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The markets rapidly rotated to an aggressive 'risk off'
position in August in response to a double whammy of concerns
– the display of alarmingly dysfunctional political
leadership on either side of the Atlantic, together with mounting
concerns over the fragility of the US economy. Consequently, global
equities contracted 13% in rapid order, Gold moved from $1628 to
just shy of $1900 and US and UK bond yields approached all time
lows.
While it is tempting to treat the sell off as an attractive
entry point we need to acknowledge that the decline in the bond
yields is posing major questions over the trajectory of growth, and
therefore returns, expected from equities. The connectivity between
nominal bond yields and nominal gross domestic product (GDP) growth
suggests we have entered the stage of the cycle when operating
leverage (the impact that a shift in revenue growth has on
earnings) turns negative. Consequently a health warning needs to be
attached to what appear to be apparently low market valuations
– 2012 EPS forecasts look set to ratchet lower.
As in 2009 and 2010, policy initiatives and macro factors, not
valuations, will be the catalysts for a recovery in equities. Much
attention is therefore focused on whether Federal Reserve chairman
Ben Bernanke can rally the market and sentiment. Unfortunately, he
is more constrained in his policy options compared to last year.
Therefore a 2010 redux is unlikely. The other policy response that
would have a major market impact would be a signal of co-ordinated
action in the eurozone (particularly a German acceptance of a move
towards fiscal union and the establishment of eurozone bonds). This
feels like hope rather than expectation. Until we get clarification
on the status of the US economy and the eurozone debt crisis,
markets are likely to remain volatile.
UK: QE2 on the radar screen
The UK economy is losing momentum. Consumption expenditure
remains extremely fragile and is unlikely to rebound sharply. It
has been impacted by sustained erosion in real disposable income
and a deteriorating labour market. The housing market remains
moribund. Net exports have failed to accelerate and with government
expenditure contracting, corporate capital expenditure is the only
visible source of growth stimulus. Growth projections of 1.7%
(2011) and 2.5% (2012) are now looking optimistic. The chancellor
has acknowledged that the recovery will be "longer and
harder" than expected. It also poses questions over the
sustainability of the austerity programme. UK gilt yields have hit
their lowest level since the 19th century.
The August Monetary Policy Committee (MPC) minutes reflected
mounting concern over the economy – no member voted for a
rate hike. There was also consideration of whether there was a case
for extending quantitative easing (QE) – a clear signal
that further QE is on the radar screen and will be deployed if
downside risks materialise.
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