish
ten-year bond yields in reaction to ECB buying, reputed to be in the order of 22 billion, there was no
good reason to believe that yields would stabilise around 5% in the absence of a continued buying
programme since the attendant austerity measures were all too subject to technical and political
execution risk.

Though the Spanish and Italian ten-year bonds had reacted from their peak levels earlier in the week,
the attendant rise in the price of gold to $1800 and the ten-year US Treasury bond yield touching an
intraday low of 2.03% did not suggest that all investors were placing their bets on a happy outcome.
Indeed, the rioting and looting in London and the UKs provincial cities which coincided with the
chaotic conditions in the stock markets were seen by some commentators as a rehearsal for the
demonstrations certain to break out across Europe as the authorities tried to implement the harsh
austerity programmes necessary to restore financial balance to their economies.

Germany slows down

After three straight sessions of substantial gains, taking the FTSE100 to 5350 and the Dow to 11,482,
the rally came to an abrupt halt as the hopes that had sustained it were dashed by a disappointing
outcome from the Franco-German summit on 15 August. Political opposition in Germany had already
effectively vetoed the idea of the country playing a solo supportive role, via the medium of
Eurobonds, or any form of fiscal union, in propping up southern Europe and now the news that growth
in the powerhouse of the Eurozone had stood still in the second quarter cast doubt on its ability to do
so.
That left Chancellor Merkel and President Sarkozy with little to talk about, but their conclusion that
the 440 billion stability fund was big enough to deal with the crisis was not what the markets wanted
to hear when it was clear that funding of well over 2 trillion would be required if the situation in
Italy or Spain deteriorated. Neither was the proposal for a financial transaction tax seen as marketfriendly and shares of exchange operators fell sharply. In the Eurozone, political expediency clearly
overruled economic necessity just as it had in America over the matter of the debt ceiling and the
deficit reduction plan.
In America, company reports continued to present a mixed picture with above expectation earnings
and outlook from one industrial giant countered the next day by a depressing result from another,
leading to share price moves in the order of 5% to 10% in either direction. Similarly, data on
production, housing and employment remained inconclusive but now with a clear negative bias, and a
rally sparked by one mildly encouraging report was soon snuffed out by a disappointing one.
Markets paused for breath in mid-August after their dramatic three-day surge but while the lead
indices were going nowhere, it was significant that bank shares continued to fall, reflecting fears
about their vulnerability if recession returned and the sovereign debt crisis remained unresolved.
These fears were soon seen to be justified by the report that one unnamed European bank had gone
cap in hand to the ECB to tap its emergency lending facility for 500 million. Coupled with
expressions of concern by the New York Federal Reserve about European banks drawing down their
cash balances held there, this raised the prospect of a repeat of the funding crisis of 2008 when
interbank lending virtually collapsed and money market funds were reluctant to lend.
Markets now began another downward lurch, helped on their way by Morgan Stanley cutting its
forecasts for global growth and stating its belief that America and Europe were dangerously close to
recession, a belief apparently substantiated by a raft of depressing data on manufacturing, housing,

employment and consumer spending released on the same day. The Dow plunged 420 points to
10,990 while the FTSE100 had its worst day since March 2009, losing 239 points to 5092. Asian
markets also suffered with Japans Nikkei 225 falling 224 to 8719 and the Hang Seng in Hong Kong
losing 530 to 19,486. By contrast bond yields sank to record lows with that on the Treasury ten-year
dipping below 2% intraday before closing at 2.08%, gold rose to a new peak of $1865, and demand
soared for the Japanese yen and the Swiss franc.

Cul de Sac
The stock market now became front page news once more. The VIX index, a cocktail of option trades
designed to measure the degree of anxiety present in the markets, shot up to record levels, prompting
more than one commentator to quote from FDRs 1933 inauguration speech We have nothing to fear
but fear itself. However, investors clearly knew exactly what they were afraid of. The hoped-for
recovery hadnt happened despite being dearly bought and paid for, and the debt crisis had simply
been kicked upstairs to sovereign states now seen to be unable to manage it any better than their banks
had done.
This left a huge question mark over the future and since the authorities seemed to have run out of
options, it was better to play safe. Hence the record outflow of money from equity and bond funds
into money market funds. Investors might earn almost nothing from these funds but they would not be
at risk of losing 20% of their capital as they would have done by holding some of the worlds biggest
banks in the first three weeks of August. Volatility of this degree is a traders dream but an investors
nightmare.
Practically zero interest rates for the next two years might be good for business but they also smacked
of desperation in that they seemed to be the last policy option open to the authorities. Many
commentators saw them as the first step on the road towards Japanisation as the economies of the
developed world adjusted to living with high debt to GDP ratios, deflation, depressed property and
stock markets, ageing populations and political stalemate. In the case of the stock market, it was
suggested that Japanisation had already arrived given that the period from 2000 to 2010 was the first
decade since 1950 in which the leading stock indices had failed to show a rise.
Nevertheless, this end of an era moment was not recognised as such and the supposed superior
attractions of equities over bonds in the long-term, i.e. over a ten-year timescale, continued to be
trumpeted. This lack of acceptance of what was looking like the new normal presented an
opportunity for major rallies as investors seized upon new policy action as promising a return to
yesterday. Thus if the idea of another round of QE to try to kick-start the recovery appeared to be
ruled out by signs of incipient inflation, it was likely to be seen as worth the risk. Already with
inflation at 4.4% in July, the Bank of Englands Monetary Policy Committee (MPC) voted
unanimously in August to keep interest rates unchanged at 0.5%. The latest growth figures from the
Eurozone seemed certain to cause the ECB to rethink its tightening bias and possibly reverse the July
rate rise to 1.5%.

Ace in the Hole?

The final week of August opened on a brighter note with markets supposedly responding to the
prospect of an end to the fighting in Libya and the restoration of the countrys oil exports. The London
market also took heart from the substantial premium attached to Autonomy by Hewlett Packard, which
indicated that the whole UK software sector was underappreciated and undervalued. Share prices
across the sector rose by 2% and more with chip designer ARM particularly in favour and now seen
as a possible target for Apple, one of its biggest customers.
Hopes were also high that Ben Bernanke would come up with some new ideas, short of QE3, at the
Federal Reserves annual meeting in Jackson Hole at the end of the week. With bids and rumours of
bids further aiding sentiment, markets embarked upon a dramatic thee-day climb. The Dow plussed
500 points to 11,320, the S&P500 was up 54 to1177, the NASDAQ Composite climbed 123 to 2467.
In Europe the FTSE100 gained 164 to 5205 and the Eurofirst 300 added 27 to 936. It looked as if risk
was on again as the US Treasury ten-year bond yield rose in those three days to 2.26% and the gold
price, which had touched $1900, crashed by more than $150.
Unfortunately for the bulls, market strength was compromised by the fact that once again banks failed
to join in the rise, hinting at serious problems in the sector yet to be revealed. In the US, Bank of
America, an institution seen as representative of the country, was the most prominent loser, its share
price already having more than halved over the year while in Europe the share price of almost every
bank seemed to be heading back towards its low point of March 2009. The capital position of all of
them might have looked a lot better than it did at that time, but recession and regulation had been bad
for business and this time around their respective states were in no position to mount another bailout
operation.
Warren Buffet now lifted bank shares off the bottom with a reprise of his move on Goldman Sachs in
October 2008, demonstrating his confidence in the future of Bank of America with a $5 billion
investment. However, it should be noted that it was the same sort of copper bottomed, belt and braces
deal he had done with Goldman Sachs, zeroing-in on preferred stock with a 6% coupon together with
an option to buy 700 million of common stock at $7.14 until 2021. Thus, apart from the confidencebuilding factor, it was a better deal for the shareholders of Berkshire Hathaway than for those of the
Bank of America.

