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]
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 French and Greek voters make their feeling about spending cuts loud and clear, we ask ourselves – why has there been such a strong swing to anti-austerity/pro-growth, how does this threaten the survival of the euro and is a Greek default still possible? The deepening slump has dampened deficit reduction, the Fiscal treaty hangs in the balance and patience is wearing thin. Crucially, according to voters and investors, time is running out.
Growth vs. Austerity: deepening slump is dampening deficit reduction
Francois Hollande’s victory in the French elections marks a significant change of focus in European politics. In contrast to the rhetoric delivered up to this point, Hollande wants emphasis of policy to be on growth instead of austerity. Why does he want this? Because the situation is deteriorating. Unless a country grows, their debt burden, as a percentage of a decreasing national output, grows and is therefore harder to manage. As iterated by French Socialist lawmaker Arnaud Montebourg, in an interview with BFMTV “Austerity is everywhere and it’s a complete shipwreck,”.
Portugal and Spain are prime examples. While the Portuguese economy is expected to contract by 3.3% this year, the deepening slump is dampening deficit reduction. In fact, the deficit almost tripled in the first couple of months of this year alone. Spain, similarly, is struggling with a deteriorating debt situation. As almost 1 in 4 are without jobs, unemployment is boosting defaults. Bad loan ratios have reached a 17 year high (see chart below on the right).
Survival of the Euro Threatened
However, such a drastic change of attitude could damage the Franco-German Alliance, political progress and the very survival of the euro. This is because for Hollande to promote growth, he is threatening the fiscal treaty, perceived as crucial for keeping the euro together in its current form. The Treaty would create closer consolidation within the European union. Handing over authority for National Budgets to a Supra-National entity could ensure the various moving parts of the region interact better as a whole. However, Hollande disagrees with the primary focus on debt and deficit limits, without any pro-growth measures.
Whilst the German Finance Minister Wolfgang Schaeuble is ready to discuss initiatives to boost economic growth Merkel has said she will not renegotiate the pact. As her spokesperson asserted, it “has already been signed by 25 out of 27 EU countries”. Instead the likelihood may be a growth pact attached to the fiscal pact. Nevertheless, the problems don’t end there. Firstly, Hollande will have his work cut out for him in an economy that is barely growing, with jobless claims at their highest in 12 years and a rising debt load that keeps France vulnerable. Secondly, can both sides agree what they mean by growth?
Growth by any other name…
France and Germany disagree strongly on how to achieve growth. Merkel maintains it is through structural reforms – making it easier to fire workers, which would encourage employers to hire, certainly a key aim for the Italian Government. However, Hollande is hesitant and instead wants growth via infrastructure spending. But Germany won’t agree to spending funded by borrowing – exactly opposite to their deficit reduction targets. Therefore, again although rhetoric can be applauded, practical plans remain elusive.
A Greece Default Still Possible
Uncertainty continues to be a key challenge for Greece as voters in a similar move to the French, overwhelmingly rejected mainstream candidates supporting spending cuts. Crucially, these cuts were aimed at securing bailouts and avoiding a default. Instead, 70 per cent of voters supported parties that promised to tear up the bailout and attempts may be made to negotiate a gradual ”disengagement” from the harshest austerity measures of Greece’s €130 billion ($168 billion) bailout. This keeps the possibility of a Greek default firmly in the picture and until a coalition is formed, a new election next month is possible.
Success is not final, failure is not fatal: it is the courage to continue that counts – Sir Winston Churchill
The human suffering of the earthquake and following tsunami in Japan is well documented. Exceeding the magnitude of Kobe both in strength and structural damage, the final cost is unknown and the aftershock which occurred yesterday did nothing to abate the concern. Surprise consequences have revealed significant weaknesses in both the word of politics and business and from an investment point of view, there are lessons we can learn…
A Political Surprise – Germany
The ruling party in Germany was voted out of office in one of its most prosperous states after almost 58 unbroken years in power. If they lose one more state election in September, Merkel could face a “blocking majority”. Despite voter concerns over the EU rescue fund (which they see as a potential ‘bottomless pit’) and claims leaders are out of touch with business, the surprise came as instead the loss was blames on Japan. After extending the life of 17 nuclear power stations and then calling a 3 month ‘thinking period’, politicians claimed the nuclear crisis swayed voters towards a Green anti-nuclear coalition.
The other surprise came to the heads of car making companies. Reliant on tight inventory management and a high proportion of electrical components, the supply chain interruptions from suffering Japanese suppliers hit these firms hard. What surprised them the most was the fact that a lot of these electrical components came from a single source. Since these were often parts sold to previous firms to be built into other parts then sold onto car makers, this concentration risk was not identified. In reaction Peugeot, Europe’s second largest auto maker by volume was forced to slow production at 7 plants in France and Spain. Japan’s Nissan saw the affects lasting for at least a month and started importing engines from their US plants – a reversal of a trend.
