World
Collateral damage
There are two main areas of concern for the markets at the moment – euro zone debt restructuring and the status of the US economy. While there is relief that the EU and IMF support package for Greece has (for the time being) avoided a chaotic bond default that would have had global ramifications, the tortuous process in arriving at a bailout agreement has inflicted collateral damage. The sharp schism between Germany and the ECB over how to treat bond restructuring illustrated a fundamental division in views. More importantly, the whole episode has laid bare the core problem – confronting a monetary union without a commensurate fiscal union and centralized treasury function. While the provision of liquidity has bought some time, the attachment of stringent austerity and privatization conditions to the bailout exacerbates the solvency squeeze confronting Greece. Consequently, the agenda has shifted from one of whether Greece will default to one of considering the damage limitation should a default occur.
In the US, QE2 has run its course. The assessment of its impact is mixed. On the one hand it definitely did a good job in reversing the deflationary headwinds confronting the US this time last year, and also succeeded in creating wealth effects via the equity market rally in the latter half of 2010. It also produced a modest fall in unemployment. However, on the other hand, the generation of excess liquidity contributed to the surge in commodity prices that not only created problems for emerging economies but also shrank real disposable income in the US. Consequently, the negative unintended consequences of QE2 seem to have outweighed the benefits. It is disturbing to see the US economy start to lose momentum even before the cessation of QE2. The hope is that this is a temporary phenomenon resulting from supply chain disruptions. The concern is that the US economy is incapable of recovering without the intravenous drip of Quantitative Easing. The economic data releases over the next few weeks will be incredibly important.
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 oversold signals to reinvest our cash holdings.
US
A temporary dip or something more sinister?
High frequency economic indicators have shown a sudden decline in US economic momentum. There are two interpretations behind this dip. The first is that the economy has simply hit an air pocket created by the supply chain disruptions caused by the Japanese tsunami. This view assumes that once manufacturing capacity starts to ramp up later in the year the US should be able to resume a c 3% growth trajectory. The second interpretation is less benign. The fact that after two doses of Quantitative Easing both the US housing market and labour market remain moribund is testament to the structural headwinds facing the economy. The rise in commodity prices has also eroded disposable income. The clear risk is that a self fulfilling cycle emerges whereby uncertainty produces a curtailment in incremental activity that then generates further uncertainty. This is very reminiscent of the 'double dip' that emerged this time last year. The US bond yield has pushed below the significant 3% level and is clearly ascribing a high probability to a weakening in economic data over the coming months. With the administration and congress facing 'debt ceiling' restrictions the responsibility once again falls on the Federal Reserve to consider what, if any, further stimulus plans are necessary. There is already conjecture over the shape and form of QE3.
UK
A more dovish MPC
The UK appears so far to have avoided Greek contagion fears. The yields on UK gilts have fallen, while those of peripheral Europe have risen sharply. In fact the UK bonds have remained closely correlated to those of the US. As in the US, the concern in the UK is over the strength of the domestic economy. Recent retail sales data has shown a worrying resumption of sub par growth (having had a temporary Royal Wedding bank holiday boost).Although the labour market has performed reasonably well, with private job creation outstripping public sector layoffs, unemployment has remained stubbornly high at around 7.7%. Despite persistently high inflation with predictions that CPI will exceed 5% later in the year as utility price hikes kick in, there is little sign that the labour force is in a position to start a wage cost spiral. In fact the latest earnings data shows a sequential decline in earnings (ex bonuses). Consequently, the biggest concern for the MPC is not reining in inflation but confronting the impact to the economy from a combination of fiscal austerity, negative real disposable income and a deleveraging household. Consequently, interest rates are unlikely to rise for quite some time. Indeed, the prospect of another round of Quantitative Easing should not be ruled out.
While the FTSE index has fallen c 7% from the 6080 level established at the end on May it remains within the 5600- 6100 trading range established since last December. Given that both portfolio and corporate cash flow remain strong we think that if an oversold signal were to be triggered we should reinvest some of our cash in the equity market. The prospective dividend yield of 3.4% also lends support.
Europe
Buying some time
The attempt to reach a resolution over the provision of a Greek fiscal bailout has not only been tortuous it has inflicted collateral damage on the euro zone leadership structure. The trenchant stance taken by the ECB in stating it would not recognize 'retroflex' bonds as collateral and that at no stage could a debt restructuring trigger a 'credit event' put them in straight confrontation with the Germans who wanted to see private bond holders sharing the losses. Although the market was relieved that the Germans eventually gave way and agreed to the notion of a voluntary bond rollover that would not trigger CDS contracts, the victory for the ECB was pyrrhic. Attention rapidly turned to whether the Greek Prime Minister would win a vote of no confidence and subsequently get the Greek parliament to vote for the stringent austerity and privatization conditions attached to the IMF/EU bail-out. For a short while markets considered the potential consequences for the banking system and global economy if these votes failed and Greece simultaneously defaulted and announced its removal from the euro. Although there was some relief that this did not come to pass, the cold reality remains that the Greek economy is destined to face a regime of debt deflation for several more years. What is quite apparent is that the discordant euro zone leadership has yet again been addressing the wrong target. They have mistaken a problem of insolvency for one of liquidity. With 2 year yields at 28% the bond market is clearly telling us Greek insolvency remains the primary issue.
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 15.1% in May. 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. We think China will deliver between 8.5-9% GDP growths this year.
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. 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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.