Passing the buck

There were no surprises coming out of Jackson Hole beyond expressions of confidence in the US
economy and just a hint that something might be done to promote a stronger recovery after fuller
discussion at the September monetary policy meeting. That hint was enough to overcome initial
disappointment with Bernankes speech and a 200 point fall in the Dow was transformed by the end
of the day into a 134 gain.
The NASDAQ Composite continued its spectacular recovery, gaining another 60 to 2479 thanks to
buyers returning in force for the big names in technology. The fact that the Fed chairman also stated

that growth policies were outside the province of the central bank served to focus attention on what
the President might say in his keynote speech on Labor Day a week hence. With the news that the
already disappointing 1.3% second quarter growth figure was being revised down to just 1%, the
odds on the deployment of some of the Feds range of tools capable of providing additional
monetary stimulus seemed to be shortening.
Such hopes kept markets on a roll in the concluding three days of August with further encouragement
provided by Hurricane Irene doing less damage than feared, a slightly better than expected US
consumer spending report for July and a Greek bank merger seen as taking some of the heat out of the
Eurozone crisis. All this was enough to send the Dow up to 11,612, the S&P500 to 1218 and the
NASDAQ Composite to 2579, providing an example for London to follow when it reopened after
Bank Holiday Monday.
The FTSE100 plussed 264 points over the next two days to 5394, the FTSE250 topped 10,000 again
with a rise of 246 to 10,243, and the Eurofirst 300 added 24 to 964. However, the fact that safe
haven bond yields had reversed their recent rise and the gold price was on its way up again suggested
to many observers that markets were demonstrating their overoptimistic bias. This view gained
credibility as far as the Eurozone debt situation was concerned; worrying events were all around as
there were signs of a political crisis brewing in Germany as Chancellor Merkels partners sided with
the opposition to brand the ECBs bail-outs and bond buying as unconstitutional, the Italian
government backtracked on its austerity package and collateral agreements were demanded as
conditions for EU states to participate in the Greek bail-out.
As for hopes of economic recovery in the US, the Eurozone and the world in general, they were
dashed in the first two days of September as PMI data for manufacturing and services everywhere
neared or actually fell below the critical 50 level which marks the borderline between expansion and
contraction. Against such a backdrop, the US non-farm payroll number for jobs created in August was
going to be accorded even greater significance than usual. The fact that it came in at zero sent markets
into a tailspin and US and German ten-year bond yields plunged to new lows of close to 2% as gold
climbed back towards the $1900 level.
Nevertheless, market strategists at HSBC, Citigroup and UBS were not dismayed and reaffirmed their
end-year targets for the FTSE100 at 6300, 6200 and 6100 respectively, basing their optimism on the
belief that companies were in good shape but that the problems lay with the high debt levels of
governments and consumers. Thus their forecasts were subject to the caveat that it was difficult to
see sustainability of earnings if theres another recession and that it could all go wrong!

Another Black Monday

With Wall Street closed for Labor Day on 5 September, it was left to European and Asian markets to
react to the Dows 253 point fall on the dismal jobs figure and the latest round of disappointing
economic data, all against the background of a growing Eurozone debt crisis. Banks led the markets
down, helped on their way by the pronouncement of Deutsche Bank CEO, Josef Ackermann, that a
number of European banks would collapse if their holdings of sovereign debt were marked to
market. The banks of the weaker Eurozone countries were regarded as especially vulnerable since
their fate was inextricably linked with their governments, a point driven home by bond yields in Italy
and Spain rising again despite substantial purchases over the week by the ECB.
UK banks were also prominent fallers with investors worries over regulation and restructuring and a
looming recession. This was compounded by multi-million dollar lawsuits over the alleged
misrepresentation of the status of securitised mortgage debt sold to US institutions. These fears were
reflected in the cost of insuring the banks bonds against default rising to record levels as shares of
those named on the lawsuits RBS, HSBC and Barclays all recorded significant losses.
The UKs High Street retailers were also sold down in the wake of gloomy August sales figures as
consumer confidence waned in the face of high inflation and low wage growth. Dixons Retail Group
(Currys and PC World) continued to suffer from increasing competition from the major supermarkets
in its core consumer electronics business and the share price at 10p was now back to its low point of
March 2009. Mining and oil shares also lost ground on growing fears of a global slowdown; the
continuing problems of BP, a major holding in every pension fund in the country, served as a
reminder to investors that buy and hold is not guaranteed to be the best investment policy.
The FTSE100 ended the day down 189 at 5102, a loss of 3.6%, but Germanys DAX fell 5.6% and
Frances CAC40 fell 4.7%, as investors ran for cover. Government bonds were in demand, pushing
the yield on ten-year Treasuries to below 2% and that on German Bunds to a record low of 1.87%,
while gold recovered the whole of the previous weeks dramatic loss to top $1900 again. The flight
to the Swiss franc had reached such a level that the Swiss National Bank was prompted to intervene
to protect its export-oriented economy and it pegged the euro exchange rate to SFr1.20.
But just two days later the merry-go-round saw the bulls back in charge. Apparently they had taken
inspiration from the German courts rejecting the contention that the bail-outs and bond buying
operations of the ECB were outside the law and from the prospect of another round of stimulus, albeit
short of QE3, to be revealed by the US president in his Labor Day speech on 8 September. The Dow
topped 11,400 again and the NASDAQ Composite reached 2500. But, significantly perhaps, the
S&P500 just failed to make it back to the 1200 mark, while in London the FTSE100 added almost
250 in three days to reach 5340.
Unfortunately for the bulls, a more considered appraisal of the judgement of the German courts
coupled with doubts that the Obama administrations $450 billion Jobs Act would make it through
Congress, made the rally look more like a swan song. The first did provide a positive in that the
courts did not judge the actions of the ECB to be in violation of the Eurozones constitution but at the

same time it stipulated that major decisions should be subject to parliamentary approval of member
states. This meant that important EU initiatives would become political footballs in every parliament
in the region, making the quantum leap towards fiscal and political unity, so desired by the
Europhiles, a forlorn hope. As for the Jobs Act, while the size was much greater than expected and
the halving of payroll taxes and the plans for infrastructure spending met with broad approval, it was
widely believed that Republicans would see it as a pre-election pitch and oppose it on principal.

To buy or not to buy?

