Junk Bonds

Credit markets today have healed after the entire U.S. junk bond market traded at distressed debt levels suggesting a substantial risk of default. Those bond prices have since recovered and now offer investors returns of 40 percent to lead major asset classes.

Rising Stocks

The U.S. stock market too has recovered lost ground, with financial stocks leading the charge. The S&P 500 Index has rallied for most of this year. The Dow Jones industrial average <.DJI> now trades around 9,300 — up sharply from a 2009 closing low at 6,547.05, but down only about 15 percent from its close at 10,917.51 on the day of Lehman’s bankruptcy filing.

Financial Shares

Financial shares have led the charge, including gains by Goldman Sachs, Citigroup, JPMorgan Chase and Bank of America.

Safe Havens

Safe haven securities, such as gold and U.S. Treasuries, reflect the rally in other markets.

CDOs

The market for giant bonds made up of underlying subprime mortgages, consumer debt and other assets is showing signs of life but no where near peaks reached in 2007 and prior years, despite signs of rebound in other corners of the bond market. Many experts believe structured bonds backed by higher quality assets will need to recover before a full-fledged recovery can take shape.

Finance ministers from the G20 are meeting in London on Friday and Saturday to discuss the next steps in battling the world’s worst economic and financial crisis since the Great Depression.

Reuters correspondents from around the world will be at the event, taking you behind the scenes and and providing unprecedented coverage through this live blog.

Britain’s Association of Investment Companies has UK investors who run Japanese equity funds whether they think the general election on Sunday will have a positive impact on the country, which is slowly emerging from recession.

Their answers can be found here, but the consensus was that the Democratic Party of Japan would defeat the ruling Liberal Democrat Party and that this would result in more consumer friendly policy or economic revival through higher living standards.

Managers were more divided on how long-lived any positive impact on stock market would be.

Our unscientific mini-poll below gives you the chance to vote on the issue — but as ever your comments are also welcome.

Five things to think about this week:

CENTRAL BANKERS IN A HOLE
-- The global economy and financial system appear on the road to recovery but that is in large part due to unprecedented official stimulus that will have to be withdrawn at some point - the questions investors want answered are when, and how.  Central bankers no longer appear to be quite as shoulder to shoulder with one another on coordinated policy as they were last year in the aftermath of Lehman's collapse.
 

CHINA STOCK WATCHING
--  It is August, liquidity has dried up with the summer holiday season in full swing, and investors are palpably more cautious about the economic outlook now than they have been for months. It is against this backdrop that that the Chinese stock market is emerging as the focal point and driver of all other asset markets. The Shanghai Composite technically slipped into bear market territory earlier last week, shedding 20 percent in the two weeks from Aug. 4 to Aug. 19 on profit taking from the 90 percent surge this year. There is no major Chinese economic data scheduled for release this week, leaving thin markets at the whim of sentiment in what is a notoriously volatile stock market.
 

GROWTH FOUNDATIONS
-- The United States, Britain and Germany unveil revised estimates of Q2 economic growth. Revised GDP figures rarely garner much attention but with initial estimates from Germany, France and Japan earlier this month all showing that these countries exited recession in the last quarter, investors will be looking for further evidence the world economy has turned the corner. The hard data is stronger now than it has been for some time but is the global economy building a solid base for recovery, or is it more likely to buckle were authorities to begin withdrawing the massive fiscal and monetary stimulus?
 

ABNORMALLY NORMAL MONEY MARKETS
-- A veil of normality continues to cloak interbank money markets, with Libor at record lows and some closely-watched measures of money market health like Libor/OIS spreads and the TED spread almost back to levels seen before August, 2007. But that is only thanks to authorities' liquidity injections, guarantees and asset purchases worth trillions.  Banks have hoovered up this free or ultra-cheap money but still are not feeding it into the real economy, with lending to business and households still patchy at best. Euro zone M3 money supply figures for July are expected to show another slowdown in the rate of growth, to 3.3 percent on the year from 3.5 percent in June.
 
SAFE AS HOUSES?
-- Figures will show how the U.S. housing market, the epicentre of the global financial crisis, is faring four and a half years on from its peak. The Case/Shiller house price index is expected to show the annual pace of price declines slowed again in June, fuelling the belief that the market has bottomed.  But the number of foreclosures is high as the U.S. labour market remains weak, and the national housing market stock remains high by historical standards. Economists say there will be no sustainable recovery of the financial system and economy without a durable recovery in the US housing market.