Source: Bloomberg – Since March 11 2011, the date of the earthquake, Peugeot (white) has caught up with the MSCI Wold Index (yellow) whereas Nissan (orange) is still struggling at a 13% lower level – all performance normalised.
The ‘Crisis Effect’– Luxury Goods
In reaction to the devastation, many in Japan are spurning conspicuous spending. Tiffany lowered their earnings expectations and expects Japanese sales (a fifth of their total) to fall by 15% in Q1 against retail demand rising 11% on average across the rest of the globe. Bulgari has now re-opened all but one of their 40 stores but, as one of their biggest markets, sees sales remaining weak for at least 6 months. This 6 month figure may have been derived from a comparison with the Great Hanshin earthquake, Kobe, back in 1995 where the after-effects were felt for approximately this length of time. However, this time around there have power cuts affecting populous areas, supporting concerns this is over-optimistic.
Source: Bloomberg – Bulgari (orange) hardly moved post-earthquake despite earnings concerns whereas Tiffany (yellow) was hit hard (-11%) but has also staged an impressive recovery (+11%)
The Bottom Line – Heightened Uncertainty
What this all highlights is the heightened level of uncertainty we are dealing with. There remains the potential for events few of us could predict, with consequences which come as a surprise and, those that are temporary, with a hard-to-forecast end date.
There are clear lessons we can learn. With a global recovery still open to macro shocks, it is prudent to remain active with an ability to protect your portfolio, whether through managers that can reduce their net exposure to markets or otherwise. And from a more stock specific point of view, know companies in which you invest well, including the full length of their supply chain and the true resilience of their client base. It’s true that crucial, often overlooked details are often only realised during times of stress, and this is by far one of the most tragic. Never stop learning.
The problem with international meetings is politicians are often “more interested in their next job than the next generation” – Anonymous source via Anthony Hilton, Evening Standard
Political turmoil has hit the three largest European economies in recent days. Portugal’s Prime Minister resigned, Merkel’s party was ousted from the most prosperous state in Germany after an almost 58 year uninterrupted rule and at France’s recent election, abstention reached a new high at 54% of the population. What are the main issues to be watching, how are they affecting investments and why is the term ‘decoupling’ now being used to describe countries within the EU?
In reaction to recent French takeovers of Italian companies, Italy is threatening to draft a bill to curtail the trend. France maintains the bill will go beyond measures conceived by Paris and tensions look to worsen as the French EDF, the largest shareholder of Italian energy company Edison prepares to replace the Italian CEO with a French counterpart. Indeed with David Cameron concerned about maintaining an open and competitive continent, the issue is one to watch. Nevertheless, with a high savings rate and exposure to German and Emerging Market economies, the outlook for Italy remains strong. In a recent auction, the maximum amount of index-linked bonds targeted was sold on Tuesday, €6bn year to date. Domestic demand remains strong.
Spanish Growth Downgraded
Another European country with issues of its own and yet resilient market reaction is Spain. The Central Bank sees a growth outlook of 0.8% for this year, lower than the government’s expectation of 1.3% growth. Unemployment is still among the highest in Europe at ~20% and they are implementing some of the deepest austerity measures to bring their deficit inline with that of France. Nevertheless, markets are forward looking and are reacting well to the aggressive policy implementation. Spreads on Spanish bonds over the equivalent German versions continue to narrow.
Even more worrying is the 43% youth unemployment (as quoted in The Guardian), higher than both Egypt and Tunisia - leading Gregory White at The Business Insider to call Spain "The Next Egypt" http://read.bi/i7fKOu. Source of chart: Miguel Navascues, an economist who spent 30years for the Bank of Spain following a posting for the US http://bit.ly/fDGb6k
Germany Facing a ‘Blocking Majority’
After another disappointing election result, the governing party of Germany could face a ‘blocking majority’ if they lose one more state in the September elections. Inner-party opposition is looking likely to intensify and after abstaining in the UN’s vote on the ‘no fly zone’ over Libya, fears of a return to isolationism have returned. Together this could compound the indecision that has dogged Merkel’s leadership so far. Nevertheless, the country’s deficit is set to fall as low as 2.5% of GDP.
Therefore, the markets are starting to differentiate between countries. Spanish and Italian equity markets are almost 9% higher than they were at the start of the year while others are still struggling. Most interesting is the lacklustre return of Germany’s equity market despite stronger fundamentals. Although this can be explained by the idea that markets move not by information on an absolute basis but relative to past performance and most crucially – expectations. With this in mind, Italian and Spanish economies are seen to be improving and doing well versus investor-set benchmarks.
The Investment Insight
There are many more hurdles along the way. The yield on Portugal’s 5-year notes surpassed 9% for the first time since Bloomberg records began (1997). The average yield across maturities lies at 4%, but the trend is upwards and once a 6% level is reached, it is argued it will become near impossible to reduce the countries debt-to-GDP ratio. In the immediate future, today’s results of Ireland’s banking stress tests will reveal the additional capital required for adequate solvency. As always, it is wise to maintain context, exploit contagion to your benefit and focus on quality for the longer-term.