Risk sentiment surges as policy moves gain traction

• Risk sentiment continues to surge, bouyed by policy intervention and fading ‘tail risk’ fears  
•  UK Q3 GDP watched for signs of improvement ahead of key November MPC meeting  
•  It is not a question of whether the euro area is weakening, but to what extent?  

A positive week for risk assets, with the major bourses retesting last month’s highs. With no decisive progress on euro area bailouts or the US ‘fiscal cliff’, and the global economic data still decidedly mixed, there are concerns that markets may be getting ahead of themselves. But, for now, the positive momentum seems well established with events over the past week giving the bulls the upper hand.

Sentiment has been lifted by growing hopes that global policy moves are starting to gain traction. This week’s Q3 Chinese GDP data provided an encouraging sign that the world ’s second largest economy is on course for a soft landing. Although headline annual growth fell to 7.4%, the quarterly profile suggests the Chinese economy may have bottomed in Q1. Elsewhere, US equities are approaching a 5-yr high; while in the euro area, peripheral bond yields have continued their sharp descent. It seems the spectre of (unlimited) ECB bond purchases has tempered the impetus to short these markets - at least for now.

The cost of 10-year Spanish debt has fallen below 5.30% - a drop of over 200bp since early August. Some progress on banking supervision at the EU Summit, Moody’s decision to maintain Spain’s investment grade rating, and successful bond auctions in both Italy and Spain, have all helped, as have expectations that Spain will shortly come to the table for ECB aid.

The improvement in risk sentiment has impacted on core bond markets. 10-yr gilt yields have risen by around 20bp over the past week, to 1.9%, with gilt sentiment also impacted by a spate of mixed, but generally firmer, UK data: retail sales posted a decent 0.6% rise in September, while the latest figures showed UK employment at a new record high. Against this backdrop, and doubts raised over further asset purchases in hte latest MPC minutes, the prospect of further QE when the current tranche expires next moth is now finely balanced.

Whether or not the MPC chooses to undertake more QE next month will hang on the tone of upcoming economic data - not least, the coming week’s Q3 GDP release (Thursday). For now, we stick with our call that the MPC will opt to purchase a further £50bn. This view, however, is predicated on the Q3 GDP data failing to show clear signs of an underlying improvement (after adjusting for the impact of Q2’s extra bank holiday and Olympic ticket sales). The Chancellor’s upcoming Autumn Statement is also likely to weigh on next month’s decision. The improvement in September’s budget deficit provided the Chancellor with some welcome news. Assuming the government sticks to fiscal austerity, the BoE is likely to continue to play its part in helping to cement recovery.

Elsewhere, the global policy focus turns to the US in the coming week, with Q3 GDP data also due and the FOMC set to reconvene. After last month’s announcement of open-ended QE (targeted at MBS, rather than Treasuries), the Fed is highly unlikely to follow up with any further measures this month, with the next policy uncertainty surrounding the expiry of Operation Twist at the end of the year. Nevertheless, the Q3 GDP data will be watched for signs of a slight improvement, with the adverse impact of the US drought and weaker external trade expected to be offset by a pick-up in consumer spending and housing. The Fed may well allude to tentative signs of improvement in its accompanying statement, but the US outlook remain fraught with risk, given the uncertainty over the Presidential Election and the looming 'fiscal cliff'.

In the euro area, attention will be on the German IFO and October 'flash' PMIs across the region. With all members of the euro area heading back into recession, the question is not whether the region is weakening, but to what extent? Given recent events, we expect the IFO and PMIs to show some improvement, albeit from still recessionary levels.

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