World
Global equities – admirable resilience but more tests to come
Considering the array of events encountered in Q1 2011 (North African turmoil, allied intervention in Libya, surging oil and the Japanese earthquake and tsunami) equity markets have displayed remarkable resilience.
The principal driver behind this resilience has been liquidity. At a corporate level, strong balance sheets and free cash flow generation have delivered a pick up in dividend payouts, stock buy backs and merger and acquisition activity. At a macro level, negative real interest rates and steep yield curves have also been supportive of risk assets. Also, the Federal Reserve have been very explicit in acknowledging that the generation of equity wealth effects was the cornerstone of their QE2 programme.
Looking forward, the markets have to contend with several obstacles. One of the key issues will be gauging the impact of a potential cessation of US QE2. While it is extremely hard to predict the precise consequences of the removal of substantial liquidity support, it will undoubtedly add to overall market uncertainty. While QE2 will probably end in June, headline US interest rates are unlikely to change for quite some time. By contrast, the ECB appears to be on the cusp of tightening. Markets often find it difficult to calibrate to a world where the central banks of the two key reserve currencies have divergent monetary policies. The third potential headwind for markets lies with the risk of a compression in margins as corporations find it increasingly difficult to pass on rising input costs. We are at the stage of the cycle where value traps emerge. The rising oil price is also a deflationary shock to global growth.
The sustained rally in global equities that lasted ran from September last year to mid February has now entered a period of consolidation. This is likely to persist until we get greater clarification over the outlook for corporate earnings and margins post the second quarter earnings releases.
US
Considering a QE2 exit strategy
The US economy has gained traction throughout the start of 2011. The labour market has gradually improved and corporate and consumer confidence indicators have rebounded strongly. Consensus forecasts are expecting 3% Q1 GDP growth. The one blot on the landscape has been the housing market where recent data indicates renewed weakness in both sales activity and prices.
The second quarter outlook becomes a little more difficult for several reasons. First, the combination of an economic recovery and the rise in commodity prices (particularly oil) is starting to see several prominent Federal Reserve Board members express the view that the QE2 programme needs to stop. Communication about a QE2 exit strategy will be very important for markets, especially as the economy swooned last April when QE1 ended. The second concern is whether corporate margins that are close to historical peak levels, can withstand the rise in input costs. The third concern is the sensitivity of the US economy to the oil price. It is estimated that every $10 increase in oil subtracts 0.4% from growth a year later. The US bond yield declined sharply in response to the Japanese earthquake and tsunami as investors sought a safe haven. However, the combination of concerns about the ending of Federal Reserve bond purchases, a potential rise in inflation and the scale of the US fiscal deficit could see bond yields retest the upper end of their recent trading range.
UK
Fiscal austerity starts to bite
Despite forecasting higher Net Borrowing over the next 5 years the Government has maintained its commitment to eliminate the structural budget deficit by 2014-15. While the markets have attached credence to the government's commitment to cut public expenditure, they are less confident about the growth assumptions used to calculate future public sector revenue streams. The estimates compiled by the Office for Budget Responsibility (OBR) assume GDP growth rebounds from 1.7% this year to an above trend 2.9% in 2013 – these look ambitious.
The combination of public sector layoffs and negative real earnings growth is already impacting retail sales and consumer confidence. This is likely to be a recurring theme as the year progresses. The latest MPC minutes disclosed a need to assess the impact of the rising oil price on the economy over the next few weeks. This emphasizes the significance of the May inflation report in determining the direction of monetary policy. While interest rate futures are discounting tightening commencing in July, we think economic data will remain sufficiently weak to see this time horizon extended. Even if the MPC do decide to tighten, they are likely to make a couple of symbolic hikes (what Mervyn King referred to as 'futile gestures') and then pause. Much of this is already factored into markets. The UK clearly requires a loose monetary policy to counter a tight fiscal policy. While equities still offer the potential of real total returns, near term performance is likely to be driven by news surrounding corporate margins and US QE2. It is worth remembering that the UK market remains highly correlated to the US market.
Europe
Not such a 'grand bargain'
While the EU leaders have just agreed a 'grand bargain' aimed at providing a permanent crisis resolution mechanism, the provisions of the agreement fell some way short of what was initially indicated. The principal shortcoming is that due to intense domestic euro scepticism the German chancellor – Angela Merkel has pushed for a substantial watering down of German capital commitments to the European Stability Mechanism (ESM).Also, a key signatory for the mechanism, Finland, has to await an election in mid April where the 'True Finns', an anti euro party, has been gaining support. It is hard not to reach the conclusion that the conflict between EU– level crisis resolution and national politics has yet to be fully resolved.
Elsewhere, the Eurozone continues to face other pressure points. Having seen the government resign due to opposition to its proposed austerity plan the Portuguese bond yield has soared to 8.7% – an unsustainable level. Markets are now fully expecting Portugal to join Greece and Ireland as the recipients of an EU/IMF led bail out. Also, the Irish are still trying to renegotiate the terms of their bailout and will seek additional funding for their banks that would forestall the immediate sale of assets.
What is notably different this time round is that the contagion risk that was apparent in 2010 has dissipated. For instance, the spread between the yield on Spanish bonds and German bonds has contracted throughout 2011 reflecting a decline in Spanish default risk.
The ECB has indicated that it is close to lifting interest rates as inflation has moved above its 2% target. The widening of interest rate differentials with the US has contributed to the almost 9% appreciation of the euro relative to the dollar in Q1. Ironically, once the ECB start tightening, the focus of the currency market could switch from interest rate to growth differentials which could see the euro start to weaken relative to the dollar.
Asia
China
China continues to confront rising inflation and property prices by raising reserve ratios, increasing lending rates and imposing property – purchase limitations. While most of the rise in inflation is due to surging food prices, the authorities are anxious to rein in loan growth in order to curb speculative property building. It was therefore encouraging to see the M2 money supply growth decline from 19.7% at the start of the year to 15.7% in February – a signal that loan growth is declining. The rebound in the Shanghai composite index in Q1 could be a tentative signal that local investors think the end of tightening cycle in China is closer than we think.
Japan
The triple whammy of an earthquake, tsunami and nuclear reactor melt down came as a heavy blow for an economy that was showing tentative signs of recovery. It now looks as though GDP will contract 1-3% in 2011. For 2012 the rebuilding stimulus should then produce between 2-3% growth. Initial concerns that supplychain disruption would be significant now look overdone. In the immediate aftermath of the quake the yen appreciated significantly (in anticipation of capital repatriation), the G7 subsequently initiated a concerted intervention to weaken the yen which has been a partial success.
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