If such considerations were enough to call a halt to the rally, signs of a split within the ECB over how
to deal with the regions debt crisis were to send the markets into sharp reverse. The catalyst was the
resignation of Jrgen Stark, the banks chief economist and executive board member, who was known
to be opposed to the banks buying of Italian and Spanish bonds. The cost of insuring sovereign debt
soared and the yield on Greek debt topped 25%, a level interpreted as providing a 98% chance of
default. Bank shares across the region fell by 10% or more with those of France in the lead given
their exceptionally large holdings of Greek sovereign debt, now seen as greatly overvalued.
In the UK, banks had their own problem to deal with in the shape of the Independent Commission on
Banking which recommended that banks retail arms should be the ring fenced and share prices
tumbled in response. Fears about exposure to the problems of European banks and to stalling
economies both at home and abroad led to falls in the 5% to 10% range among US national banks and
the Dow dipped below 11,000, unimpressed by a lacklustre speech on the economy by the Fed
chairman in which he made no mention of deploying the tools at his disposal.
However, a further 168 point dip to 10,824 was turned into a 69 point gain to 11,062 on a rally
supposedly triggered by expectations that China would step in as a buyer of Italian bonds after a
report that China Investment Corporation (CIC) officials had visited Italys Ministry of Finance. Most
commentators thought that this would be an unlikely event since the CICs premature foray into
Portuguese bonds had incurred losses and in any case the ECB was already a buyer. At the same time,
the incident stressed that the Eurozone debt crisis was now the main focus of market attention, a point
made all too clear as the Euro fell out of the $140 - $145 box that had contained it for the preceding
six months, helped on its way by signs of the ECB relaxing its hawkish monetary policy stance and the
prospect of a rate cut.

Holding the line

A joint statement by Germany and France on 15 September that Greeces future remained in the
Eurozone seemed to reassure investors, raising hopes that Greece would continue to receive funding
and avoid default, and markets continued to rise. Fears about the stability of Eurozone banks were
also allayed by the agreement of the developed worlds five leading central banks to provide shortterm dollar funding to those banks shut out of US money markets, and Senor Barroso delivered his
own boost to sentiment by pledging to come up with proposals for the creation of Eurobonds. Less
welcome in Europe were the urgings of the US Treasury Secretary, Timothy Geithner, for the regions
leaders to get their act together, given that the Obama administration was not seen a much of a model
for integrated policy action.
By the end of the third week in September, the rally appeared to have run its course but after a 5.2%
gain over five straight sessions, the S&P500 had managed to regain the technically significant 1200
level, the Dow had topped 11,500 and the NASDAQ Composite was above 2600. In London, the
FTSE100 plussed 3% to 5368 and the Eurofirst 300 had firmed 2.3% to 937. In the context of this
renewed wave of optimism, bond yields were rising again and gold fell back to below the $1800
mark. The breaking news of a $2.3 billion loss racked up by a rogue trader at UBS failed to spoil the
party, save that of the bankers who had seen the ICB report as not too bad but now heard calls for the
timescale for its implementation to be accelerated.
Markets marked time awaiting the outcome of continuing high level talks between the troika of the
IMF, the European Commission and the Greek premier, but by now practically every financial
commentator saw default as inevitable. It was no longer a case of if by when. They also expressed
surprise that the markets could entertain any hope that the dreaded event could be avoided by granting
a second instalment of the bail-out package in return for the passing of even harsher austerity
measures than the original ones that had led to massive civil unrest.
By the same token, the rise in European markets on the day that Italian debt was downgraded one
notch and given a negative outlook by Standard & Poors was regarded as illogical and clearly had
more to do with expectations that the Feds two-day meeting later in the week would see another
rabbit pulled out of the hat in some form of stimulus. The betting was on the Fed selling shorter-term
Treasuries to buy long-term ones in their place, thus holding its balance sheet level while keeping
interest rates low in a strategy called Operation Twist.
Most commentators saw little merit in the manoeuvre since long-term rates were already at historic
lows and because supposedly much more stimulative measures had obviously failed in the last two
and a half years, indicating that the Fed was flogging a dead horse. Using a gaming analogy, one
writer, Simon Black of GB Capital, suggested that Ben Bernanke, when faced with the simple choice
of Stick, twist or bust, was going for the only choice that gave him any sort of chance. Similarly, the
London market remained firm on indications that the Bank of Englands MPC was ready to downplay
inflation expectations and vote for a further round of QE.

Against the odds

Unfortunately for the bulls, the markets were to demonstrate that it is better to travel hopefully than to
arrive. The unveiling by the Fed of the $400 billion Operation Twist had the misfortune to occur on
the same day the IMF chose to downgrade growth forecasts both for the US and the world and when
the European Commission revealed that growth across the European Union had slowed to a virtual
standstill.
Thus with the sovereign debt crisis still in full swing and European banks seen to be struggling with
capital and asset quality shortfall, this growing evidence of a slowdown in global growth gave
investors nothing to hang on to and nothing to look forward to. It seemed that all their disappointed
hopes had coalesced at one point and markets everywhere reacted violently, wiping out the whole of
the preceding weeks gains and then some.
Commodities suffered along with equities on the prospect of falling demand and to the surprise of
many, gold and silver prices also nose-dived as their supposed safe haven characteristics were
forgotten in the dash for cash. The popular explanation for their abrupt fall from grace was profittaking by those who had been buyers earlier in the year, to pay for their large losses incurred in the
rest of their portfolios. It was also noted that haven status required a high degree of stability and
predictability and that the recent extraordinary volatility in the prices of gold and silver undermined
their traditional role of providing insurance against the depreciation of paper currencies.
In the final week of September, the Eurozone crisis was at the top of every agenda and hopes centred
on a 3 trillion plan drawn up at an emergency meeting of the G20 finance ministers at the IMF HQ in
Washington. It was designed to save the euro by recapitalising at least 16 continental banks with a
substantial injection of funds plus contingent capital reserves to be drawn on if required, thereby
giving Greece the room to default without bringing down the regions banking system. The EFSF
would also be given additional funds to increase its bailout capability. After two days that had seen
nearly 700 points wiped off the Dow, 70 off the S&P500 and the FTSE100 dipping below 5000, a
return to marginally positive territory on 23 September reflected hopes that all was not lost. In the
words of Tim Geithner, the threat of cascading default, bank runs and catastrophic risk, had been
taken off the table.

The game goes on

On the evidence of a relief rally over the next two days that saw the losses of the previous week
regained, it might have been assumed that all these risks involved had indeed been taken off the
table. However, this was clearly not the case and most commentators agreed that this was only the
beginning of a long and difficult process and markets were getting more than a little ahead of
themselves. A Financial Times economics correspondent Wolfgang Mnchau was rather more
sceptical, doubting the ability of the members of the European Council to come up with an action plan
of a scale hard to fathom to save the euro and that, even if they did, they would struggle to go on and
sell it to their constituencies.

