Political rows over currencies and a harsh dose of fiscal austerity are set to test financial markets in the coming week, just as investors appear to be settling in for a solid end-of-year stock rally.
The G-20 finance meeting in South Korea at the end of the week is likely to be dominated by disagreements over foreign exchange rates, with implications for global investment flows well beyond currencies.
Japan's unsuccessful struggle to date to keep its yen competitive, for example, is one of the roots of its stock market's massive underperformance this year.
Britain's spending review on Wednesday, meanwhile, is also likely to be watched closely given its billing as one of the most detailed expositions of fiscal austerity plans in a Group of Seven country to date.
Both come as prospects of the U.S. Federal Reserve printing more money as part of a new quantitative easing (QE) stimulus program have driven world equities to two-year highs.
In the past week, the MSCI all-country world index hit a level last seen just after the collapse of Lehman Brothers in September 2008.
It has been led by flows into emerging markets. Fund trackers EPFR said global emerging market equity funds took in a more than a net $2 billion in the week to October 13, while Pacific equity funds had their best week on record.
By contrast, since markets started to plan for more QE from the Fed the dollar has fallen some 9.5 percent against a basket of major currencies.
This effective devaluation of the dollar has triggered anger in countries likely to see their currencies rise or, if pegged, pressured to rise as a result.
Responses have ranged from straight intervention (Japan) through withholding tax on investors (Thailand) to threats of new limits on forwards (South Korea). Beijing and Washington have remained at loggerheads with the latter pressuring for something to be done about what it sees as an unreasonably weak yuan. It is with that as a background that investors are gearing for what could be a turbulent G20 finance summit.
"The body language doesn't look good," Piroska Nagy, senior adviser to the chief economist at the European Bank for Reconstruction and Development, told a Reuters briefing.
Failure to find agreement, which many view as likely, could stir up financial markets in the short term — for example by confirming the likelihood of QE and creating more pressure for currency intervention.
That would keep current equity trends steady or even enhance them — witness the initial gains on stock markets on Friday after Fed Chairman Ben Bernanke confirmed the likelihood of more easing.
But it could also stir up currency and fixed income markets, and along with them commodities, which are mostly priced in dollars. The broad commodities Reuters-Jefferies CRB index has moved upwards in lockstep with the dollar's downward slide since August.
Investors have also begun expressing worries about the threat of trade protectionism — viewed by free marketers as a dangerous threat to economic growth and, thus, investment.
"The fact that the Chinese are unlikely to give way (on currencies) ... is going to leave the Americans even angrier," said Charles Dumas, head of international services at investment advisers Lombard Street Research.
"The anger level against China goes up (and) the chance of (protectionism) has to be substantially increased."
The coming week also offers investors a more parochial but nonetheless potentially significant event — Britain's spending review.
It includes details of plans to lop off more than 80 billion pounds ($128 billion) from the government budget between now and 2015 to tackle an 11 percent deficit.
The overall plan has generally been priced into markets, but the details could have some impact on bonds and sterling.
Big-name U.K. equities tend to be global in nature and so the stock market impact, if there is any, should be limited to smaller companies.
"There may be certain sectors that may be affected by it. And it also has implications for jobs," said Mike Lenhoff, chief strategist at wealth manager Brewin Dolphin.
But the process of laying out what could be painful and unpopular cuts will be a stark reminder to global investors of the state of many developed market economies and the difficulties they are likely to face in coming years.
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