Comment on the recent turmoil in financial markets
Financial market confidence has been knocked severely during the past week with equity markets posting sharp declines around the world. Over the weekend, further negative news came with the announcement that Standard & Poor’s has downgraded the US debt rating from AAA to AA+.
What caused the latest crisis?
Poor US economic data1 have sparked fears of a looming recession just as America’s debt-ceiling fiasco and the latest (and still inadequate2) European rescue package have further undermined confidence in the world’s leaders.
1 In particular, the downward revisions to GDP data (Friday, 29th July) and the weak ISM manufacturing survey on Monday, 1st August.
2 See our Hot Topic dated 27 July for our thoughts on the EU deal.
With $2.4trn of deficit cuts now coming in the US, there is also a growing sense that policymakers are out of ammunition. Unlike in 2008/09, fiscal policy is now being tightened, interest rates are at zero and the appetite for (or perceived effectiveness of) further quantitative easing has waned. Meanwhile, in Europe, the fourth bailout in 14 months has done nothing to stem contagion risk to Italy and Spain.
While US economists revised down their growth forecasts, stock markets tumbled. And the fear is that a loss of confidence in financial markets will further damage the real economy. This potential negative feedback loop has shaken investor confidence and it is the reason why a policy response is needed to stem the panic and break the loop.
Is another global recession likely?
After a sluggish first half, most economists were forecasting a rebound in the global economy during the second half of 2011. But deteriorating financial market conditions in an already fragile economy pose a substantial risk to this view.
Recession is not inevitable so long as the current crisis can be contained. Not all of the economic data has been bad. A post-earthquake recovery is underway in Japan, which will have global ramifications: for example, US vehicle sales bounced in July following Japan-related disruption. Hot Topic 8 August 2011
US weekly jobless claims have been slowly improving and Friday’s employment report for July was stronger than anticipated. US monetary and credit indicators have also picked up lately (M2 money supply, bank lending, consumer credit). South Korea, the World’s seventh largest exporter and one of the first countries to report trade data each month, posted strong exports in July. Furthermore, the recent decline in the oil price will support growth prospectively.
Financial market volatility has stirred fears of another 2008 Lehman-style meltdown. But there are some very important differences as we stand today. First, financial and credit conditions are generally nowhere near as stressed as in late 2008 – the weakness this time has largely been concentrated in equities, European sovereign spreads and European financial credit spreads. There is abundant liquidity in Western banking systems and central banks are poised to provide more if needed. Unless a calamitous policy error occurs, a repeat of the previous credit crunch should be avoided.
Second, most companies are in much better financial health today than in early 2008. Balance sheets have been strengthened greatly and profitability has been remarkably resilient. In most regions, balance sheet improvement applies to the financial sector as well. US banks balance sheets, for example, are much more liquid and less leveraged than in 2008.
How will markets react to S&P’s downgrade of US debt?
It is impossible to know with certainty what the market’s reaction to S&P’s downgrade of US debt will be. In our view, most likely it will impact market sentiment negatively with the largest reaction felt in risk assets, rather than in US Treasuries themselves, which, somewhat perversely, may benefit from their safe haven characteristics on a short-term view.
The downgrade itself conveys little fundamental news – the US fiscal problem is well known. Moreover, the downgrade was somewhat expected given previous S&P statements. We do not expect large numbers of forced sellers of Treasuries for several reasons: (i) US bank regulators have stated that the downgrade will have no impact on risk weightings; (ii) foreign central banks will continue to hold US debt; (iii) the other rating agencies currently maintain an AAA rating for US debt and (iv) we do not believe many investors have AAA-only mandates. Furthermore, as Barclays Capital has pointed out, behind the US the next most liquid bond markets are Japan and Italy. Which would you prefer?
On a short-term view, it may be the case that US Treasuries underperform other perceived safe havens such as German bunds or even UK gilts. The dollar may well weaken against the yen or Hot Topic 8 August 2011
Swiss franc, although both central banks intervened to weaken their currencies last week. Less liquid or emerging market currencies may come under short-term pressure.
In our view, however, what happens in Europe this week is likely to be more significant for markets than S&P’s downgrade of US debt.
What must policymakers do?
Europe’s crisis poses the greatest threat currently. The S&P downgrade is secondary since the US government will not default now it has raised the debt ceiling.
It is now very much up to the ECB. A plausible long-term solution to the crisis may be a fiscal union in Europe but we are a long way from this at present. The ECB is therefore the only institution with the power currently to ease tensions in Italian and Spanish bond markets. Moreover, concern is quickly spreading that France will be next under attack.
The news late on Friday that Italy will bring forward fiscal tightening and implement reforms is helpful. Italy must do its bit. The reality, however, is that actions taken by the Italian government will take months or years to show results. Markets are not so patient, which is why the ECB must act.
There is no reason why Italy need be in danger of default on a short or medium time horizon. While at risk long-term, Italy’s debt dynamics have so far been relatively stable. But unless bond yields are reduced, the crisis will deepen.
The ECB must then be bold. The time for worrying about moral hazard is over. The tragic irony is that the more decisively the ECB acts by buying Italian and Spanish debt, the less it need worry about the credit risk of such purchases. Headlines this morning that the ECB is intervening is therefore encouraging. Italian and Spanish 10-year bond yields, at the time of writing, have fallen around 80 basis points today to yield 5.32% and 5.19% respectively, compared to 6.2% and 6.3% last week.
The Federal Reserve committee, meanwhile, meets this week. We expect little news at that meeting other than reassuring words that the Fed stands ready to ease further if needs be. The Fed does not yet seem ready for QE3, in our view. But should the crisis intensify further such action will become likely. Hot Topic 8 August 2011
Implications for Ashburton strategy
We outlined in July that we felt markets had entered a riskier phase - see Strategy Update dated 15 July. Unfortunately, that has proven the case and to a far greater extent than we anticipated.
Under the current circumstances caution is warranted. The risks at present are significant and dependent on the appropriate action from policymakers.
That being said, a repeat of the 2008 financial crisis is not likely so long as policymakers act rationally. Central banks have the tools to prevent a liquidity crisis. As long as the ECB intervenes to buy sovereign debt then further sovereign defaults (after Greece) can be avoided. Last night’s statement of intent from the ECB is to be welcomed and must be followed up with sustained action.
For those with courage and a medium- to long-term horizon, equities present the best opportunity on a risk-reward basis given current valuations, in our view. A globally diversified basket of leading blue-chips with low debt and strong balance sheets will likely perform better than most assets over the next few years. Better quality high-yield non-financial corporate bonds may also outperform. At current yields, global government bonds will provide paltry returns to the medium-term investor, and investment grade corporates only moderately better.
Brave investors may also find opportunity in emerging market equities. Inflationary concerns and monetary tightening have held back emerging markets this year. Slower global growth and lower energy prices may ease tightening fears and buoy the asset class once the current panic subsides. There are already some early signs that Chinese interbank rates eased last week.
From a currency perspective we maintain our long-held view that a number of emerging Asian currencies will appreciate against the majors over the coming years.
Tristan Hanson, Head of Asset Allocation
Head of Asset Allocation
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