Still, after three days of rises that had taken the FTSE100 up 250 points and the Dow up 450, hopes of
an enduring solution to the Eurozone debt crisis appeared to be winning out over such scepticism;
buyers took more notice of the Greek premiers claim that he would do whatever it takes than of the
angry crowds thronging Syntagma Square and demonstrating the political and execution risk
involved in implementing austerity programmes in a democracy.
Or they did, at least, until the final day of September when the Dow plunged 240 to below 11,000
(hitting 10,913), the S&P500 lost 29 to 1131, the NASDAQ dropped 65 to 2415, the FTSE100 fell 68
to 5128 and the more domestically-exposed FTSE250 fell 166 to 9819. European markets also
recorded significant losses, but most striking were the setbacks in Asian markets where Hong Kong
saw 770 points trimmed from its index and Tokyo witnessed 155 taken from the Nikkei 225, with
sentiment further damaged by a run of disappointing manufacturing data from China.
The net result was that stock markets everywhere had experienced one of the worst quarters on
record. The FTSE All-World index was down 17% to log its poorest performance since the Lehmanaffected fourth quarter of 2008, the S&P500 fell 14.3% to record its worst performance since that
quarter too, while the FTSE100 dipped 13.7%, a fall unmatched since the aftermath of the dot.com
collapse in 2002. Hong Kong managed to beat all other markets on the downside with a 21.5% drop
to 16,822, close to the level ruling at the time of its reunion with mainland China 14 years earlier.

Back to the drawing board

It was no surprise that end-year forecasts for the FTSE100 would be subject to revision and The
Sunday Times invited the investment bankers polled at the beginning of the year to revisit their
predictions. Goldman Sachs thought the index would be going nowhere and could even post a
negative gain compared with its original forecast of 7100. Morgan Stanley revised its forecast of
6400 to below 5000, while Deutsche Bank, Citigroup and UBS revised their forecasts from 6880,
6750 and 6700 respectively to 5800, 6200 and 5900. Substance for such rethinking of earlier
optimism was provided by the now widespread recognition of the high probability that even if euro
disaster could be headed off, this would not mean that a double dip recession was not still on the
cards and such an event would serve to betray former earnings expectations on a grand scale.
So save for one or two fans of contrary opinion, no one entered the final quarter of the year with high
hopes. Rather there seemed to be a more generalised appreciation of the probability that the
authorities, i.e. the central bankers and their political masters, were in unfamiliar territory and faced
with an impossible problem for which there was no simple or acceptable solution. This was a Catch
22 world where the question How can an economy grow as it embraces a necessary and credible
deficit reduction programme?, cannot be answered by those who created the problem in the first
place.
Registered to a.mudassar88@gmail.com

Quarter four, October to December

Eurozone crisis rolls on
The final quarter of 2011 opened inauspiciously with the Dow plunging 258 to 10,655, the S&P500
slipping 32 to 1099, the NASDAQ Composite down 79 to 2335 all the lowest levels of the year
while the FTSE100, after dipping below 5000 intraday, closed down 53 at 5075. As always, Wall
Street was calling the shots and Asian markets followed it down as the Hang Seng dived another 572
to 16250 and the Nikkei Dow fell 89 to 8456.
The apparent failure of the Eurozone leaders to get to grips with their debt crisis was now seen to be
a threat to everyone, everywhere, and was assumed to be the principal reason for the market slide; but
sentiment in the US was also adversely affected by a sharp fall in the share price of AMR, owner of
American Airlines, and rumours of a bankruptcy filing after four loss making years. Adding to the
gloom was the news that 130-year-old former Dow constituent, Eastman Kodak, was to undertake a
restructuring following its failure to find a new role for itself in the face of the digital revolution and
foreign competition.

Dexia in trouble again

In the same week, further depressed by Moodys downgrading of Italian debt, the Dow initially lost
another 250 to 10,404 and the S&P500 fell to 1087, at which point it entered technical bear market
territory by racking up a 20% decline from its May high. But then in the final hour of trading US
markets staged a dramatic recovery in response to an unsubstantiated newspaper report that EU
leaders had pledged to come up with a plan to recapitalise ailing European banks. Hopes were
further boosted by the prospect of another round of stimulus after Ben Bernanke had concluded a
downbeat assessment of the US economy by saying that the Fed was prepared to take further action
as appropriate. The Dow ended up 153 on the day at 10,808 and the S&P500 trimmed its 20% drop
with a 24 point advance on the day, taking it to 1123.
With the rebound coming after the close of European markets they did not have the opportunity to
track Wall Streets gains until the next day but even when they did a majority of market commentators
believed that US buyers had been clutching at straws. There had been no formal decision to support
the banks and use of the European Financial Stability Facility (EFSF) to do so would have to go
through a process of ratification by all the member states.
And things were moving quickly. Dexia, the Franco-Belgian bank that specialised in municipal
funding, was in trouble again after being denied access to wholesale money markets. Since this was a
facility upon which many other European banks relied, it was hard to avoid the conclusion that they
could soon find themselves in the same predicament as Dexia, especially now that toxic sovereign
debt was an issue, something it had not been three years ago. France and Belgium agreed to guarantee
Dexias debts to the tune of 90 billion and orchestrate a break-up but the fact that the bank was
having to relive its experience of 2008 served to confirm the suspicion that Eurozone banks and their

governments had not done as much to clean up their financial act as had their US and UK rivals.
The point was not missed that Dexia had passed the latest bank stress tests with flying colours, tests
that still had not factored in any re-pricing of sovereign debt held by the banks as core capital and
usually held to maturity. To impugn the inviolability of sovereign debt seemed to be regarded as a
form of lse majest, but with banking analysts already talking about a discount of 60% for Greek
sovereign debt, one of 40% for that of Portugal and Ireland, and 20% for Italy and Spain, a more
realistic approach was clearly going to be needed in a recapitalisation move estimated to involve a
minimum of 200 billion.

Waiting on the Fed

Meanwhile US markets and their followers continued to advance, interpreting the Fed chairmans
statement that the recovery was close to faltering as making it even more likely that he was ready to
take further action as appropriate, complementing the Bank of Englands 75 billion gilts
repurchase programme as well as the ECBs move to buy 40 billion of covered bonds and make
unlimited liquidity available to the banks. Then hopes that the US economy might be a little less
faltering than first thought were revived by the September jobs report which showed a gain of
almost twice the number expected accompanied by retail sales data for the month also coming in well
above forecasts. However, on the eve of the G20 summit to hammer out the recapitalisation
proposals, a sourer note was sounded by the ratings agencies downgrading of a dozen UK banks and
financial institutions as well as knocking another notch off the debt of Italy and Spain.
One City editor was highly critical of the UK bank downgrades on the grounds that they were not at
risk and that in any case the ratings agencies were not perfect, remembering their endorsement of the
sub prime securities that had caused the crisis in the first place. A contrary view held that knowing
they had made mistakes in the past, the agencies were simply covering their backs in the knowledge
that an intensified Eurozone debt crisis would leave no bank anywhere unscathed. Furthermore, their
action was consistent with the Bank of England governors view that the world was experiencing the
worst financial crisis in history.

