WORLD
Hit by a double whammy
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 (in the US regarding the debt ceiling negotiations and the EU regarding the handling of the sovereign debt crisis), 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 question mark over the trajectory of growth, and therefore returns, that can be expected from equities. The connectivity between nominal bond yields and nominal 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.
What is quite clear is that 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 use the Jackson Hole speech to rally the market and sentiment. Unfortunately, he is more constrained in his policy options compared to this time last year. Therefore a 2010 redux is unlikely. The other policy response that would have a major market impact would be a signal of coordinated action in the Eurozone (particularly a German acceptance of a move towards fiscal union and the establishment of Eurozone bonds). Again this feels like hope rather than expectation. Until we get clarification on the status of both the US economy and the Eurozone debt crisis, markets are likely to remain volatile.
US
Budget brinkmanship – erosion of confidence
The US equity and bond markets have had a tumultuous few weeks. Despite reaching a last minute agreement to extend the debt ceiling and hence avoid a government shut down, the extended process of brinkmanship and political posturing has created a lingering impression of dysfunctional leadership in Washington. All of this occurred at a time when confidence over the economy was dissipating. The catalyst for this erosion in confidence came with the disclosure in the Q2 GDP release that revisions to prior data not only showed that the depth of the recession had been more severe than previously thought, but also the recent pace of recovery had been more modest. Compounding this concern, the latest ISM and Philadelphia Fed indicators suggested that the uncertainty engendered by Washington was producing a rapid curtailment in overall economic activity. The Federal Reserve is clearly concerned at recent developments and has given an unusual commitment to keep interest rates static until 2013. Despite S&P downgrading the AAA credit rating, US bonds have performed very well with 10 year yields falling to near all time lows. While this is partly attributable to risk aversion the fact that most of this move can be explained by the decline in real yields (a growth proxy) should be seen as a clear signal that the US economy is establishing a much lower nominal growth trajectory.
UK
QE2 is on the radar screen
The UK economy is losing momentum. Consumption expenditure which constitutes 2/3rds of the economy 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 unemployment rate has increased from 7.7% to 7.9%).The housing market also remains moribund. Net exports have failed to accelerate and with government expenditure in contraction mode, corporate capital expenditure is the only visible source of growth stimulus. Consequently, the growth projections of 1.7% (2011) and 2.5% (2012) used by the government in the March budget are now looking optimistic. Indeed, the chancellor George Osborne has publicly acknowledged that the recovery will be both 'longer and harder' than expected. It also poses questions over the sustainability of the current fiscal austerity programme. The deterioration in sentiment regarding the status of the UK economy has contributed to UK gilt yields hitting the lowest level since the 19th century.
The August MPC minutes reflected a mounting concern over the direction of the economy and revealed that for the first time since May 2010 no member voted for a rate hike. There was also consideration of whether there was a case for extending quantitative easing. While it was felt the case was not quite strong enough it was a clear signal that further QE is on the radar screen and will be deployed if downside risks materialise.
EUROPE
Approaching the point of no return
The hope that the emergency EU heads summit at the end of July did enough to alleviate pressure on the Eurozone economies did not last for long. The failure of the meeting to address the core structural flaws facing the Eurozone by either boosting the resources of the EFSF support mechanism, or giving an undertaking to move towards fiscal union and the issuance of a Eurobond, left the markets dissatisfied and in the mood to renew their attack on the politicians. The initial target for the markets was Italy where an already high debt to GDP ratio left it vulnerable to solvency risk. Italian 10 year bond yields once again moved above 6% – forcing the Italian administration to increase its fiscal austerity programme. The spotlight then rapidly rotated to France with fears that its AAA credit rating was at risk due to the potential costs of bailing out Spain and Italy but also due to the exposure of French banks to Italian debt.
In the absence of coordinated political responses to the crisis the ECB convened an emergency meeting to sanction peripheral bond purchases. This programme has worked quite well pushing Italian and Spanish bond yields down 100 basis points and buying some time. However, the ECB is a reluctant participant and sustained bond purchases are unlikely.
We have now passed the point of no return in terms of the Eurozone crisis with the markets demanding definitive clarification from Germany as to whether or not it is willing to accede to fiscal union. This is because they correctly see this as the only route to the sustainability of the euro. The markets are in a tenacious mood and will once again come back to test the resolve of the EU leadership on this issue. One thing is certain, Germany can not continue to kick the can down the road.
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 14.7 % in July. The lagged correlation between money supply and CPI inflation indicates that Chinese inflation has most probably already peaked. Although China is not immune from a slowdown in developed economies the reorientation of the economy from exports to consumption (including a big expansion of social housing) should enable it to continue to grow GDP in excess of 8% in 2012.
Japan
The Japanese economy has started to recover from the impact of the earthquake and tsunami. The supply chain disruptions were not as great as first feared and consensus forecasts expect the rebuilding process to deliver 2.8% growth in 2012. The yen has rallied significantly partly in response to capital repatriation but also due to its safe haven status. The pressure this is exerting on the economy and corporate margins has prompted the finance minister together with the BOJ to consider measures to curtail the recent strength of the currency.
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