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