Saving the banks

Reports that the G20 had agreed to a comprehensive plan to rescue Greece, recapitalise the banks and
beef up the EFSF, and that it would be announced after a further meeting in the first week of
November, seemed to satisfy investors. Hope triumphed over scepticism and stock markets soared.
Not surprisingly, bank shares were major beneficiaries with those of France in the lead, but resource
stocks and commodities also recorded substantial gains in the expectation that a solution to the crisis
meant that the chances of a double dip recession were diminished. Wall Street shared in the
enthusiasm over these supposedly dramatically improved prospects in Europe and rises took place
across the board with the Dow moving up 330 to 11,433, the S&P500 climbing 30 to 1194 and the
NASDAQ Composite up 86 to 2566.
In London, the FTSE100 added 450 points in four days to reach 5400 while in Europe the Eurofirst

300 gained 70 over the same period to 962. The Euro also rallied strongly from a low of $1.33 to
$1.36. Asian markets followed suit with Hong Kongs index climbing 2000 points to top 18,000
again, helped by reports that the Chinese governments domestic investment arm was topping up its
holdings of state-owned banks in a confidence-building move designed to allay fears of problems
developing in an overheated property sector.

Boosting the EFSF

If such a strong performance by the markets was enough to convince most strategists within the
financial institutions that a resolution of the Eurozone debt crisis was being forged, sceptics in the
shape of practically every economist and City columnist still harboured the gravest doubts. The latter
emphasised that all that was on the table were proposals a deal was still a distant prospect and
recognition of the dire consequences of failure was not enough to ensure a happy outcome. In any
case, commentators reasoned, throwing money at the crisis was not going to solve it. The EFSF, they
stressed, was not a limitless resource but an agglomeration of guaranteed monetary contributions
apportioned around the Eurozones member states or, in other words, a fund created by a group of
over-indebted low growth nations to help another group of even more over-indebted no-growth
nations.
Furthermore, the EFSFs bonds had a rating inferior to those of Germany and their credit spread over
the Bund had widened threefold since July in a period that had seen the cost of insuring top-rated
French and German debt rise to record levels. As for leveraging up the existing 440 billion fund to
the estimated 1 trillion or even 2 trillion required to deal with the crisis if investors saw this as
the answer not a single economist could be found to agree with them. Rather the latter saw such an
increase of the guarantees by the stronger member states to this level as a form of contagion spreading
the risk from the periphery to the heart of the Eurozone and creating a fiscal union of sorts but one
without the structural reforms required to make it work and create a platform for growth.

Greece hangs on
The reports that Greece would get the 8 billion second tranche of its bailout package to see it
through to the end of the year in spite of the fact that it had fallen behind in implementing the
promised austerity measures and its budget deficit had risen seemed to convince investors that
everything possible would be done to prevent the country defaulting. Accordingly, markets continued
their rise for a second straight week, coping with a mixed bag of results at the start of the US third
quarter earnings season, more evidence of slowing growth in China, and yet another downgrade of
Spains government debt.
By the end of the second week of October, the major US indices had recovered most of their August
losses and moved into positive territory for the year to leave the Dow at 11,644, the S&P500 at 1224
and the NASDAQ Composite at 2667. The FTSE100 had gained over 500 points from its low of
4944 at the start of the month to reach 5465 and the Eurofirst 300 had put on over 60 points to 975.
There was a brief setback at the beginning of the third week of October when a leading German

politician asserted that no instant solution to the debt crisis should be expected to emerge from the
imminent G20 summit but a triple digit loss was transformed into a triple digit gain on a report that
Germany and France had agreed over the nature of the funding and settled for a fivefold increase in
the EFSF. Given the obstacles being encountered in the implementation of austerity programmes, as
evidenced by the turmoil on the streets of Athens, informed opinion had it that the EU leaders felt they
had no choice but to keep throwing money at the problem and hope for the best. In such a risk-on
situation, the bears argued, instead of placing their bets investors would be better advised to watch
and wait.

UK unemployment and inflation rise

The London market had its own problems with rising unemployment, disappointing retail sales
numbers and official forecasts of fourth quarter GDP growth to be near zero. The Bank of England
was also seen as having little option but to provide a further dose of quantitative easing (QE) to the
economy. It was a policy decision nevertheless widely criticised both for its doubtful efficacy in
increasing the flow of credit in the context of a dysfunctional banking system and for its more certain
adverse impact on savings and pensions.
CPI inflation then complicated the picture further by coming in at 5.2% in September, a 20-year high.
Given the 2% target this figure was considered to make the Bank reluctant to boost QE up to 100
billion, the top of the range apparently under discussion at the last meeting of the Monetary Policy
Committee (MPC). Such reluctance was welcomed by many commentators who saw the latest round
of QE as another step on the road to debt monetisation and eventually runaway inflation.

Another Grand Plan

Stock markets were in no mood to pay heed to all these caveats and hopes remained high that the
European leaders would devise a comprehensive plan to deal with the regions debt crisis. By the
end of the third week in October, the Dow had topped 11,800, the S&P500 was up to 1238, recording
a 9% gain over the month to date, and the NASDAQ Composite had reached 2637. In London the
FTSE100 was within a whisker of 5500 again and in Europe the Eurofirst 300 was close to regaining
the 1000 level.
The bulls were delighted but the bears were unshaken in their conviction that the Eurozone debt crisis
was simply not capable of resolution and that markets were rising on unrealistic hopes. The argument
of the bears went that there was no way the PIIGS (Portugal, Italy, Ireland, Greece and Spain) could
grow their way out of their problems while instituting austerity programmes and with all 17 member
states pursuing the same path, overall growth was certain to be seriously inhibited. It was argued that
the weak would pull down the strong, a development already in train as evidenced by rising bond
yields in both categories.
But the bears were wrong at least for the next couple of days and the announcement on 27 October
that the European leaders had agreed on a package of measures to prop up Greece, recapitalise the
banks, and increase the firepower of the EFSF sent world stock markets soaring. The FTSE All

World index rose 5.6% on the week to regain its peak levels of July and August. This was led by the
Dow recording a 423 point gain to 12,230, the S&P500 moving up 47 to 1285 and the NASDAQ
Composite climbing 100 to 2727. European markets also rose strongly with Germans DAX up 6.3%,
Frances CAC 40 up 5.6% and the broader EuroFirst300 rising 4.1% to 1017. In London the
FTSE100 registered its fifth straight weekly gain this time of 3.9% as it rose to 5702.
Asian markets also responded positively to the news and Japans Nikkei Dow topped 9000 again and
Hong Kongs Heng Seng surged through the 20,000 level. Banks were in the vanguard of the advance
but their gains were soon trimmed as investors looked with a more critical eye at the detail in
Europes grand plan. Primarily, the worry was that in the process of boosting their capital to 9%
core tier one ratios, the banks would shrink their balance sheets by restricting lending, thus creating a
negative feedback loop, hurting asset prices and leading to higher provisions for loan losses.
Writedowns of the magnitude of the 50% haircut on Greek sovereign debt held by banks and other
financial institutions, voluntary or not, allied with the prospect of hard times in a coming recession,
made the proposed capital increases look woefully inadequate. Similarly, the 1 trillion figure judged
by EU leaders to be sufficient to enable the EFSF to prevent the debt crisis spreading to Italy and
Spain was also shown to be not enough to inspire confidence when the next day Italy had to pay
6.06% at an auction of its 10-year bonds. This interest rate contrasted with the 5.86% paid just a
month earlier and came despite intervention by the ECB on the open market.

