Is the current market optimism justified?

Second, US political conditions are improving as even the most radical Republicans start seeking consensus for the reasons discussed in this column last week. This political mood may not be reflected in public perceptions for some time. But the financial and business communities have clearly begun to sense it, as evidenced by the waning interest among investors in the new "drop dead" deadlines for fiscal conflict that political pundits continue to emphasise.

A third reason for optimism is the improvement in global economic and political conditions—especially the lifting of uncertainties about a breakup of the eurozone and the leadership transition in China. These fears weighed heavily on financial and business confidence for most of last year. But China is growing strongly and is politically stable, at least for the next few years. In Europe, the currency crisis may not have been resolved, but it has been frozen, at least until after Germany's election in September. As a result, the fears of political shocks that until recently obsessed financial markets have diminished dramatically.

As always, things could go wrong. The two most daunting threats for the year ahead are the prospect of higher interest rates and the unintended consequences of Japan's generally welcome policies of radical reflation. Long-term interest rates are certain to rise in the bond markets if investors turn out to be right in expecting a stronger global recovery. In fact, this process has started already, with 10-year rates rising in the United States to over 2% from 1.4% in July. Thus far, rising bond rates have been a healthy phenomenon, reflecting improved economic conditions, but if 10-year rates rise above 3% or 3.5%, they will become a headache for financial markets and corporate investors.

In much the same way, Japan's expansionary policies are a welcome boost to global recovery hopes. But if the yen continues to depreciate, competitive pressures will intensify, especially on companies in Europe, where the central bank seems willing to let the euro rise without limit while Japan and Switzerland manage their exchange rates down.

... contd.

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