Five things to think about this week:

APPETITE TO CHASE? 
- Equity bulls have managed to retain the upper hand so far and the MSCI world index is up almost 50 percent from its March lows. However, earnings may need to show signs of rebounding for the rally's momentum to be sustained. Even those looking for further equity gains think the rise in stock prices will lag that in earnings once the earnings recovery gets underway, as was the case in past cycles. The symmetry/asymmetry of market reaction to data this week -- as much from China as from the major developed economies -- will show how much appetite there is to keep chasing the rally higher. 

TAKING CONSUMERS' PULSE 
- A better picture of the health of the consumer will emerge this week as U.S. retailers' earnings coincides with the release of U.S. July retail sales data and the UK BRC retail survey comes out on the other side of the Atlantic. With joblessness still rising, the reports will show how willing households are to spend and whether deep discounts, which eat into retailers' profit margins, are the only thing that will tempt them to shop -- both key issues for the macroeconomic and corporate outlook. 

CENTRAL BANK WATCH 
- After last week's Bank of England surprise, all eyes turn to what sort of signals the U.S. Federal Reserve and Bank of Japan will send on the outlook for their respective economies and QE programmes. After the BOE's expansion of its QE programme the short sterling strip repriced how soon UK rates would rise. But the broader trend recently in the U.S., euro zone and the UK has been to discount rate rises in 2010 -- and possibly as soon as this year in Australia. Benchmark interbank euro rates have risen for the first time in two months, and central bankers everywhere, including China, face the delicate balancing act of managing monetary tightening expectations in the months ahead. 

PRICE PROTECTION
-This week's inflation data (from Germany, France, Italy, euro zone, U.S.) is unlikely to contain any nasty surprises. But the U.S. Treasury's willingness to consider bringing back the 30-year TIPS suggests that enough investors and reserve managers are looking beyond current subdued price data to future inflation risks from QE programmes, etc. That will ensure a close eye is kept on breakevens and whether the main issuers of inflation-linked products in the euro zone are inclined to increase issuance of such products.

TRADE 
- Official resistance to currency appreciation has been evident in some developed countries (Switzerland, RBA, RBNZ, among others) and there are suspicions that some Asian central banks may also be inclined to check such trends given the fierce competition among the world's exporters to grab what orders there are. Trade data this week will show how trade flows are faringand the extent to which Chinese economic activity is driving them.

Investor sentiment goes through various phases in an economic cycle — from optimism, euphoria to panic and depression, back to hope and optimism.

James Thomson, investment manager of Rathbones global opportunities fund, discusses the current stage of investor morale.

Five things to think about this week:

Q3 - CLUES AND CUES
- Global equity markets started the quarter positioned for economic stabilisation after a strong Q2 performance but, even so, EPFR data shows less than a third of the cash that flooded into money market funds in 2008 has exited in the year to date. The Q2 reporting season, which is about to kick off (Alcoa out this week), will show whether there are reasons for investors to draw down their cash holdings further. The U.S. data that came out before the long July 4 weekend held more negative surprises than positive ones, and macroeconomic confirmation of recovery will be needed to tempt more wary investors into equities.

BOND YIELDS
- Benchmark U.S. and euro zone bond yields broke lower after the U.S. non-farm payroll data but the VIX hit some of its lowest levels post-Lehman and a recent compression of intra-euro zone spreads has yet to go markedly into reverse. Which of these trends turns out to be sustainable will become more evident in the next few weeks, particularly as U.S. supply resumes this week with TIPS, 3, 10, and 30 year auctions.

L'AQUILA SUMMIT
- The slow-burning international reserve currency debate could pop up at the G8/G8+5 big emerging powers summit in Italy this week. China's public stance is that it is not pushing the issue but Beijing also reckons a debate on this would be normal at such a forum. It is unclear if any final statement will mention it in a way that would rattle FX markets. But sideline comments on the debate will be closely watched and particular focus will be on which countries, if any, would be willing to join China, Brazil and Russia in their commitment to buying the IMF SDR notes -- for which crucial groundwork was laid down this week.

FOLLOW THE MONEY
-  Questions remain over what use is being made of the 442 billion euros ($619.6 billion) of ECB one-year money that was pumped into the market. A spike up in overnight deposits clearly suggests banks are continuing to park a significant proportion of that cash at the ECB. Any swings in that data will be closely watched for signs that the money could be put to work in other parts of the rate/fixed income market -- or maybe even filter through to the economy in the form of lending. The BOE will also be in focus, with clues sought on the outlook for its QE strategy.

