WORLD
Risk aversion is in the ascendant
Over the last few weeks markets have had to contend with an array of issues that have increased risk aversion. One of the primary drivers behind the risk off trade has been the open rift between the ECB and the EU finance ministers over whether or not to allow Greece to restructure its debt. This has not only generated concerns over the health of the European banking system but also resurrected systemic contagion fears, with Spanish bond spreads widening significantly. The euro has fallen 5% against the dollar in response to the mounting uncertainty. Adding to the overall confusion, the markets still expect the ECB to increase interest rates another notch in the summer even though this clearly creates adverse financial conditions for the peripheral economies. What seems evident is that even if the Greek bond restructuring/bailout issue is sorted out soon, the underlying solvency crisis in the periphery is a long way from being resolved. We must therefore expect further pulses of tension that will impact the euro over the coming months.
Another headwind for markets has been the uncertainty surrounding the cessation of US quantitative easing (QE2). The savage sell off of various commodities such as Silver and oil at the start of May was possibly a foretaste of the enhanced volatility that the withdrawal of excess liquidity can produce.
Also, there is a growing concern that as in 2010 the withdrawal of quantitative easing is coinciding with signs that the US economy is losing momentum. A good lead indicator on the US economy is the bond yield which has been falling sharply of late. We need to watch this closely as a sub 3% yield could well trigger a double dip scare.
The fundamental underpinning for equity markets remains the health of corporate cash flow and balance sheets. This is driving growth in merger and acquisition activity, stock buy backs and dividends. Valuations look reasonable with most prospective PE's below their respective 5 year averages. Consequently, although we see the summer months as a period of increased volatility with potentially more downside than upside risk we will seek to take advantage of any down drafts to reinvest our cash holdings.
US
A 3% Bond Yield poses some big questions
While the US equity market has been range bound in May, the bond market has experienced a significant rally. The yield on the 10 year bonds have declined from a recent peak of 3.6% to 3.1%. We recall that the decline in bond yields this time last year signaled a full scale double dip alert. While some of the recent high frequency economic indicators such as the services ISM are indicating that US growth has peaked, they are not so far indicating a rapid decline. Indeed, decomposing the bond yield shift shows that the bulk of the move has been due to a decline in breakeven inflation rather than real yields (a growth proxy).
It could also be the case that the recent volatility in commodities and uncertainty in the eurozone has seen US bonds benefit from their safe haven status. This is somewhat ironic in that the US debt ceiling has been extended to August and the US has so far been the one major economy that has not instigated any formal fiscal austerity programme.
Our view is that the move in bonds has probably been overdone. We have forecast a range of 3.25%-3.75% for quite some time. However, if the US bond yield was to fall below 3% it will not only pull UK and other bonds with it but also exert a powerful influence on the Federal Reserve and Chairman Bernanke regarding the impact of the withdrawal of QE2.They will be keen to avoid a replay of Q2 2010.
UK
A defensive rotation
The Bank of England's May inflation report reduced UK growth forecasts to 1.8% and 2.5% for 2011 and 2012 respectively. The 2012 growth forecast might still prove to be a bit ambitious and is currently about 50 basis points above consensus forecasts. CPI inflation is projected to peak close to 5% this year and then start to decline rapidly in the first half of 2012.
It is interesting to note that having recalibrated market expectations to a higher CPI number later this year (a function of rising utility costs) the stronger than expected April CPI reading of 4.5% hardly shifted interest rate expectations. Having weathered a storm of criticism during the first quarter, Mervyn King has re-established his standing and gravitas within the MPC. He has consistently voiced his concern that the profile of domestic demand is too fragile to absorb a sequence of rate hikes and that pushing up rates to confront imported inflation would be a 'futile gesture'. Now that the main hawk (Andrew Sentance) has left the MPC and wage cost inflation shows little sign of accelerating, monetary policy is unlikely to change until the latter end of the year at the earliest.
The FTSE 100 equity index has spent the most of 2011 in a narrow 250 point trading range. However, looking beneath the surface we have begun to see more pronounced sector rotation take place. In May, increased volatility in commodity prices was the catalyst for a rotation from cyclical to defensive sectors. If growth expectations remain subdued and the ending of US QE2 continues to exert downward pressure on commodities then defensives are likely to continue to outperform.
EUROPE
Grappling with Hydra
The problems in the European periphery have established 'Hydra-esq' properties. As soon as the authorities address one problem (they have just signed off on the 78bn euro Portuguese bailout package) another problem pops up. Once again Greece is taking centre stage as it has become apparent that it faces another fiscal shortfall that cannot be funded via the bond market. The prospect of a second Greek bailout has exerted enormous pressure on the eurozone leadership structure. The EU finance ministers have stated a preference for a soft option of debt restructuring known as 'reprofiling' (extending the bond pay back period) over a direct bailout. This would have the advantage of not requiring banks to mark down the value of the bonds on their books. However, the ECB has voiced staunch criticism of any notion of bond restructuring and have said they would not recognize 'reprofiled' Greek bonds as collateral for refinancing obligations. It is also concerned about the implicit contagion implications.
In all likelihood the ECB's view will prevail but this implies Greece will receive a bailout with conditions that simply buy a bit of time but doesn't address the core solvency issue.
The uncertainty engendered by the fractured leadership in the eurozone has resulted in a decline in the euro. It has fallen by 5% against the dollar since the end of April.
ASIA
China
China continues to confront rising inflation and property prices by raising bank reserve ratios and increasing lending rates. 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. M2 money supply growth has fallen from 19.7% in December to 15.3% in April. The lagged correlation between money supply and CPI inflation indicates that Chinese inflation could start to decline in a couple of months. This does not preclude further interest rate hikes but it does suggest that Chinese tightening has almost run its course.
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 supply-chain disruption would be significant now look overdone. After the G7 initiated a concerted intervention the yen weakened by 8%. However it has subsequently started to rally – possibly reflecting a repatriation of capital.
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