The Big Bazooka misfires

The virtually unanimous conclusion of commentators on the economy and the markets was that the
G20 summits promised Big Bazooka had turned out to be a peashooter and had done nothing to
address the regions structural deficiencies that had led to the crisis in the first place. Without a
credible strategy and a plan for returning to growth, a resumption of an escalation of the crisis was
seen as inevitable. An apparently upbeat third quarter growth figure in the US did nothing to lighten
the mood even though a modest 0.6% was presented in a more encouraging form as an annualised rate
of 2.5%.
The Organisation for Economic Co-operation and Development (OECD) then weighed in with its
assessment of Eurozone growth prospects which looked for a marked slowdown in 2012 and growth
of no more than 0.3% against this years 1.6%. The UKs slightly better than expected third quarter
growth of 0.5% was also widely seen as no indicator of further improvement in the fourth quarter
given the weakening Purchasing Managers Index (PMI) figure for manufacturing and a long history of
revisions.

Greek democracy disappoints

If rising Italian bond yields had cast doubt on the effectiveness of the Eurozones comprehensive plan,
the shock decision of the Greek prime minister to offer the population the choice of accepting it or not
in a referendum, put everything back to square one. Since Greeces plight had been created by the
actions of a political and financial minority, it seemed only fair in the birthplace of democracy that
the majority should have its say, but the decision also illustrated the near-impossibility of ever getting
17 very disparate nations to act in unison. The difficulty of herding cats was a comparison that came
to mind for more than one commentator.
The markets took fright on seeing the rationale for the October rally swept away in an instant and on
the last day of the month share prices plunged on exchanges across the world. Bond yields in
countries regarded as safe havens dived to record lows with that on US 10-year Treasuries dipping
below 2% as risk off once again became the name of the game. The dollar returned to favour and the
Euro crashed to $1.36 from the $1.41 level it had reached three days earlier on revived stability
hopes for the region and then Japan added to currency volatility as massive intervention by the central
bank to weaken the yen led to a fall against the dollar from 0.75 to 0.78.
Commodity prices also lost all their recent gains as global slowdown fears increased and gold
disappointed its many fans by falling below $1700 at one point and casting doubt on the reliability of
its safe haven status. The first trading day of November saw heavy losses continuing on stock markets
everywhere on fears that the delays involved in implementing the proposed Greek referendum would
make default inevitable. By the close the Dow was down 574 points from its rally peak to 11,657, the
S&P500 was down 66 to 1218 and NASDAQ Composite had slipped 131 to 2607. In London, the
FTSE100 at 5421 had seen almost 300 points trimmed from its 27 October high and the Eurofirst 300
had lost 57 over the same period to end the day at 961.

ECB cuts rates

The markets rollercoaster ride carried on for the rest of the first week of November with a vigorous
bounce back sparked by the dropping of the Greek referendum plan accompanied by the call for a
vote of confidence in the present Greek government. The ECB also cut its key interest rate by 25 basis
points to 1.25% (although most commentators believed a cut to 25 basis points would have made
more sense in the circumstances). These events were clearly judged by investors to carry more
weight than the postponement of the EFSFs planned 3 billion bond sale due to lack of demand and
Italy having to pay 6.4% on 10-year bonds at its latest auction, again despite supportive purchases by
the ECB.
The question was now ventured that if the EFSF was not able to raise 3 billion, how could it hope to
find backers for its new 1 trillion bailout fund? The statement about the US economy made by the
Fed chairman might also have been expected to damage sentiment but downward revision of growth
and employment prospects was rather interpreted as boosting the chances of QE3.

MF Global in the dock

One other event in the week that could have been seen as ultra-bearish was the collapse of the futures
and commodities broker dealer MF Global resulting from its $6.3 billion exposure to peripheral
Eurozone sovereign debt which had prompted credit downgrades, margin calls and capital increase
demands from the regulators. Bear Stearns had shown in 2007 that there is never only one cockroach
and if CEO, Jon Corzine, a former CEO of Goldman Sachs, could make such a bad bet, he was not
likely to have been the only one to have done so.
The matter was further complicated by the disappearance of $633 million of client funds in the week
post-audit leading up to the bankruptcy filing. The fallout from the situation was soon to hit other
broker-dealers and in New York, Jefferies shares dived by 20% on news of client defections and
futures exchange CME also fell sharply. Meanwhile in London nervous selling cut 20% from ICAPs
share price as confidence in the sector was undermined and counter-party risk flagged.

Italy in the frame

Despite this worrying background, hopes remained high that the G20 meeting reconvened in Cannes
for the last day of the week would result in positive action to resolve the Euro crisis. The fact that
nothing came out of the meeting in the from of a credible crisis resolution strategy proved a great
disappointment, especially for those who had been looking for some degree of participation by the
International Monetary Fund (IMF) given the global ramifications of the problem. Italys prime
minister, Silvio Berlusconi, also failed to inspire confidence in his austerity programme after taking a
crisis, what crisis? approach to those who questioned the countrys ability to refinance some 300
billion of public debt in 2012.
The consequences of this lack of progress were soon seen as Italys 10-year bond yields jumped to
6.68% on the first trading day after the conclusion of the Cannes meeting. The countrys funding costs
were now uncomfortably close to crossing over 7% and into the danger zone where debt levels are
judged to be unsustainable and with 1.9 trillion of debt to finance, Italy had more to worry about
than most. Given that Italy was the third largest economy in the Eurozone, ranking after Germany and
France, and had the third biggest bond market in the world, the problems of Greece paled into
insignificance beside those of a country not too big to fail, but too big to bail.
Despite this clear evidence of the Eurozone debt crisis being ratcheted up to a much higher level,
stock markets showed little sign of alarm, apparently looking for political changes at the top in Italy
and Greece to ensure that the required austerity measures and structural reforms were implemented.
However, the rally taking the Dow well over 12,000 again and the FTSE100 to over 5600 intraday in
mid-November was not accompanied by the usual sharp rise in US Treasury and German Bund yields
seen in recent rallies. At the other end of the bond market spectrum, Italian yields moved above the
7% red line and into territory that had forced Portugal, Ireland and Greece to seek bailout funds.
The plight of Italy now supplanted Greece as the hot topic on the financial pages, serving to unsettle
stock markets already rattled by a run of downgrades of GDP growth and by the failure of the bi-

partisan Super Committee in Washington to agree on the scaled-down $1.2 trillion deficit reduction
plan. Nevertheless, markets were to respond positively to the resignation of the Greek and Italian
premiers and their replacement by unelected technocrats and to further intervention by the ECB.
Buying of Italian bonds pulled their yields back to 6.5%, managing to give the impression that the
situation was being brought under control in anticipation of the comprehensive and wide-ranging
package of reforms to be delivered by the new rulers of Italy and Greece.