COMMODITY RISKS
- Commodity price volatility looks to be on the cards. A rally in industrial raw materials risks tapering off unless a stronger economic rebound materialises soon, both in big emerging economies and their developed counterparts. For soft commodities, the focus is increasingly turning to the potential impact on harvests from El Nino weather patterns that are developing. Investors will have to decide whether they would be better off exposed to stocks linked to the metals/minings, which will at least earn dividends, or to the commodity itself -- or neither. As for any spike up in food prices, the fallout would be even wider at the current economic juncture, and complicate both policy and investment decisions.

(Reuters photo: Santiago Pandolfi)

Central bankers have not had much reason to be happy over the last two years, as the financial crisis has lurched from bad to worse.

But the European Central Bank at least is now finding comfort in the fruits of its injection of close to half a trillion euros in 12-month funds last week, which has pushed money market interest rates to new record lows. 

“We are very happy, we see clearly that we decreased the risk premia,” ECB President Jean-Claude Trichet said on Thursday, after the ECB kept its benchmark rate on hold at 1 percent.

Still, the ECB’s generosity in filling bank coffers with cheap cash could paradoxically help financial institutions defer the day of reckoning when they will have to write down bad loans and toxic assets on their books, and adjust their balance sheets. Flush with ECB cash, banks could be encouraged to think they can hang on to past investment mistakes, rather than writing them down now. 

The Swiss-based Bank for International Settlements, a forum for the world’s central banks, says this painful process is a prerequisite for financial and economic recovery, and the International Monetary Fund  says the euro zone is lagging the United States in writedowns.

Maybe the ECB is not helping.

Five things to think about this week:
    
PUTTING THE RALLY TO THE TEST
- The surge in risk markets has tapered off as investors take stock of recent weeks' rally and the data flow injects a dose of sobriety. The scale and duration of any market pullback will be the test of how much sentiment has really changed. Sluggish April U.S. retail sales were the biggest cause for pause and this week's flash PMIs will give more Q2 information.

FX FOCUS
- A pause in the recent recovery in relatively risky markets is shifting attention to the changing FX environment. Clear-cut correlations between moves in major FX rates and swings in risk appetite could be in the process of being eroded and some in the financial markets are wondering if and when relative economic performance will replace risk appetite as a driver for exchange rates. Investment flows will be affected if the dollar looks like it might resume a long-term downtrend.

QE EXIT STRATEGY
- ECB, BOE, Fed officials are making reassuring noises about QE exit strategies but no clear mechanism or timeframe has yet emerged and all indications are that balance sheet expansion is still the order of the day. Yield moves suggest bond markets are more enthused in the short term by signs they will kept on the QE drip feed than by concern about the potential price problems down the road. Central bankers have yet to address the back up in yields that would be seen if they were they to exit the market at a time when debt issuance is continuing to flood the market - as it will for some time to come.

BATON PASSES TO EUROPE
- Post-stress test capital raising by U.S. banks will put the spotlight on European banks' balance sheets, not least given the EU version of the stress tests looms and IMF estimates suggest euro zone lenders have more toxic assets to write down than their U.S. and UK peers. But timing is everything and few would want to try to catch up with U.S. banks' tier 1 capital ratio building just when the equity rebound runs out of steam.

BRICs
- The dollar's retreat could see money which had been repatriated to the United States start to flow out again, potentially to the benefit of emerging markets. While BRICs have led the emerging market bounceback so far, India has lagged Brazil, Russia and China considerably. Now that elections are out of the way, it will become clearer how much of the Indian underperformance is down to political uncertainty.

Some more bits and bobs to capture the current mood among investors:

-- Some stock indexes have started to fall below their 2008 lows, meaning the turn-of-the-year rally has petered out. Dead cat bounce?

-- Analysts are becoming increasingly downbeat about corporate earnings. Seven of the 10 sectors in the S&P 500 are looking at a year-on-year decline in earnings, according to Thomson Reuters proprietary research. That's the highest number of sectors in negative territory since Q4 2001.

-- UBS economists have sharply revised down estimates for 2009 growth in Japan, China, much of the rest of Asia, and the euro zone. They now expect world GDP to grow a paltry 0.4 percent this year.

-- Politicians are getting more irate about bankers. Franz Muentefering, head of Germany's Social Democrats, says: "Most (of them) are hard working and responsible. But there are also louts, pyromaniacs and gangsters."