Published in CityA.M.
The global recovery does not fully account for the rise in markets, and the growth that would justify these elevated price levels is not guaranteed. (more…)
‘Wind down’ is not withdrawal but watch negative news flow in the US; treading water is not growth so keep the champagne on ice for Europe; price is not value so beware investor sentiment; falling unemployment is not rising employment so watch the participation rate; and a hiccup is not a correction so keep an eye on an exit…
The room’s getting crowded, the party’s been going on a while but more people could arrive. Just beware fair weather friends and a sign it could be time to think about leaving…
Investors are expecting an eventual reduction of support by the Fed, and Merkel winning the election this weekend. However, what stock markets have not priced in is the resurgence of Eurozone troubles into the headlines. So what are the options, why is this important and how will this effect markets?
[Click image below or this LINK to watch this as a TV Clip]
Published on the Front Page of the Huffington Post Business
With strong words to support the Euro, Mario Draghi, the European Central Bank President, quelled fears over the future of the Eurozone. However, the bailout negotiations in Cyprus revealed cracks in this ‘floor’ supporting the region and markets. A ‘Banking Union’ has been undermined, imbalances within the region magnified and individual systematic risk returned. Divergences within the global banking sector will widen but with the Fed likely to remain accommodative, bullish market sentiment may continue to overshadow concerns elsewhere. Nevertheless, this recent turmoil has highlighted that we’re far from an end to the crisis.
[Click image below or this LINK to watch this as a TV Clip]
As U.S. stocks and the European equity index ended last week in positive territory, against a backdrop of disappointing data, market moves seems misplaced. Instead, Central Bank action is cosmetic not medicinal, a tool for reassurance not economic change. Developments from the recent EU Summit are either temporary or limited and capital remains restricted. However, economic deterioration heats up the pressure for action. Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.
Central Bank Action is Cosmetic Not Medicinal
Central bank action is being met with scepticism, and initial market rallies used as selling opportunities for profit taking. This is because moves are cosmetic and not medicinal, as in the short term they may reassure markets that measures are being taken, but they are of limited effectiveness at significantly boosting growth. Even Draghi himself, the President of the European Central Bank, argued “price signals (have) relatively limited immediate effect”. They won’t stimulate demand and, by potentially hurting bank profitability, could reduce the incentive to lend – the opposite of the target outcome.
Nevertheless, for the first time, we have seen the ECB cut the benchmark interest rate below 1%. In the same week, the Bank of England announced it will be increasing asset purchases by £50m. With weak US data and Bernanke already cautious, the pressure will be on to turn ‘Operation Twist’ into a more traditional waltz. Investors will be hoping the Fed will pump more liquidity into the system instead of ‘twisting’ or neutralising purchases by selling elsewhere along the yield curve.
Summit Moves Are Limited
The outcome of extensive talks at the EU Summit likewise fuelled a ‘false rally’. Spanish government bonds have since returned to hover around the unsustainable 7% level again despite developments. Instead, the 3 key ‘achievements’ are temporary or limited, as explained below…
1. Senior not guaranteed: Investors have been moved higher up the pecking order and will now be repaid for loans made to Spanish banks before the bailout fund. Being the ‘first’ in line to get money back is indeed an improvement but crucially the risk of loss is still there and may continue to worry the markets.
2. Wishful thinking? The government has been removed from the equation with bailout funds now able to offer loans to struggling Spanish banks directly. Removing government involvement in bank bailouts to protects sovereign bond yields ignores the possibility investors will continue to view the health of the banks as a driver of economic health.
3. Bond buying boost limited: Bailout funds may now buy debt directly from “solvent countries” (read: Italy). However, this is a limited source of demand and again short-sighted.
Capital Remains Restricted
The size of the problem remains a key concern and a crucial measure missing from the Summit was a substantial strengthening of the ‘firewalls’. At €500bn, the rescue fund is only 20% of the €2.4tn combined debt burden of Spain and Italy. The risk that a lack of funding will leave European leaders unable to stop the crisis spreading remains.
Economic Deterioration Heats up the Pressure for Action
With a backdrop of a deteriorating economic environment, Europe is far from able to ‘grow out of the problem’. German manufacturing deteriorated for 4th consecutive month. Relied upon as a rare source of growth, the outlook is dimming. European unemployment has reached its highest level since the creation euro. This is unlikely to spur spending and instead put the pressure back on Central Banks to do something to kick-start economic growth.
Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.
Note some of this article has been published by the Financial Times
With political pitfalls possible, eyes on Chinese easing, and a flight to quality by investors, policy is driving market direction. This week, the minutes from the latest Federal Reserve meeting will be scoured for signs of further fiscal support. Moreover, the Bank of England’s inflation report will be reviewed for changes to the outlook for growth and inflation. Central bank rhetoric will determine how investors trade. (Watch this as a slide show…)
Political Pitfalls Possible
France’s new President will meet German Chancellor Merkel today with opposing views on the fiscal treaty (see previous post). Furthermore, until a Greek coalition is formed, turmoil there will continue.
Eyes on China Easing
After data disappointed last week, the Bank of China cut the reserve requirement ratio by 50 basis points on Saturday. This is the equivalent to injecting around $64 billion into the banks. Investors remain watchful on Chinese policy, hoping it remains accommodative as the economy cools, to protect global growth.
Flight to Quality
Unsurprisingly, with the climate uncertain, investors have rushed into perceived safe havens. With much money still on the sidelines, a reversal of this trend could provide a hefty boost to markets. Appetite for risk is a crucial current driver.
QE3 Back on the Table?
The Federal Open Market Committee (FOMC) minutes will be scoured for signs of fiscal support. Housing market weakness and elevated unemployment has caused Bernanke to leave the door open for further stimulus. Any indication of inflation easing could put the possibility of QE3 back on the table. Although still unlikely, with elections due this year, the pressure is on for policy to remain accommodative.
A Worse Outlook for UK Inflation and Growth?
The Bank of England’s inflation report will give investors colour on the headwinds for consumption and the economy as a whole, as growth and inflation forecasts may be amended. Plunging purchasing power will keep consumer spending stifled. As rising inflation data calls an end to a 5 month easing trend and continues to surprise on the upside, investors will be watching for an increase in the inflation forecast. Higher energy prices and lending rates have kept the risk to the upside and as we dip back into recession, businesses are unlikely to boost hiring. Investors will therefore focus on whether the growth outlook is downgraded. Headwinds are severe and sentiment remains depressed.
As the US launches $400bn ‘Operation Twist’ in a desperate attempt to kick-start the economy, concerns arise over how effective this will be. It’s true that something needs to be done and inflation restricts the options open to the Fed but the strategy has a poor track record in terms of effectiveness. We will be in a lower growth environment for longer and should prepare accordingly.
The Economy Struggles: Something needs to be done
The US remains driven by consumer spending (~70% of GDP), but weak consumer confidence and limited access to financing are severe headwinds. Unemployment is stuck at 9% and even more worrying are the ‘under-employment’ figures which include those that have been forced to cut their working week rise as far as 18.5% of the population. In addition to discouraging spending, the longer this continues, the more skills are being eroded. Therefore the US government is under an immense pressure to act.
But inflation restricts options
So what can they do? When conventional monetary policy has become ineffective, since short term interest rates are already low, that’s where quantitative easing steps in. With the aim of stimulating the economy, the Fed will buy financial assets in order to inject money into the markets. Bernanke has made it clear that one of the pre-requisites is a re-emergence of deflationary risks. However, inflation remains stubbornly above 2%. Pumping more money into the markets increases its supply and therefore reduces its value. With the currency less valuable, it doesn’t go as far as it used to and you get less ‘bang for you buck’. Things seem more expensive and inflation has been boosted.
Operation Twist to the rescue?
There is hope. One form of quantitative easing avoids the problem of inflation – Operation Twist. The strategy still involves the Fed buying long term government bonds, but in this case, it’s offset with selling short term bonds. This avoids flooding the market with cash which would exacerbate inflation. Another way this method is also described, by selling short term bonds and buying longer term bonds, is an extending of the maturity of Fed’s bond portfolio. Buying these long dated bonds increases demand and therefore reduces the amount of interest the bond issuer has to offer to entice buyers. A reduced longer term rate makes for example mortgages (long term borrowing) more affordable which would hopefully encourage spending.
A Poor Track Record
History teaches that Operation Twist may be of limited use. When it was applied back in 1961, it only reduced rates by 15bps! This would not be enough to encourage spending, hiring and boost the economy sufficiently.