The technocrats take over

Most economists believed that investors were jumping the gun and that the grey technocrats were
going to have no more success than their predecessors in foisting austerity and reform on a restive
population. The overwhelming consensus was that having embarked upon the Eurozone experiment,
Germany and France had no choice but to see it through to its logical conclusion of fiscal union by
making the ECB the lender of last resort with the same powers as the Federal Reserve and the Bank
of England and issuing Eurobonds. It would be a long, hard slog fraught with political difficulties as
structural reforms were carried out across the region but this was an all or nothing situation and
nothing was not an option.
Anything less would be only a temporary patch-up, prolonging uncertainty and making a solution even
more difficult. But there was still no question that whatever master plan the Eurozone leaders
devised, it would take time to get it accepted and the way bond markets were behaving it now looked
as if time was fast running out.
Bond investors are not the sort to wait and see how things are going to turn out and given the alarming
speed of the deterioration in peripheral sovereign debt markets in the year to date and even in the last
month, it was clear that pre-emptive action was the order of the day. Unlike equities, bonds are
supposed to be a relatively safe and risk-free asset forming the rock upon which the whole financial
system is based, and as such they comprise core holdings for banks, insurance companies and pension
funds. The managers of these financial institutions are not in the business of risk-taking and if the rock
of the Eurozone bond market was starting to crumble then it could no longer find a place in their
portfolios. Such an outcome inevitably endangered the regions whole financial system and made a
rising equity market illogical, given its dependence on the availability of credit.

Treasuries trump Bunds

Things were looking bad enough already but the final week of November saw them take a dramatic
turn for the worse as the US Treasury/German Bund spread abruptly reversed from its usual 15 to 20
basis points in favour of the latter to 15 to 20 in favour of the former. Contagion had now spread to
the core of the Eurozone and simply by reason of Germany being part of the region, the Bunds haven
status was compromised, a development promptly confirmed on 23 November when its bond auction
saw only two-thirds of the offerings taken up.
The next day (24 November) a downgrade of Belgian debt by Standard & Poors saw its 10-year
yields rocket by over 100 basis points to 5.89%, serving to make the point that all the Eurozone

countries were regarded by bond investors as being in the same boat. But once again, after a shortlived shakeout taking the Dow down to 11,231 and the FTSE100 to 5127, stock markets seemed to
take these dramatic developments in their stride, hoping that the obvious seriousness of the situation
would force Germany and other EU leaders to come up with a radical plan to save the Euro.
Reported to be under discussion was a Franco German stability union to be formed outside the
Treaty to oversee members finances, a new Treaty, fiscal union and a common corporation tax, but
Germany was said to oppose any change in the role of the ECB and the issuing of Eurobonds. There
was also talk of a plan by the IMF to create a 400/600 billion fund to bail out Italy but this was
promptly denied by the fund. Given the unconvincing nature of such explanations for rising stock
markets, the real reason was more likely to be the conviction of US money managers that the Fed was
on the point of launching QE3 with the purchase of $800 billion of securities, to include $545 billion
of the mortgage-backed variety.

Great Expectations
Whatever the reason, in the last three days of November the Dow added a staggering 813 to top
12,000 again, the FTSE100 was up 340 to reach 5505, and the Eurofirst 300 rose almost 80 points to
979. Confidence was further boosted by the Fed co-ordinating with the other leading central banks to
ease liquidity strains in financial markets by reducing the costs to European banks of raising dollar
funding. This move was widely interpreted as a sign of global solidarity in the face of the Eurozone
debt crisis. At the same time, it was only the amplification of an existing arrangement and while it
would help European banks cope with an intensifying liquidity squeeze, it would do nothing to solve
the key funding problems of many of the regions governments.
Hopes now centred on the much-heralded make or break summit to be held in Brussels on 9
December and markets remained firm in anticipation of a decisive breakthrough in negotiations to
save the Euro. In the event, none of the measures widely acknowledged as essential to achieve this
end were agreed. There was no mention of a change in the role of the ECB for it to become a lender
of last resort, or even to enlarge its bond-buying capacity. And there was no plan to create
Eurobonds. All that came out of the Summit of Summits was a fiscal compact enshrined in a new
intergovernmental treaty of questionable legality, dedicated to imposing strict budget disciplines over
the 27 member states and making the bailout fund a little larger. The European banks had won a
breathing space from the ECBs cut in interest rates back to 1% and the offer of unlimited liquidity for
up to three years against lower quality collateral, but there was no helping hand for the needy
sovereign states.

The UK says No
Clearly, Chancellor Merkels conviction that the peripheral nations needed to embrace austerity and
reform had prevailed; the solution to the Eurozone sovereign debt was to spread the gospel of the
benefits to be derived from following the German example of hard work and thrift. Still, given the up
and coming difficulty of getting the new treaty ratified by so many different parliaments, the British
premiers decision to opt out on Day One was in part a recognition of the impossibility of getting the
treaty approved in Westminster, with or without the safeguards he wanted in the national interest.
Given the huge measure of public support for David Camerons action, it was more than likely that
the leaders of many other member states would be having second thoughts on Day Two and Day
Three as the realisation dawned that their national budgets would be vetted by the bureaucrats in
Brussels and their austerity programme would go on and on. Opposition parties would see
opportunity in such a situation, remembering that the crisis had already led to the fall of governments
in every single one of the PIIGS.

Italy on the rack

The response of Italian bond yields to the lacklustre outcome of the Summit of Summits was to
reverse their pre-announcement decline and soar back towards the critical 7% level, while key stock
market indices, after an initial decline, quickly stabilised with the Dow holding above 12,000 and the
FTSE100 still clinging on to the 5500 mark. Bearing in mind the financial mayhem that would erupt
across the globe if the second largest reserve currency and the second most traded currency in the
world fell apart in a disorderly way, the fact that stock markets in New York and London remained so
firm and close to peak levels for the year seemed to demonstrate a devil-may-care attitude on the part
of investors.
Some commentators believed the reason for this attitude to be that they were too afraid of missing out
on the spectacular rise that might be expected to follow news of a swift and final solution of the
crisis,.This idea clearly had less to do with politics and economics than with behavioural finance
where one study shows that when faced with a choice between a safe but unprofitable option and one
which is high-risk but potentially high reward, the investor will be tempted to go for the latter.

ECB saves Santa rally

Confident expectations that the traditional Christmas rally would continue unchecked took a knock in
mid-December; no resolution to the Eurozone crisis appeared to be in sight and both the president of
the IMF and the governor of the Bank of England had chosen to express their opinion that the world
was on the verge of a 30s-style depression. By 19 December, the Dow was below 11,800 and the
S&P500 only a whisker above 1200, while in London the FTSE100 had fallen back to 5365.
Then, perverse as ever, stock markets responded dramatically the next day (20 December), led by the
Dow recording one of the best rises of the year with a 337 point gain to 12,103 before adding another
191 to 12,294 over the next three days. The trigger for the advance was a flurry of ostensibly
encouraging data on US housing starts and jobless claims, strong demand at the latest Spanish bond

auction and a modest rise in German business confidence. By far the biggest boost to sentiment came
from the inauguration of the ECBs new long term refinancing operation (LTRO) with a massive cash
injection into the European banking sector. The operation had been well-signalled but the take up of
almost 500 billion was well above the range of 250/350 billion expected, indicating both the
desperate need of the banks for refinancing and the ECBs willingness to act as lender of only resort
for the Eurozones banking system.
The move was widely welcomed as serving to head off otherwise likely bank defaults in 2012 but the
ECB was also believed to have compromised its own credibility as a central bank since, unlike the
US Federal Reserve and the Bank of England, it could not count on the unqualified backing of a
unified state. Furthermore, the expressed desire of the French government that the banks new
borrowings could and perhaps should be used to buy sovereign debt was seen as a way for the ECB
to bypass the constitutional block on its own buying. If this was indeed the case than the fates of
Europes sovereign debt and the banking system were becoming ever more indivisible and the cost of
failure even higher.
If the newly refinanced banks decided to do no more than rollover their own debt as it fell due and
leave surplus funds on deposit at the ECB rather than indulge in the carry trade by buying higher
yielding sovereign debt, then the debt crisis was no nearer a solution. After all, it was peripheral
sovereign debt that was at the root of much of the banks troubles in the first place, and they were
unlikely to want to risk a second disaster.

