World
The return of risk aversion
The demonstrable loss of momentum in the US economy combined with signs of heightened anxiety from the Federal Reserve over the risks of deflation has dominated market attention over the last few weeks. The catalyst for the deterioration in the outlook has been the sharp slowdown in job creation over the last 3 months and signs of fragility in the housing market. The Fed is clearly worried that the US economy is stalling. Bond yields have moved sharply lower in response to weak data and the rhetoric shift by the Fed appears to be factoring in much lower trend (nominal GDP) growth. It is worth recalling that the historical correlation between bond yields and nominal GDP growth is high. This has increased the pressure on the Fed to restart quantitative easing but they have stated they will need to see further evidence of a slowdown before enacting a new programme. Meanwhile, the Japanese yen has appreciated sharply as domestic savers repatriate their foreign investments in response to the heightened levels of risk and uncertainty in global markets. This adds to the deflationary pressure on the economy as it reduces the cost of imports and reduces net exports the main driver of growth.
In contrast to the US, the euro-zone has posted strong Q2 GDP growth, and a sequence of positive news flow. Despite this the European equity market has performed in line with the US market (on a local currency basis) emphasizing the strong correlation to the US market. The euro has started to retrench after experiencing a strong rally as the focus spins back towards the growth and debt profile of the peripheral economies.
While Q2 earnings were stronger than expected they have not produced substantial revisions to forward estimates and therefore have had relatively limited market impact. What has been more noticeable is the acceleration in the pace of merger and acquisition activity as corporations utilize their free cash flow.
US
Heightened anxiety
The observation by James Bullard the president of the St Louis Fed that the 'US is closer to a Japanese style outcome than at any time in recent history', not only raised the spectre of the US entering a deflationary trap, it emphasized the growing concern within the Federal Reserve at the loss of momentum in the US economy. This was reinforced by Ben Bernanke who mentioned that the US 'had a considerable way to go before it had made a full recovery'.
There are two primary sources of concern at the Fed. The first is the weakness in the labour market where only 150,000 private sector jobs have been created over the last three months. The expected three month run rate at this stage in the economic cycle should be closer to 700,000. The shortfall in job creation is unusual given the strength of corporate cash flow generation, and the breakdown in the usual transfer mechanism is perplexing.
The other area of concern is the fragility of the housing market. With an estimated 25% of US mortgages unable to be refinanced the housing market faces pressure from foreclosures and a significant inventory of unsold property.
While the Fed will leave rates unchanged for the foreseeable future it has agreed to reinvest the proceeds from the maturing mortgage-backed securities to purchase Treasury Bonds (at a rate of c$15-$20bn a month) – effectively maintaining the size of their balance sheet. However, they have not yet signaled rolling out a second phase of Quantitative Easing (QE2) but have kept the option open. Bond yields have fallen sharply in response to the combination of weak economic data and the prospect of the activation of QE2
UK
A de facto shift in the Bank of England remit
While the latest Bank of England inflation report lowered UK growth forecasts for 2011 to 2.8% from 3.5%, these remain well above the 1.9% consensus forecast. This infers a downward bias to subsequent revisions. The report also forecast that CPI will remain above the 2% target until at least 2012, due to the impact of the rise in VAT in January next year. However, the Bank of England Governor Mervyn King, reiterated his conviction that the UK faces disinflationary headwinds due to a combination of a large output gap, weak credit creation and fiscal consolidation.
This stance is supported by signs that core inflation has started to decline and impending public sector cuts are already impacting economic activity. The decline in 10 year break even inflation from 3.25% in April to 2.5% at the end of August is additional confirmation that inflationary expectations will remain subdued.
The BoE is well aware of the dangers of a negative feedback loop emerging whereby talk of austerity reduces both confidence and activity. Because of this the BoE is de facto trying to shift their remit from strict inflation targeting towards a Fed style blend of growth and inflation targeting. Consequently, interest rates are likely to remain unchanged for a long while and as with the US Fed, the BoE has discussed the possibility of restarting Quantitative Easing if necessary.
The FTSE All Share 12 month forward consensus EPS estimates have flat lined since April but are still 22% higher than at the start of the year. This leaves the market on a prospective PE of 9.8X. The 12M forward dividend Yield of 3.9% is now higher than the 3.8% 30 year bond yield. The big question is whether in a low growth, low bond yield world, equities will need to yield more than bonds going forward.
Europe
A beacon of strength – but is it sustainable?
The euro-zone economy delivered 1% GDP growth in Q2 almost twice the Q2 growth rate expected from the US. Consequently full year 2010 consensus estimates have moved from 1.1% to 1.4%.
It is worth noting that the rebound in growth has been narrowly based and mainly reliant on net exports (principally German exports).
The recovery in industrial production and exports has seen a surge in business confidence and purchasing managers surveys. The hope is that this will soon translate into job creation and falling unemployment. Should this occur the recovery in the euro-zone will become both broader and deeper as consumption demand becomes the driver of incremental growth. This would also help transfer excess savings from Germany to the peripheral economies. However, it still remains to be seen whether the euro-zone can fully decouple its business cycle from that of the US.
The euro rallied between June and early August on the back of incremental improvements in both growth and interest rate differentials relative to the US, and also from reduced fears over the status of the banking system. Since then it has declined as attention has once again started to refocus on the solvency issue surrounding the peripheral economies.
Asia
China
The authorities in China have been attempting to slow the economy to a more sustainable growth rate by reining in the property market. They have done this by tightening lending standards and restricting the growth in credit creation. To this end, broad money growth slowed to 17.6% in July, compared with a peak of 29.6% in November 2009. House prices are showing signs of moderating having increased by 10.3% YoY versus a rise of 12.8% in April. Inflation moved back above the 3% target and might prove difficult to reduce as food price inflation persists. In order to counter balance the risk of export growth slowing sharply next year China needs to bolster consumption demand. This could be achieved via targeted incentives and allowing the revaluation of the renminbi.
Japan
Japan's GDP growth slowed to just 0.1% in Q2 as domestic demand turned negative, leaving net exports as the only driver of growth. Indeed since the recovery began in 2009 Q1 net exports have accounted for around 85% of the rise in GDP. Clearly the continued strength in the yen (the trade weighted yen has appreciated 17% YTD) poses a clear risk to export growth. There is also the additional risk that Japanese companies decide to relocate more production capacity overseas further curtailing domestic demand. The Bank of Japan is under increasing pressure to consider intervention to weaken the currency but remain reluctant to act. Excess spare capacity is still delivering persistent deflationary headwinds.
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