Santa Rally?

9 December 2016

With Italy losing its government after the referendum No and the European Central Bank indicating lessening monetary support from April 2017 onwards, the past week should have been full of market drama. The opposite was the case - again. Italian equities rose almost 7% over the course of the week and likewise European equities strengthened after Maria Draghi's ECB announcement and gained a good 5% over the course of the week. Very nearly enough to push them into positive territory for 2016. So is this Santa Rally unstoppable and markets '˜of their heads'?

It would seem to me that every setback for the political establishment around the world just serves to convince markets more that change is in the air. This change is called: Fiscal expansion. With fiscal stimulus can come a growth jolt and with that, deflationary fears turn into more normal inflation expectations. All signs that a return from the '˜New Normal' to the '˜Old Normal' has come to within reach.

As Renzi's name is added to the growing list of western politicians (Cameron, Clinton, Hollande) who are rejected by angry electorates are in the hope that the populist simplifiers will do a better job at managing the economy, the western political class has come under existential pressure to improve their performance. As we will argue in one of the articles this week, deficit spending for fiscal investment stimulus suddenly doesn't sound so scary anymore - when the electoral reaper is at large.

Rising equity markets, despite a rapid sell-off in the bond markets appears to indicate that financial markets are no longer scared by the prospect of rising public deficits either, as long as they put an end to the economic slow growth ice-age.

As market barometers are beginning to flash red with overbought signals, many have begun to ask whether this rally can be sustainable or will reverse even before Santa arrives.

As I discussed here over the past weeks, the economic momentum and market sentiment is strengthening as corporate earnings are once again growing and macro-economic indicators are hitting multi-year highs which are all supportive of a rerating of markets. Furthermore, the return of inflation expectations as well as the looming clamp down on Chinese overseas investments have all mobilised money for stock market inflows that previously sat in cash, bonds or abroad.

This is not to say that there isn't a risk that market expectations are becoming a little exuberant and they may fall back if politician prove to be slower in changing their ways than markets anticipate, or the US$ strengthens more than is healthy for the rest of the world. However, the positive forces driving markets are stronger at the moment than they have been for a number of years and medium term optimism - at least for economic progress - are probably in order.