Despite Greece’s woes, medium-term outlook constructive for risk assets

Notwithstanding the recent sharp rise in volatility induced by concerns about European sovereign risks, our primary medium-term view continues to be constructive for risk assets. Prior to the recent intensification of market concerns about the risk of tightening credit standards, our shorter-term indicators had been flagging that risk assets were overbought and vulnerable to a correction.

We consequently scaled back exposure on a temporary tactical basis. At the same time our medium-term indicators continued to strengthen. Following the sharp sell-off in risk assets and increase in risk aversion, both shorter and longer-term factors are now encouraging us to take advantage of shorter-term weakness.

We now believe we have an additional valuation cushion as markets are oversold and the VIX is back at levels that are consistent with recession. The macro environment remains broadly constructive, suggesting that the recovery has momentum. The US yield curve remains steep, pointing to a continuing US recovery, which has been one of the most reliable indicators.

Final demand is clearly picking up across key economies, suggesting that growth will continue to accelerate even after the current inventory adjustment is over. Chinese indicators are supportive of a 'soft landing' for the Chinese economy, following a burst of unsustainably rapid economic expansion, while core European macro indicators still point to a robust recovery. In addition, corporate earnings growth has continued to exceed analysts’ forecasts, which were regarded as excessively optimistic by market participants. The reporting season for S&P 500 corporate earnings is almost complete. Earnings were up 46.5% compared with a year ago, some 16.6 percentage points above analysts’ estimates made just a month ago. The equivalent figures excluding financials were lower at 33.3% and 8 percentage points higher. Earnings for European companies were lower, but still outstrip expectations.

Will European contagion continue to spread?

The key issue then is whether European contagion will continue to spread, resulting in a general tightening of credit standards that is sufficient to undermine the current global recovery and plunge the world back into recession. While the Greek, Portuguese, Spanish and Italian economies combined are not key drivers of global growth, their impact on European credit conditions is important, along with the attention that they draw to sovereign fiscal weakness internationally.

While much will doubtless be written about the sustainability of the euro and the ability of the weaker members of the euro zone to meaningfully address their fiscal challenges against a probable background of anaemic growth, the steps taken at this weekend's ECOFIN meeting would appear to be sufficient to deliver a solution, at least for the time being. These included a European stabilisation mechanism of up to €60 billion, drawing on funding from members of the euro zone (with lending subject to IMF conditionality), complemented by a special purpose vehicle of up to €440 billion (backed pro rata by all EU member states) with the IMF expected to provide half as much again.

Central banks internationally have reopened their temporary US dollar liquidity swap facilities in order to reduce liquidity strains and the European Central Bank has announced its intention to intervene in euro-zone public and private debt securities in order to ensure adequate liquidity. As well as materially reducing the general risk of contagion, the net result of this is to keep monetary conditions easier than they might otherwise have been, which in turn may result in excessive asset price inflation.

One of our principal concerns has been the extent of the deterioration of sovereign credit risk and the continuing reluctance of governments to address this problem in a serious and timely manner. Although a cyclical bull market cycle could still run its course, even with broadly inadequate fiscal retrenchment, this would probably be associated with a further de-rating of equity markets and periodic bouts of severe risk aversion, such as the one we have just experienced. Paradoxically, the problems of Greece may well prove to be the mechanism by which the minds of politicians are focused on the difficult but necessary task of securing a longer-term recovery.

For now however, once attention turns from the Greek problem, investors are likely to rediscover their pro-risk bias.