Last updated: November 30, 2011 7:56 pm

Action by central banks lifts rally hopes

Thank you, Mr Bernanke and Co. That was the clear reaction of investors on Wednesday after the world’s big central banks unleashed joint intervention to pump dollars into the financial system.

Only hours earlier, equity strategists were ruminating over the impact of a wave of bank downgrades by Standard & Poor’s Those hoping for a year-end rally after a dismal November were, for the most part, losing faith in the ability of policymakers – politicians and central bankers – to resolve Europe’s sovereign debt crisis.

Though far from a “silver bullet” – the central bank action is designed to head off a liquidity crunch for the eurozone’s commercial banks rather than tackle the causes of the crisis – the effect was powerful. US and European shares, already supported by China’s decision to loosen monetary policy, shot higher.

The S&P 500 closed at its high for the day, up 4.3 per cent, leaving it less than 1 per cent lower for the year so far. The Dow leapt nearly 500 points to record its best one-day gain since March 2009.

On the other side of the Atlantic, the FTSE Eurofirst 300 index of blue-chip European stocks soared as much as 4 per cent, the most in more than two months, before ending up 3.6 per cent. Germany’s Xetra Dax index jumped 5 per cent by the close. The Eurofirst remained down 12.5 per cent for the year, testament to how tough trading has been as the crisis has worsened.

France’s biggest banks and financial companies, such as BNP Paribas, Société Générale and Crédit Agricole enjoyed strong gains.

“The markets have until this week been pricing in policy inaction and gummed up dollar funding for European banks,” says Richard Batty, a global strategist at Standard Life Investments. “This is obviously a welcome sign that policymakers have recognised the funding problems that banks are facing.”

One reason the effect on equities, and other risky assets including the euro and commodities was so strong, was few were expecting the central banks to act. “The market was really surprised to see central banks come in like that,”says Anthony Controy, head of trading at BNY ConvergEx. And with the Vix, Wall Street’s so-called “fear gauge”, falling below 30, investors were cautiously optimistic.

However, while helpful, the view in the markets was that bigger steps will be needed.

Fund managers say the “relief rally” could quickly unravel unless policymakers, and the European Central Bank in particular, acts more forcefully to shore up the eurozone’s indebted governments.

“We’ve been continually disappointed by policymakers for two years now, so we remain cautious about the outlook, absent a more comprehensive policy response,” Mr Batty says.

Jack Ablin, chief investment officer at Harris Private Bank says: “The one signal I’m looking for is for the ECB to start ‘quantitative easing’ that buys the eurozone time to come up with a long-term solution for its debt problems. “

He says the central banks’ move buys the market about a week of breathing space. Wednesday’s gains and the prospect of a December rally for stocks will dim unless the ECB starts printing money.

Europe’s debt crisis has been weighing on Wall Street. Though the S&P 500 index has been more resilient than other major indices, fear of banking contagion has sent S&P financials down 20 per cent this year. Banks in the Eurofirst 300 have fallen by a third.

All this has outweighed solid US non-financial corporate earnings and recent evidence that the US economy is growing, casting doubt as to whether Wall Street can rally into the year end. Fund managers, moreover, complain that a lack of liquidity is exaggerating market moves. That is encouraging investors to stay away more.

“We need to see equities stabilise and focus on economic data,” says Michael Kastner, principal at Halyard Asset Management. “Decembers can get really nasty as people pack it in and move to the sidelines and there is a good chance investors get chopped up by the volatility.”

Bulls hope that better US data could motivate buyers to enter the market. “At some point earnings have to matter,” says Jim Paulsen, the chief investment officer at Wells Capital.

If recent history is any guide, an end of year rally is not out of the question. Since 1986, the S&P has on average gained 2 per cent in December, with a positive performance 80 per cent of the time.

“Being overweight risky assets is a very bold call at the moment, but if you are underweight you could miss out on a powerful rally on any good news,” says Larry Kantor, head of research at Barclays Capital.

But, while US equities look cheap when compared to prospective earnings and are very attractive versus low yields on US Treasury bonds, the risk of a severe deterioration in the eurozone crisis – leading to one or more disorderly sovereign defaults – is real. Wednesday’s 400-plus point surge, in a year of exceptional volatility, could yet prove another false dawn.

Additional reporting by Telis Demos

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