Fisk gets real

The relatively strong showing by Wall Street in the final quarter despite the obvious lack of progress
in finding a solution to the Eurozone crisis encouraged the bulls to look for a continuation of the trend
in 2012. However, given the record of the European leaders to date and the appalling consequences
for the world economy if they failed to resolve the crisis, the bears were convinced that this was no
time for investors to take any sort of risk.
Even those few commentators who did not go along with the judgement of rating agency, Fisk, that a
comprehensive solution to the Eurozone crisis is technically and politically beyond reach still
advised the utmost caution and recommended a portfolio of safe haven bonds and high-yielding multinational consumer goods companies that fell into the national treasure category in their home
countries. In this vein, America was seen as the investment target of choice in that it offered relative
security and stability with an economy expanding moderately in contrast to a Europe already in
recession and at risk of financial meltdown.

Home on the range

The US economy would inevitably sustain some collateral damage if the situation in Europe
continued to deteriorate but it was still the worlds biggest economy and largely self-sufficient in
energy, food production and other natural resources. Of course, it had much the same debt problems
as the rest of the developed world and needed to address them in the same way, but it had the ability
and the time to do so despite the impression given by the wrangling in Congress over deficit reduction
plans. Also, just two political parties going head to head over the issue had more chance of coming to
an agreement than would multiple parties in 27 very different countries.
Even the failure of the Super Committee in Washington to strike a deal over the $1.2 trillion deficit
reduction proposals was interpreted as a positive by adherents of the US de-coupling thesis in that
under constitutional law, the cuts would be automatically implemented after the 2012 election,
pushing the economy into a necessary phase of accidental austerity without further political argument.
Although low-yielding Treasuries had merit as a safe place to hold cash reserves at a time when even
the biggest banks and money market funds were exposed to risk, mega-cap multinationals, US
domestic leaders and utilities with a long history of stability and progress were the obvious
investment choices. In this context, it was perhaps significant that IBM and McDonalds turned out to
be the top performers of the Dow 30 in 201l with the index up 6.1% over the year.

BRICS on the back foot

Emerging markets disappointing performance in 2011 had eroded their once enthusiastic fan base
and they attracted few recommendations for the New Year. There was now little talk about the fastgrowing BRICS de-coupling and carrying the rest of the world but more of the evident slowdown in
India and China accompanied by rising inflationary pressures demonstrating how dependent their
economies were on demand from the developed world. Furthermore, it was feared that they would
take a bigger hit as inflows of foreign capital slowed and even reversed, something that was now
happening in India, while in China falling demand for its manufactured exports would put its creditbased domestic consumption boom at risk.
In turn, this would be bad news for the economies of Brazil and Russia which had come to rely upon
steadily rising demand for their natural resources. A run of high-profile financial scandals had also
served to downgrade the investment attractions of emerging markets in the eyes of Western investors,
reminding them that these faraway countries of which we know nothing were possessed of alien
business cultures. Japan was also in danger of falling into this category after the Olympus affair; here
even the endorsement of Warren Buffett would have a problem turning around confidence in a
situation where 20 years of hopes had been betrayed.
A few observers were keeping a wary eye on the countries of Eastern Europe where the MSCI group
index had lost 25% in 2011. All of them were members of the European Union or potential candidates
but being peripheral to the PIIGS they received relatively little attention. However, political tensions
were high, particularly in Hungary, and were expected to intensify in 2012 as a result of the fallout
from the crisis at the heart of the region. The Balkan countries have an unhappy history of their

political quarrels having dire consequences far beyond their borders.

Gold loses its shine

Gold salvaged its hedge role by recording an 8% gain over the year but since peaking at $1900 in
August amid talk of topping $2000 by year-end, it lost much of its appeal as it fell back to below
$1600 in the final quarter. Despite the erosion of its traditional safe-haven status at a time of
continuing economic turmoil, Goldman Sachs still looked for a recovery to $1900 again in 2012.
Other analysts disagreed, largely on the grounds that the speculative frenzy and extreme volatility in
August had compromised golds image as a model of security and stability and destroyed its value as
a dollar hedge. Any would-be buyers were advised to go for physical gold now that excessive
demand earlier in the year had led to a proliferation of paper claims on gold well in excess of actual
stocks.

The final countdown

With the FTSE100 at 5571 recording a fall of 5.6% over the year (after peaking at 6069 in April and
dipping below 5000 to 4944 in October), an apparently dull performance was still a great deal better
than that of the principal continental bourses where Frances CAC 40 was down 16.7% and
Germanys DAX was off 14.1%. The UKs relative isolation from the Eurozones problems was
reflected in this disparity as it was in the yield on 10-year gilts, now a full percentage point lower
than that on French bonds and almost on a par with German bunds. Sterling benefited accordingly and
remained broadly unchanged against the dollar on the year after peaking at $1.66 in April when
downgrades of US debt were all the rage. Similarly, that was also the high point for the Euro at $1.48
but it was downhill all the way from there to $1.29 by year-end as sovereign debt woes intensified.
All the betting was on the Euro going lower still in 2012.
Forecasts by leading banks and brokers of where the FTSE100 would stand a year hence averaged
around 5800 but ranged from a low of 5000 to a high of 6565. After over optimism in 2011 forecasts,
this indicated that sitting on the fence was the most favoured institutional position but Lex in the FT
(with an excellent record of calling the shots since the onset of the crisis in 2007) was prepared to be
more forthright. With European economies awash in growth-restraining public and private debt,
needing growth to pay it down and with monetary stimulus ineffective this is not an environment for
a big stock market upturn. As for the popular argument of the bulls that shares are cheap, Lex pointed
out that this was so only when compared with artificially depressed Treasury yields and that while
P/Es appeared low, they would go lower still if corporate earnings weakened, as seemed likely in a
hostile business environment.

Also from George Blakey and Harriman House

A History of the London Stock Market 1945-2009
www.harriman-house.com/historylondonstockmarket2009

Print ISBN 9781906659622

eBook ISBN 9780857191151
World Financial Markets in 2010: The trading, the players and the stories behind a year in the
stock market
www.harriman-house.com/worldmarkets2010

eBook ISBN 9780857190987

World Financial Markets in 2012: The trading, the players and the stories behind a year in the
stock market
www.harriman-house.com/worldmarkets2012

eBook ISBN 9780857192936

Registered to a.mudassar88@gmail.com