Tensions in global financial markets stemming from the euro zone's sovereign debt crisis appear to be easing, setting the stage for investors to dip back into risky assets in the second half of this year.
China's announcement on Saturday that it will end the yuan's 23-month peg against the dollar, clearing the way for appreciation of the Chinese currency to resume, is likely to reinforce the recovery of an appetite for risk.
Last week's relatively successful bond sales in peripheral euro zone countries, and expectations that the Federal Reserve and other central banks will keep borrowing costs low, are calming investor nerves after a risk storm in May prompted a rush to safe-haven assets.
Against this backdrop, world stocks, measured by the MSCI index <.MIWD00000PUS>, scored their biggest weekly gain since early March last week and hit a one-month high on Friday. European shares <.FTEU3> have rallied for eight days in a row, while Asian stocks posted their best week in six months.
The euro rose to a three-week peak above $1.2400 at one stage late last week, marking a substantial rebound after it hit a four-year low below $1.1900 less than a fortnight ago.
In a sign of normalization, Wall Street's fear gauge, the Volatility Index <.VIX>, tumbled below 24 on Friday after setting a 14-month high above 47 in May.
Fund tracker EPFR reported that over $37 billion flowed out of money market funds in the latest week, while global equity funds saw the biggest inflow since early April.
This week brings a series of event risks, including the summit of leaders of the Group of Twenty nations in Canada, at which divisions over economic policy and financial regulation are likely. The U.S. Federal Reserve holds a monetary policy meeting, and Britain will announce an emergency budget, its first concerted attempt at handling its debt problem.
So the pace at which investors get back into risky assets may be moderate.
As we do not believe in a double-dip recession, we remain positive, said Frederic Buzare, global head of traditional equity management at Dexia Asset Management.
We may conclude that there is significant upside potential for the equity markets but that is not a free lunch. Difficult summer months are probably in prospect before a rally starts in the fourth quarter.
Global stocks, commodity-linked currencies and other higher-yielding currencies may receive an immediate boost this week in response to China's decision on the yuan.
Although any appreciation of the yuan is expected to be very gradual, it could in the long term help to boost China's purchases abroad and reduce the trade imbalances which contributed to the global financial crisis of 2007-2009.
China's decision, which follows months of diplomatic pressure from its main trading partners, may also improve the prospects for economic policy cooperation within the G20 and ease fears of a U.S.-China trade row -- though this is by no means certain, since Beijing will remain able to guide the yuan-dollar exchange rate as it wishes.
Leaders of the United States, the European Union, Japan and the International Monetary Fund were among those welcoming China's announcement.
In terms of what this means for global markets, it should be an immediate positive for risk appetite, reducing risk premia across assets, Standard Chartered said in a note to clients.
As such, we should see a knee-jerk move lower in the dollar against both emerging market and G10 currencies. Particular beneficiaries should be those who export to China -- whether in commodities or manufactured goods -- as this should be seen as a positive for Chinese consumption.
This week also brings a fresh reading of international business sentiment, with flash surveys of the euro zone's manufacturing and services sectors.
Credit Suisse says global Purchasing Managers Indexes suggest the world economy will grow about 4.5-5.0 percent in the second half of 2010. This implies fears of a double-dip recession in weak areas such as the euro zone may be overdone.
Corporations are also healthy. According to the Swiss bank, corporate free cash flows stand at an all-time high of 3.6 percent of gross domestic product, and cash on balance sheets is at a 50-year high of 5.8 percent of total assets.
The second quarter corporate earnings reporting season, which begins next month, could provide a positive backdrop. Thomson Reuters data shows the earnings growth rate for S&P 500 firms <.SPX> is estimated at a still-strong 27.5 percent in the second quarter, after 57.4 percent in the first quarter.
Despite the noises that characterized the market, it should not be forgotten that the world has returned to growth and emerging economies still have a bright prospect, said William de Vijlder, chief investment officer at BNP Paribas Investment Partners.
He recommends cautious asset allocation, maintaining limited exposure to risky assets while overweighting commodities and emerging markets.
AREAS OF RISK
Among areas of risk this week, Spain may still worry the markets despite drawing strong investor appetite when it sold 3.5 billion euros of bonds on Thursday.
Spain's parliament is expected to vote this week on the minority government's labor market reforms. While analysts think the reforms will likely pass, this will require cooperation from opposition parties.
The country is far from insolvency, but debt roll-over risk remains an issue, Goldman Sachs said in a note to clients.
However, it added, If the Spanish authorities reinforce their commitment to address the budgetary consolidation, engage structural reforms, and recapitalize the banking system, there is no reason to think that spreads won't stabilize and reverse.
The G20 summit in Toronto on Saturday and Saturday may provide more clarity on financial sector reform. There has been disagreement among member countries on reform in areas such as a proposed tax on banks, and a U.S. plan to ban risky proprietary trading at some banks, which the European Union has rejected.
At a preparatory meeting in South Korea earlier this month, G20 finance ministers fell short of agreeing on any global bank levy because of opposition from Canada, Brazil and Japan.
(Editing by Andrew Torchia)