Monthly Archives: July 2012

Europe Update…

Markets have again entered a period of summer uncertainty, justifying a review of what is happening, how it might affect your investments and what you might do to profit from the situation.

First, it is important to recognise that this is different from summer 2011 in several ways:
– Market prices are already very low, whilst corporate profitability remains healthy, making it hard to justify a sharp market correction unless there is a really dramatic macroeconomic outcome.
– For this reason, even though markets have been struggling, the volatility of prices is low and we don’t sense the same degree of panic that we experienced last summer.
– Central banks around the world are more successfully reassuring markets that they have the potential to act as needed, providing a support to asset prices that was less obvious last summer. So what is causing the market trouble that we are experiencing at the moment?

The two key issues are Greece and Spain:
– Greece is struggling to hit its economic targets, and has been suffering from political stagnation since its recent election. Notably, the head of the privatisation authority has quit. The IMF and EU have been firm that Greece needs to restructure more aggressively. The incumbent government is likely not opposed and will use the pressure of the Troika to move things forward. One fast and reassuring solution would be a debt-for-equity swap with bondholders, as a way of breaking the privatisation logjam. But in the short-term, the market is worried that Greece will suffer further debt write-downs as it misses targets coming due. Such fears may be over done, and Europe will probably bridge short-term problems, if Greece manages to move on structural concerns.
– The situation in Spain is more complicated. It exists on two fronts, in the regional economies and in the banking sector. The banking issues can surely be solved with relative ease now – the bailout has been agreed. This is causing stress in the funding market, as Germany insists that the Spanish government shoulder the liability for the bailout cash – until the pan-European banking authority is established. Spanish debt-to-GDP could jump between now and the creation of a banking union, but then it should decline again.

The regional problem is both more comparable to Greece’s problems. Spain’s regions have enjoyed a high level of autonomy and have incurred large debts. These debts are already reported on Spain’s debt-to-GDP numbers (67% in 2012 on IMF estimates). The fact that the central government is being forced to help the regions is good, in the sense that it will make it easier to bring local spending under control. Where does it all leave us? Since the ECB cut interest rates, the euro has been falling and this should help somewhat. But, the bottom-line, as we have said before, is that Europe’s problems will not end quickly.

It took Germany years to restructure into the competitive state it now is, Europe is unlikely to do it quicker. But, the political will remains. Although Europe keeps disappointing, it does keep moving in the right direction, demonstrating the extent of political determination. With such a backdrop, the risks in European bond markets may continue to come and go, and further rescues and bailouts cannot be ruled out. Look for the ECB to get more involved with Europe’s financial system again. Last summer the equity market crashed on low volumes and high fears.

This summer we face many similar problems, but with a fresh perspective, market pricing and understanding. Assumptions that the market will crash from this level may well be too pessimistic. It certainly makes sense to gradually increase exposure to high dividend and significantly under-valued stocks. Please contact us for more details. Best regards, James

Market Comment 3 July 2012

Markets sprang back to life reporting healthy gains after the European Summit last week. The S&P 500 in the US gained 2.0% on the week, the EuroStoxx 50 index gained 3.6% and the EUR gained 0.8% versus the USD. Russia climbed 5.0% as the price of oil rose 7.5%. Clearly, the market was pleased with the outcome of the European Summit, will the positive dynamic last?

The European equity market has bounced 12.5% from its recent lows and is now close to both its 100 and 200-day moving averages. A clean break higher would certainly indicate increased confidence that political processes have overwhelmed the systemic issues. However, from the current level we may need more help to break through. The market has already rallied quickly and will likely shift its attention back to the macro data, where the picture is more cloudy.

This week we see several key data points. The US employment numbers and manufacturing numbers are of considerable importance gauging that country’s ability to sustain growth without resorting to further stimulus. A raft of European data is expected to reflect austerity pressures. And, most important, the ECB and BoE will hold rate-setting meetings. Consensus seems to expect that the ECB will cut rates and the BoE will increase its government bond purchases. Neither decision will markedly impact the economic situation in the near-term, but either will stimulate further optimism on the part of investors.

The market remains risky as the economics are still difficult, and policy execution risks remain very high. But, the European Union continues to move slowly in the right direction, with continuous steps toward fiscal union. Such steps support optimistic claims that the European situation better reflects the circumstance that led to the formation of the United States of America than the events that led to the dissolution of the Soviet Union. At its own outset, the USA attracted concerns of inconsistencies and unsustainable dynamics. But, the sheer force of political will kept the project alive long enough to achieve sufficient integration to overcome the multiple crises that have occurred since.

In the last two years, Europe has repeatedly failed to overcome doubts about levels of commitment. But, at the same time it has been slowly adjusting and advancing toward a more sustainable solution. Now we are getting closer to seeing what that solution looks like, what are the market implications?

Despite their recent bounce, European equities are at depressed levels. Cyclical stocks will remain exposed to economic stress, and are best bought on corrections. Dividend stocks should continue to pay well, with lower downside risk, and the euro ought to resume its decline if the ECB goes ahead with the rate cut that many now expect.

Russia too stands to benefit, as market stress eases. The Russian equity market has shown an excessively high correlation with Europe. As such, it is severely discounted, even whilst the more flexible FX policy means that ruble earnings are stable. Over the summer, investors should understand that the Russian economy has weathered the recent crisis quantitatively better than previous events. Its discount to global markets should begin to close. Buying Russian funds and blue chips looks increasingly wise.

Best regards,