No drama, but no all clear for investors

Euro zone leaders' agreement to pursue stricter budget rules to preserve the euro may be just enough to put a floor on a sell-off in risk assets into year-end, if not to turn around investor sentiment completely.

Investors, however, are about to enter a period of holiday-thinned liquidity, which can lead to sudden and explosive moves. So assumptions about calm or calmer markets need to be tempered.

All 17 members of the euro zone, and other EU countries aspiring to membership, agreed on Friday to forge ahead with stricter budget rules as part of efforts to tackle the debt crisis and tighten fiscal integration.

Britain said it could not accept proposed amendments to the EU treaty, so the euro zone will negotiate a separate treaty alongside the EU treaty with a tougher deficit and debt regime. [

Despite some disappointment, world stocks, as measured by MSCI .MIWD00000PUS, have only lost around 1.6 percent in the past week -- nothing to be alarmed about given the index rallied more than 8 percent in the previous week.

Stocks fell sharply on Thursday after European Central Bank President Mario Draghi poured cold water on market hopes the bank could ramp up bond buying, seen as key to stabilizing rising borrowing costs of highly indebted euro zone members.

But by Friday afternoon European stocks were making cautious gains with the euro zone deal seen as at least a step towards ending the debt crisis.

"It's a compromise solution but there isn't a silver bullet. If you look at elements put in place there are some positives. We're seeing the path towards the solution," said Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management.

"Risk assets have been extremely correlated because of systemic risks. But for medium to long-term investors it's an interesting entry point. There's value there. It's not a picture of complete doom and gloom."

HSBC Asset Management likes commodity and emerging market stocks as well as corporate bonds, while it views safe-haven government bonds as too expensive.

China's move to create a $300 billion investment vehicle operating two funds, one focusing on Europe and the other on the United States, also supported European stocks on Friday.

Liquidity Challenge

As well as the year-end thinning of trade, liquidity conditions are being exacerbated by large-scale deleveraging by banks.

Europe's banking watchdog estimates the region's 71 banks will have to increase their capital by 114.7 billion euros, more than predicted two months ago, to make them strong enough to withstand the euro zone debt crisis and restore investor confidence.

Banks will look to fill any shortfall through rights issues and by shrinking loans to customers, selling assets or cutting dividends or staff pay. National governments may have to bail out lenders unable to find the cash.

"As a result of less proprietary books on the sell side, fewer people are able to take the other side of the trades. We're in for a period of correlated volatility," Poole said.

Barclays Capital expects euro zone banks to sell 0.5-3.0 trillion euros, or up to 10 percent of their assets, to raise capital in the next nine months.

"We expect tighter lending standards and reduced availability of credit to accompany asset sales," the bank said in its 2012 outlook.

"Tighter credit has the dual effects of furthering the macroeconomic deterioration ... as well as leading to increased high-yield defaults, as companies dependent on access to financing start to fall."

Investment grade and high yield corporate bonds have been popular asset classes for those who want to add risk outside of the equity market, but higher default rates may discourage them.

Barclays expects the default rate for European high yield debt to be 4-6 percent, double its 2-3 percent forecast for the United States.

But shrinking liquidity may not be all bad for long-term investing.

"Banks are having less capital to commit to trading activities and have less liquidity. The bid offer spreads become very wide, or where you had six markets giving you a quote it's down to two," said Rod Paris, head of investments at Standard Life Investments (SLI.L).

"It might encourage more long-term investment behavior, because of the costs of coming in or out. It may well take some of the froth out of the market."

[Source: By Natsuko Waki, Reuters, London, 09Dec11]

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