With yet another week of melodrama still playing out through the corridors of power in Athens, almost all investors will be anxious to move on from a bewildering series of summits and knock about politics. So what can be the verdict at this point? Some progress, we feel, but not nearly enough to turn the page on this saga yet. In fact, another nail biting episode may be getting under way in Rome.

We would frame the crisis under 3 headings at this point:

1. Greece. If there is one clear message from the latest twist, it has to be that eurozone patience has finally run out. Greece must accept the terms of the 26 October agreement in order to receive the sixth tranche of the first bail-out package. We believe the new coalition government will approve the deal as well as the second private sector initiative (PSI-2). Elections will generate further volatility in the new year but eurozone leaders’ blunt ultimatum should prove effective in concentrating the disparate parties’ minds.

2. The European Financial Stability Facility (EFSF) and the International Monetary Fund (IMF). Here developments are less encouraging. The G2O showed clear reluctance to nourish this feeble infant, at least before the end of this month when details of its revamped structure have been finalised. The G20 have proposed a special summit before the next scheduled event planned for February. The message at this point is  that the non-eurozone powers would rather use the machinery of the IMF to support the Spanish and Italian debt market than operate via the EFSF; this is hardly a vote of confidence.

3. Italy. The most disquieting development is the steadily sinking Italian bond market. Despite formally committing to quarterly surveillance of its reform programme by the IMF, the government is seeing its credibility evaporate. It may require dramatic intervention by the European Central Bank (ECB) to prevent 1O-year Italian sovereign yields moving up to 7% but that would have to coincide with a far more draconian 3 year fiscal programme than offered by the incumbent coalition.

So, risk assets remain locked in a vice between healthy corporate profits and an improved take on the U.S. economy on the one hand; and policy dysfunction that may trigger a damaging European recession on the other. Self help takes time to generate results, since any positive policy shocks look limited from here. Equities have ridden out a very difficult quarter so far but we see upside from here being a tougher proposition.

In the tumult that was last week (the calling and uncalling of referenda in Greece), an important pronouncement made by the new president of the ECB, Mr. Draghi, may have been missed. He mentioned in passing, while cutting interest rates by 25 basis points, that the eurozone economy is likely to dip into recession next year. It is not clear that the equity market has taken this on board fully. At the moment the consensus forecast for European earnings is a growth rate of 11% for 2012. This looks a bit on the optimistic side given some of the headwinds we anticipate for Europe. A more realistic expectation would be for earnings for the full year to be flat, perhaps down by around 5%.

Data releases in the U.S. have been more upbeat by some margin. GDP posted 2.5% (annualised) in the third quarter. Other releases have been somewhat encouraging. Last Friday’s payroll number was behind expectations marginally, printing a gain of 80,000 from an expected 95,000, but the previous two months saw very strong upward revisions from the initial releases. This helped to reduce the unemployment rate to 9% from 9.1%. Other releases were at least in line with expectations. The Institute of Supply Management Purchasing Managers Index for manufacturing was down at the overall level to 50.8, but revealed strength in new orders and employment. Equally, some of the decline from the previous month’s level was due to a clear inventory drawdown. As this is rebuilt through the final quarter, there should be some support for the slow recovery currently underway in the U.S.

As highlighted above, the ECB’s diagnosis that the euro zone will likely fall into a “mild recession” around the turn of the year, combined with declining inflationary pressure, were the principal reasons for a 25 basis point. In the U.S., the Federal Reserve also met last week, and although it did not announce any further policy easing, it clearly left the door open to QE3. At the September meeting, 3 committee members voted against further easing by Operation Twist.

This time round, the only dissenter was a single member who believes more accommodative policy should be adopted right now. Clearly, the committee has taken a much more dovish tone, with specific policy towards the hampered housing market still a “viable option”. In China, while we are not expecting broad policy easing in the form of interest rate cuts, there is a growing possibility that “fine tuning” policy could be adopted, especially as the eurozone crisis is hampering Chinese exports. With money supply growth and new loans both well below target, there is room for monetary expansion, should it be warranted.

The change in policy stance by central bankers over the past month is an important and necessary turnaround from earlier in the year. The global economic recovery is slowing (although exaggerations around a U.S. economy are still over-estimated in our view). While there are several reasons for the slowdown – from political concerns, the Arab Spring oil price spike, the Japanese earthquake, a collapse in household and business confidence – it has coincided with a tightening in financial and liquidity conditions. These are the consequence of wider corporate bond spreads, lower stock markets, lower real income growth (especially as inflation increased), a strengthening greenback (up nearly 10% between May and end-September), deteriorating money market interest rates (i.e. increased interbank financial stress), and a slower growth rate of money supply.

However, since the end of Q3, credit spreads have narrowed (especially in the U.S.), stock markets are off their lows, inflation is moderating which should support household income and deleveraging, and most importantly, central banks have returned to easing mode.

The Bank of England undertook £75 billion further QE, hawkish members on the FOMC have become more dovish, China is edging towards easing mode, the Bank of Japan is intervening in the yen, and the ECB – who are already providing unlimited liquidity to the banking sector until 2013 - has finally signalled its intention to reverse the rate hikes experienced in the first half of the year. The ECB becoming more like the Fed and expanding its purchases of peripheral debt would clearly support the recent turnaround in financial and liquidity conditions, a welcome support to both the global economy and financial markets.

The elevated levels of uncertainty and volatility within global markets at present have prompted many investors to re-examine the role of exchange traded funds (ETFs) in their portfolios. The flexibility these products offer to invest is well documented. However, as tactical rebalancing and manoeuvrability in portfolios grow in importance, the nature and characteristics of ETFs warrant re-examination.

There are two principle ways in which ETFs are constructed: physically-backed or swap-backed.

Predominant in the U.S. market, the first type is underpinned by the underlying securities. A physically backed ETF investing in the S&P 500 index would, as its underlying holdings, consist of a proportion of each of the 500 securities within this index. The advantage of this method is surety that the ETF has underlying securities which may have a value should the ETF provider fail. However, costs of full physical replication can be high, especially for broad or illiquid benchmarks.

While a synthetic or swap-backed ETF may allow a more esoteric benchmark to be tracked at lower cost, the total return swap backing the ETF has counterparty risk of which clients should be aware. If the bank to which the ETF provider pays a cashflow falls into financial difficulty, unable to pay the return on an index to the ETF provider, a synthetic ETF may own none of the underlying assets. It will have some collateral backing the structure but this collateral may be very different to the assets which the ETF is trying to replicate. However, compared to an exchange traded note (ETN), against which there is no collateral posted, the synthetic ETF is relatively more attractive. The size of the synthetically backed ETF market, at around $195 billion or 13% of all global ETF assets, remains modest.

While ETFs may allow clients greater flexibility in navigating high volatility markets, evidence by one investment bank suggests ETFs and financial futures may be exacerbating high correlations and elevated volatility. Futures and ETF volumes as a percentage of total equity volumes now stand at above 80% and 40% respectively, compared to 35% and around 0% in late 1997. Given the close relationship between excess correlation (correlation over and above that implied in the market pricing of options) and ETF volumes, more widespread use of ETFs may add to the very volatility investors seek to avoid in employing these products.

source: Merrill Lynch