Month: October 2011

Stagflation risk and what this means for stocks

As the outlook for growth continues to deteriorate, whilst the price for goods and services remain stubbornly high, the risk of stagflation returns. This would be a tough scenario, where policy options tackling one of these issues would only worsen the other. This creates substantial downside risk for stock valuations based on bullish growth forecasts, whilst making it more prudent to invest in price makers able to pass on rising input costs.

Lower growth outlook

The outlook for growth is bleak. The IMF has reduced their forecasted expansion of Europe from 2% to 1.6% and Goldman Sachs swiftly followed suit predicting France and Germany will fall into recession next year, with the EU stagnating. The data looks supportive of this view. German retail sales disappointed expectations, with a contraction of -4.3% in July vs. -0.5% expected. With Europe still our largest trading partner, the effect on the UK could be severe.

Outside the EU, countries aren’t immune. China’s Purchasing Managers Index has fallen below the 50 mark, the line separating expansion from contraction and GDP growth came in at 9.1%, falling from 9.5% and below expectations.

QE increases stagflation fears

In an effort to boost the economy, the Bank of England surprised many commentators by increasing their purchases of UK government bonds, from £200bn to £275bn.  However, this is not without its risks. It is not a guaranteed strategy to boost growth and crucially create jobs. Instead, it is more likely to increase inflation.

Taking bonds out of the market and pumping cash in their place only reduces the value and purchasing power of the currency, making goods and services more expensive. Inflation is already above the 2% target set for price stability, hitting a rate of 5.2% at the latest measure this week. In the EU the value jumped to 3% in September, the fastest increase in 3 years and potentially a reason behind their Central Bank’s decision not to cut rates.

Unemployment in stagnating economies is an issue and highlights the threat. Spain is struggling with 1 in every 5 of their people without a job, increasing to 45% of the youth population, and Portugal’s jobless level has reached highs not seen for over two decades. The US’s September figures are stuck at 9.1%, although CPI came in below expectations. Here in the UK the level might ‘only’ be 7.9% but this is still high and stubbornly so, with inflation surprising on the upside.

The stagflation quandary (where stagnation and inflation meet) is that to tackle unemployment and boost growth, interest rates would be cut, however not only are they already low, but that would boost inflation even further. Likewise, to tackle inflation, interest rates might be increased but this would only hurt growth and employment.

A lose-lose situation.

Risk of Stock Downgrades

So what has this meant for stocks? Firstly, there is downside risk to stock valuations. With many valuations based on forecasted growth, downgrades could negatively impact and seem more expensive. Analysts are 10 times more bullish on the growth outlook than economists. Although, always more optimistic, that is twice the historical average.

Secondly, it may be more prudent to invest with those that are price makers not price takers, as well as with a protected demand base, in order to be able to pass on rising costs.

A Greek default on the cards but the banks aren’t listening

The markets expect a Greek default and time is running out. However, banks still haven’t recognised enough of this loss, highlighting the pent-up risk in the sector. Deep-seated scepticism continues to drive market volatility and this will continue until a credible plan is on the table.

A Greek default due

Markets are pricing in a 93% probability Greece will default, with the country missing its deficit reduction targets, contracting greater than anticipated (-5.5% vs. -3.8%) and unable to meet salary and pension obligations within the next couple of weeks. However, there is still much uncertainty on what the next steps will be. Politicians are still clinging to the hope further bailouts will help and hinting they will demand private investors to bear a bigger part of the pain (“technical revisions” to allow greater haircut) but Finland is demanding collateral and time is running out.

“Time to move”

Despite ‘kicking the can down the road’ and delaying decisions over the next tranche of the Greek bailout, the markets are looking to the G20 meeting in Cannes on 3rd – 4th November as the final deadline for decisive action. Political pressure is high as Geitner demands it’s “time to move” and Obama issues some stark words accusing the EU of having a fiscal plan that is “scaring the world”.

Banks are not prepared

Dexia, one of Europe’s largest banks, hit the news with their need for some form of rescue. Their reliance on short term funding may be their current problem but the outlook is no more rosey. They have only reduced the value of their Greek bond debt exposure by 21%. If they, along with BNP Paribas and Soc Gen write-down these debts by 51%, that will cause massive losses amounting to E3bn. That’s of course assuming Greece doesn’t fully renege on all outstanding loans due.

Pent up risk

Therefore there are still many events that could shock the markets. Although so far market falls have been followed by short term rallies as investors use the opportunity to buy back into the markets. Crucially though, upside and downside moves are exhibiting a large amount of intra-day volatility. This highlights the deep seated scepticism that will only be removed once a credible and clear long-term plan is put into action. Until that time, the swings will continue.

CNBC Clip: Europe Weighing on Markets