What can you do?
Prepare for a lower growth environment for longer. Pay attention to the type of customer a company in which you’re interested in investing services. A strong balance sheet, pricing power and protected demand will serve firms well.
The US Equity market in less than two years, as measured by the S&P500, has doubled from its post crisis March 2009 low. Volatility has sunk. US Unemployment remains high. The Fed is fueling a speculative boom with the riches accumulating to the few. US Labor struggling to get back to a decent or any work and the geopolitics paint a complete opposite picture to the market euphoria. All the while clouds in the global geopolitical sphere continue to gather pace. While in the west we measure progress many times by the rise or fall of the markets alone on a daily basis – For the people of Egypt the long struggle for jobs, social justice has only begun. On Feb 13th, the military council abolished the constitution… timetable to nowhere is all we can see… as the military positions to further consolidate its stranglehold on the people. Unrest potential is building in the Arab world. From the lands north of Sahara- Northern Africa. From the Nile to the Euphrates. From the Mediterranean to Mesopotamia. The two ‘I’s, Israel-Iran, eyeing each other and global players are taking positions. China has a new world status and it could test its newly found powers, all the while weaknesses are building into its own economic system that risk world destabilization. Change in the status quo in the middle east and elsewhere where pressures have been building for some time now can have seismic implications for growth of the world economy. Rather growth stalling at best with uncertainty keeping long term investment plans at bay and hungry jobless populations or democratically starved plutocratic nations citizens pressuring for reforms. Global aggregate demand on the government side is pressured to collapse as spending at current intervals is unsustainable. The pace of implementation of structural reforms is slow and major structural reforms measures are still to be taken. Will the Fed stimulus policies continue to keep the economy from faltering? We take the view that the higher you are the greater the fall and the highs we are now are not compatible with the struggle to put bread on the table for most families. Even in the most affluent of Nations. Ours. The Baltic index has closed at near quarter century lows. Ship oversupply? Yes. Australia flood impact? Yes. Trade used to be the life blood of world economy. Now it is finance. Speculative flows of money looking for a quick domicile for short term gain. Capital has always ruled the world but money movements of such intensity is a relatively new phenomenon that our econometric models do not have much historic data to go by. All is so synchronized now around the world. The supply of funding for excess speculative building abundant from the central authorities. Yet Trade the heart pulse of human global endevours and interactions since time in antiquity- trade- global trade- is telling us otherwise. Something is happening. Something big. The amount of trade is clearly going down as things look up in government, central banks and brokerage house reports. The Greek ships have been taking much to China but lately they come back many times empty. Yet the forward looking equity markets of our Western World…measures of progress in the eyes of many.. vain quests of financial engineering yet once more.. have been marching higher. Fundamental and technical traders follow the same momentum of a rising tide on stimulative action not structural reform. This is not healthy. The system has yet to cleanse itself. Something has to give…..
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INVESTMENT INSIGHT: Invest in HIGH QUALITY companies – strong balance sheets – cash flow rich
“Despite various forms of support from the Bank of England and from Government, it is clear that the lending capacity of the banking system, in the UK and elsewhere, is impaired and will take some years yet to recover. Some banks need to continue de-risking and de-leveraging.” (Paul Fisher – Executive Director Markets and member of the Monetary Policy Committee – Bank of England)
As discussed, the outlook for the demand for debt is not looking rosy. Consumers, companies and governments are all focused on reducing the amount of borrowing on their “books”. (See \”Isn\’t the consumer dead?..\”). On the other side of the equation, the supply of debt is also limited. Despite record stimulus packages, the amount of money that has reached the end user has remained muted.
In the US, commercial and industrial loans have fallen at an unprecedented rate.
And in the UK, earlier this year, less banks stated they plan to increase supply of credit in June than March (BoE). Between Apr ‘11 and Jan ‘12 lenders are due to repay £185bn raised under BoE special liquidity scheme. Furthermore, any banks that are able and willing to lend are being deterred with the threat of stricter global capital requirements looms as well as a tightening of credit scoring criteria.
INVESTMENT INSIGHT: Invest in high quality names, those with strong balance sheets, cash flow rich and therefore less likely to struggle needing to raise finance and instead more likely to have the capital to make value-adding acquisitions / increase market share