Posted by:
Andrew Bell

23 June 2010

The transition from markets driven by easy money to a greater focus on earnings growth and the possible threats to the economic recovery has continued to prove laborious for equity investors. Whilst the fears of contagious sovereign defaults (centred on Greece) in May have abated, there are residual concerns about the growth consequences of the sharp rise in funding costs for fringe Euro governments, the fiscal tightening by a range of governments to get out of, or avert, trouble with the bond vigilantes and the fractious relationship between the Obama administration and the business sector. The latter has manifested itself by initiatives on oil drilling and regulating the financial sector that appear more designed to play to the political gallery than hit the spot in policy terms.

Recent weeks have seen worries about a double dip recede. The commitment by European governments to help maintain bond market stability during the fiscal adjustments being made by the mañana republics arrested the sell-off in sovereign credits, with equities bottoming out a few weeks later. Although it is too soon to quantify any hit to growth caused by the disruption to confidence and the ensuing fiscal tightening, measures of confidence are not collapsing, suggesting that yet again the financial markets have exhibited manic-depressive swings that are more severe than any underlying economic changes. The prospective ratings on many equity markets at the May troughs appeared to discount a drop of a third in corporate earnings, which was only likely if economies sank back into recession. Whilst this cannot be ruled out, levels that already seemed to discount an adverse outcome have prompted bargain hunting.

In the UK, the budget has met the need to announce a range of tough spending and tax decisions that should reinforce confidence that, with a reasonable cyclical following wind, the UK will be able to restore its finances to a sustainable footing over the next 5 years. The deferred nature of many of the cuts, together with measures to support personal incomes and demand in the nearer term, should protect the nascent economic recovery from the ravages of intemperate fiscal wrecktitude. The balanced nature of the measures (including some unusually redistributionist tax measures for a Tory Chancellor to announce) should help sell the programme to Middle England, avoiding the loss to credibility that could result from massed protests and strikes (the Greek example). It also seems likely that monetary policy (possibly via resumed Bank of England [BoE] bond purchases) will respond supportively to any serious growth wobbles.

There appear to be two principal risks (assuming that we avoid the central one of the Coalition fracturing under the inevitable pressure of public criticism). The first is that the process for “populating” the headline cutback figures with specific economies fails to deliver, resulting in waning credibility later in the year (with the risk that an improving growth outlook saps the will for sacrifices). The second relates to the review of public sector pensions (where the state’s liabilities are almost as large as the conventionally recognised national debt of some £900bn). Fronting the pension review commission with a former Labour Cabinet Minister might dilute the substance of any reforms more than it legitimises the selling process.

From an investment point of view, the Budget should take gilts towards the back of the queue for punishment by bond investors (which is not the same thing as saying they represent a safe store of value). The pressure from fiscal tightening will make it easier for the BoE to maintain a loose monetary policy without appearing to have lost the plot on inflation, while the squeeze on consumer incomes and government largesse underlines the importance of a competitive currency in sustaining the forward progress and rebalancing of the UK’s economy. 

Another source of economic angst that has seen positive news in recent days is the Chinese government’s inflexibility over its exchange rate. This had led to a belief in western economies that it was deliberately keeping its currency undervalued in order to support its economy through exports. Although being pegged to the rising dollar meant that it experienced an effective trade weighted appreciation over the past year, the political pressures are greatest in the US, which is always prone to flirtation with protectionism in preference to self-denial or frugality. The decision to restore the policy of a progressive creep (no reference to any politician alive or dead) is unlikely to lead to a dramatic change in the dollar parity but will deflect criticism of China’s trade policy at this weekend’s G-20 gathering. More important, it signals that a previously closed door is now open. Even if hesitantly implemented, a policy of Renminbi appreciation and local wage growth should help with rebalancing the global economy (i.e. increasing domestic demand in China and sustaining the Chinese boom in the face of current inflationary pressures).

The financial fault lines in Europe and more resolute UK efforts to restore viable public finances are likely to return central banks and governments to prioritising economic growth and avoiding deflation, after appearing to have prematurely assumed victory over recession early in 2010 and embarked upon plans to “exit the emergency stimulus”. This priority is not universally accepted, with Germany appearing to think that it would be all right if everyone were as financially cautious as its own citizens. Since the German banking system has substantial exposure to imperilled Euro sovereign debt, pragmatism seems likely to prevail but the collapse in confidence during May (which was largely self-inflicted as a result of inept Euro crisis management) came close to denying some governments (and many European financials) access to credit markets, in similar fashion to months surrounding the Lehman bankruptcy.

The G-20 summit in Toronto this weekend would ideally re-emphasise members’ commitment to promoting economic recovery and global rebalancing and averting the threat of deflation, which is the biggest single threat to an orderly workout of the debt overhang from the credit boom. The Euro scare (where the risks are barely concealed, let alone solved) should have punctured any complacency that countries can pursue their own parochial needs without respect for the wider picture, which appears to reflect deficient levels of demand and pressure to squeeze economies further through fiscal policy. China has responded by boosting the prospects for domestic demand and heading off an inflation problem, Japan (having the most entrenched deflationary problem) has tentatively embraced quantitative easing and the policy bias seems to have shifted back to sustaining recovery. This may require commonsense on the timing of increasing bank capital requirements and the extent of “punishment levies” to pay for public support - they cannot simultaneously rebuild their balance sheets, pay “fines” and finance loan growth at faster rates. While addressing the longer-term regulation of the sector is important, it is time to farm the banks as milch-cows rather than kicking them as scapegoats (no disrespect to goats is intended).

Comments or feedback are always welcome at theblog@witan.co.uk.

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