Market Review 4 June 2010

The last month has been very uncomfortable. The markets for risk assets have been highly volatile and that volatility is probably not over.

Over the last month, Europe has shifted public policy in the direction of significant fiscal restraint, although, and for the time being, the stance of European monetary policy is unchanged. The euro has dropped and Europe will now get a boost from foreign sources of demand.

Greece has enacted a deficit reduction equivalent to 9.5% of GDP for 2010. On 9 May, Spain and Portugal each added to previous deficit reduction commitments equivalent to another 1% of GDP for 2011. Since then several more governments have joined in the movement of fiscal consolidation – Germany, France, Italy and the UK have announced new steps or the intention to implement previous commitments. 

Governments seem to be treating this as a window of opportunity to pursue reforms (like raising retirement ages) that would not be possible in the absence of a euro area crisis. Beyond these efforts, there is a broader European-wide effort to impose tighter budget rules. Inevitably, reductions in public expenditure may lead to slower growth in the short-term. 

JP Morgan estimates total fiscal drag for the euro area at 1.3% in 2011 and another 1.2% in 2012. However, this negative should be compensated for by the positive shift implied by a shift of resources from the public to the private sector.  

Although European fiscal policy is getting tighter, monetary policy so far looks little changed. The ECB’s balance sheet, after growing €80 billion in the first week of the new programme, grew by just €7 billion last week. The ECB’s bond buying programme purchased €16.5 billion the first week and then €10 billion last week.

Press reports had it that most of the buying came after the markets were unsettled following Germany’s naked short-selling ban. For the time being, the ECB’s approach looks like a limited programme designed to stabilise government bond markets.

Meanwhile, markets in Europe are now preparing themselves for the upcoming Spanish government debt rollover. €8 billion of Spanish government bonds need to be refinanced by 18th June. This is to be followed by a €16 billion bond refinancing by the end of July. Altogether, Spain may need to refinance up to €38 billion by the end of September. 

Spanish government bond yields have been rising. The 10 year yield is now 4.58% – up from 3.85% in mid April. Spanish two year government bonds have reached nearly 2.7%, yield spreads with Germany are near record highs since the EMU was created, Spanish CDS spreads are inching up and German Bund yields have fallen amid a flight to safety. Last week the Spanish Prime Minister’s previous allies, the Catalans, abstained from voting on last week’s Spanish fiscal reform bill, in which Zapatero cut an additional €15 billion in spending, aimed at reducing the deficit further over the next two years. The bill passed by only one vote. The market is clearly testing the willingness of the Spanish government to borrow at higher rates.

The other headline news story has been BP’s Mexican woes. If nothing else, BP would appear to be accident prone. Its current “bad patch” started with the disastrous Texas City refinery explosion on March 2005. Then there was the near sinking of the Thunder Horse rig less than a year after its inauguration, a result of hurricane Dennis in July 2005. In March 2006, a pipeline leak near Prudhoe Bay, Alaska, resulted in the worst oil spill in the Alaskan north slope’s history. And now the Macondo blow out with the sinking of the Deepwater Horizon rig, the loss of 11 lives and an oil spill of enormous proportions.

Official US agencies put the spill flow rate at around 19,000 barrels per day but some estimates run as high as 100,000 barrels a day. The oil field below is estimated to hold 50 million barrels of recoverable crude oil. It would take nearly seven years to empty at the official flow rate. Besides trying to cap the leak, BP is currently drilling two other wells to stem the pressure and extract as much crude cleanly from the field as possible.

Deep water and ultra deep water exploration in recent years has seemed to be one of the last “new frontiers” for oil majors. The Macondo disaster will undoubtedly slow the process. Mr Obama has put a six month moratorium on exploration and production in depths greater than 500 metres and the White House is studying tighter regulations on deepwater drilling.

The moratorium on deep water activities in the US is probably mildly bullish for oil prices. However, it is worth remarking that currently there is a lot of spare production capacity available to world markets. OPEC has nearly 5 million barrels a day of spare production on standby – far more than the combined deep water projects in the Gulf of Mexico. Still, offshore activities in the Gulf account for about 30% of total US production and the combined deep water production is capable of providing 1.45 million barrels a day (this includes all oil in depths greater than 305 metres and the moratorium is only for 500 metres and greater).

One of the consequences of the moratorium may be a push towards greater US onshore exploration, especially shale oil and gas. But for now, ample inventories and spare production capacity elsewhere can absorb the impact of the moratorium on supply without undue detrimental price impact. We do not see a major problem for world markets yet.

Within Japan, the DPJ government’s support ratings have plunged to levels that usually predict crushing election defeats. With a little over a month until the upper house elections, the DPJ had its two senior leaders resign. So far, Finance Minister Kan has declared his candidacy for DPJ party leader (and, therefore, prime minister). The senior leadership of the DPJ is thin and has shown no ability to reach decisions.

The resignations have come at the end of the one of the fastest declines in a Japanese administration’s popularity ever. The DPJ won a massive two-thirds majority in the lower house elections last August. That two-thirds majority provides a way for the DPJ to continue to run the government until August 2013 at the latest but the loss of the Upper House will not make matters easier.

With Kan as the probable next prime minister, the 2011 Japanese government budget deficit will likely be held to the same limits as the fiscal 2010 budget, implying ¥44.3 trillion yen of government deficit bond issuance. This should not be a problem if past precedent is anything to go by. In addition, Kan has said that he would like to see the yen weaken.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30  years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.