Unemployment

Bad News For Europe, Good News For Investors

Bad news out of Europe, Germany in particular, makes two potentially profitable outcomes significantly more likely. Firstly, the European Central Bank will be more flexible in its efforts to keep Greece in the Eurozone. Secondly, there are fewer roadblocks in the ECB’s way for announcing further QE. Policy is diverging. While the US contemplates tightening, Europe is exploring the opposite. Resulting currency moves could provide a welcomed boost to European exporters.

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Bad news for Europe, good news for investors

Investor hopes for ‘government bond-buying’ QE were raised today as Germany came under renewed pressure.

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Investors are calling this risk “Lehman Squared”

As Eurozone turmoil resurfaces, Gemma Godfrey takes you through the under the radar risks and how to trade them.

The risk of Greece leaving the Euro is looming large over markets as a ‘snap’ election nears on Jan 25th. Threatening to reverse the austerity measures (spending cuts etc) required for bailout funds and remaining in the Eurozone, Syriza looks likely to lead any coalition government, if it does not win outright.

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Your 5-a-day: 5 of The Biggest Misunderstandings Cleared Up

‘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…

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Should Banks Be Lending? (CNBC Video Clip)

European Central Bank action has failed: Some have claimed the LTRO was a game changer but it hasn’t solved the structural issues within Europe. They continue so yields are starting to rise again, and the lending isn’t being passed on to consumers and businesses… Watch the debate below and vote…

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.

‘Operation Twist’ – What is it? How could it help? But why will it not?

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 Debt Ceiling: The How, Why and What Could Happen?

The deadline for delivering a deal to allow the US to continue to borrow and spend, August 2nd, is approaching. Mirroring issues in the EU, a problem of debt cannot be solved by yet more debt. With the threat of a downgrade looming, any rise in interest rates could make the situation worse, hitting the tax payer and US exporters. Moreover, an increase in this ‘benchmark’ rate could impact the UK and hurt our property market, and a weaker dollar could result in job losses in our export sector. Further afield, with China the largest holder of US debt, the concern could spread globally towards countries relied upon to drive future growth. But failing to raise the ceiling isn’t an option and may cause an eventual default further down the line. Therefore, a deal will be struck and a balance found between demands for more spending cuts and aspirations for tax increases.

The US has ‘maxed out its credit card’

The US debt ‘ceiling’ is the maximum amount of bonds the US can issue, i.e. the maximum amount the US can borrow to finance its spending. The limit is currently set at $14.3tn but with the country spending approximately $120bn more than it takes in terms of revenue each month, after funding its participation in 2 world wars, rescuing the financial system post-Lehmans and pumping the economy with new capital to boost economic growth, the debt limit was reached on May 16. Put another way, the US has maxed out its credit card.

The issue echoes EU troubles: Debt cannot solve the problem of debt

Instigated in 1917, the debt ceiling has in fact been raised 74 times since 1962 alone. It should be noted; raising the limit does not increase fiscal spending but merely allows current obligations to be met and annual deficits to be financed. Nevertheless, in the current environment, with sovereign debt crises in Europe, investors and rating agencies are becoming acutely aware that cannot solve a problem of debt with more debt and the extent to which the ceiling would have to be expanded is troublesome. Obama’s proposed budget will require a ~$2.2tn hike just to meet next year’s obligations.

A lose-lose situation could hit tax payers and US exporters

Even if the ceiling is raised, there are other issues to tackle. S&P in April threatened reduce the credit rating of US debt. The importance of this threat should not be underestimated. With a ‘AAA’ status and ‘stable’ outlook’, any downgrade would threaten its role as the safest place to store savings. To retain their position, the US needs to address how it will not only plug this short-term gap, but also meet longer-term challenges. A hit to confidence would increase the rate of interest demanded by investors to compensate for a higher perceived risk of loss. This would increase borrowing costs for the US, worsening their debt burden and further limiting the amount of new debt they would be able to issue. It has been estimated that even an increase of 25 basis points could cost tax payers $500m more per month. With less demand for US treasuries, there would be less demand for the dollar to fund these transactions, making the products the country exports more expensive abroad and again hitting their balance sheet.

The issue could hit the East and future global growth

In its extreme, uncertainty could spark another financial crisis as well as put the dollar’s status as the world reserve currency at risk. (Interestingly, a McKinsey investigation reported less than 20% of business executives expect its dominance to continue to 2025). For this isn’t an isolated incidence. Dollar-denominated US debt is held world-wide (especially $1.1tn by China), spreading the problem towards the very countries many are lauding as growth drivers of the future.

UK jobs, home prices and recovery could be hit

There could be dire consequences felt even in the UK. The US is our largest export partner, spending $50bn for our products last year alone. A weaker dollar would damage American buying power, making these products more expensive and damaging demand. This would cause companies producing these goods to suffer and jobs would be lost. Furthermore, if fears over the ability of the US government to repay its debts led to investors demanding more to lend to the UK government, mortgage rates would become more onerous and it could be harder for buyers to purchase a property. With less investors able to buy and therefore lower demand, sellers may be forced to lower asking prices to get a sale.

Failing to raise the ceiling wouldn’t cause an immediate but an eventual default

In the near-term, the US could continue to function. Failing to be able to increase borrowing would necessitate spending cuts: to military salaries, social security, medicare and unemployment benefits. Furthermore, some of their debt could be rolled over so long as the overall amount of treasuries outstanding didn’t rise. However, this is unsustainable in the medium to longer-term and would lead to an eventual default.

With too much at stake a deal is likely to be reached

The issue is currently being used as a negotiating chip by Republicans to get deeper cuts and long-term reforms whilst refusing to raise taxes, versus the White House aiming to cap tax exemptions and reduce ‘inequalities’ benefitting big business. Nevertheless, with such serious ramifications possible, it is unlikely a deal will not be struck.