Market Review 8 June 2010

Equity markets fell sharply on Friday following the US non-farm payroll numbers and concerns about Hungary. The headline increase in US non farm payrolls of 431,000 was swollen by temporary government hiring of 411,000 workers to complete the national census.

That boost had been expected. The surprise came in relatively anaemic private sector job growth after three months of healthier hiring and an increase of 218,000 in April. The US economy added just 41,000 private sector jobs in May falling well short of market expectations.

Fears escalated too on Friday that Europe’s debt problems were spreading beyond the eurozone after Hungarian officials warned for a second day that the country was at risk of a Greek-style crisis. Hungary’s forint fell to a one-year low, the cost of insuring its debt rose sharply and equities fell across central Europe after a spokesman for Viktor Orban, the new Hungarian prime minister, said the economy was in a “grave” situation and a default was possible.

It is not entirely clear whether the Hungarians were totally serious about the likelihood of default or grandstanding for domestic political consumption. The results of official comments, though, were predictably swift – equities fell by over 5%, the forint dropped by 1.5% against the euro and CDS premia widened by 69bps to a 11 month high of 392 bps.

However, some perspective is needed. For a start, any comparison with the situation in Greece is misplaced. Public debt in Hungary is high but at 78% of GDP it is well below Greek levels. What is more, short-term external government debt (ie debt due to be repaid to foreign creditors within the next year) is just 2.4% of GDP and Hungary’s budget deficit it running at around 4% of GDP, well below Greece.

Data from the Bank for International Settlements in Basel, Switzerland, showed that cross border banking exposure to Hungary was $158.1 billion at the end of the third quarter, compared with $302.6 billion for Greece, $286.7 billion for Portugal and $1.15 trillion for Spain. Not surprisingly, Hungarian officials started to backtrack over the weekend.

Hungary’s economic situation is stable and recent comments about a possible default were “unfortunate”, according to State Secretary, Mihaly Varga. He also pledged to stick to the budget deficit goal approved by the country’s creditors. Nonetheless, the euro itself weakened 2.5% last week against the US dollar and fell below $1.20 for the first time since March 2006.

It still remains higher than the close of $1.1837 on 4th January 1999, the first Monday of trading after its introduction and stronger than the $1.1842 monthly average since inception. It is also 40% higher than its all time low.

Of perhaps greater significance, the G20 meeting at the weekend did not deliver a unified message. Indeed, there was a remarkable public airing of differences between the Europeans and the Americas about the best way to proceed. The Europeans flatly reject American encouragement to spend and stimulate their way back to growth, preferring instead to focus on balanced budgets and fiscal sustainability.

The change in tone from the statement released after the previous meeting was remarkable. The European approach was received with both disbelief and criticism in some quarters, with Professor Krugman in the New York Times representing the Keynesian corner in referring to the European call for fiscal consolidation as “utter folly posing as wisdom”.

There was no agreement either on a global bank tax. The markets’ take on all this is that the best course for the Europeans at present is to continue supporting its periphery and to allow the euro to weaken to give the Continent more export growth potential.

CDS markets closed last week reflecting general concerns about the creditworthiness of European nations. The 5 year CDS on Ireland moved out to a new high of 285bp as did Italy at 245bp and France at 95bp. The French 10 year bond spread over Germany has also started to widen out more quickly and closed Friday at 43bp having traded around +25bp for most of the month. As a measure of growing pressure on the European core, this spread is being watched closely.

Frankly, we have some sympathy with the European policy prescription of fiscal restraint and devaluation. In the face of devaluation, the rebound in export orders can be swift. The UK’s index of export orders rose to its highest in at least 15 years in the second quarter as a weaker pound bolstered demand for British goods in Europe and emerging markets, at least according to the UK’s Engineering Employers Federation.

The number of UK companies saying that their export sales had risen in the three months through June exceeded those reporting declines by 23%. This compares with 3 in the first quarter. The pound has fallen about 23% on a trade-weighted basis since the start of 2007, making UK exports more competitive. The UK economy grew 0.3% in the first quarter, aided by the biggest jump in UK manufacturing for four years.

Similarly, German factory orders unexpectedly jumped for a second month in April as the weaker euro boosted export demand and companies increased investment. In Germany, orders adjusted for seasonal swings and inflation, rose 2.8% from March, when they had surged 5.1%. Interestingly, economists had forecast a 0.4% drop. Compared with a year earlier, orders gained 29.6%.

The key to the desirability or otherwise of public sector spending cuts is whether governments or individuals spend money more efficiently. In the UK, some modest cuts have been announced already and the budget on 22 June will go further but the really significant step will be a thorough ‘spending review’ later in the year.

Over the weekend, the UK Chancellor of the Exchequer pledged a root and branch review of UK public spending. Today, he expects to publish details of his approach as he prepares for the ‘spending review’ later. The review will set departmental spending limits for the three years starting April 2011.

“What we want to do is undertake a real examination of where we’re getting value for money in government, of whether what the government does really needs to be done”. The government will “take a much more fundamental review of government expenditure than a pro-rata cutting exercise”.

This must surely be the right approach. Reports that the British government is looking to Canada’s experience in the 1990s are mildly encouraging. The key feature of Canadian policy from the late 1980s onwards was to abandon neo-Keynesian notions that fiscal measures have an active part to play in reaching the goal of full employment.

From a peak level of 9.1% of GDP in 1992, Canada’s general government deficit shrank to 5.5% of GDP in 1995 before moving into surplus by 1997. A key event in this improvement was Mr Martin’s 1995 Budget, which reformed the system of transfers between the federal government and the provinces. It is difficult to find a parallel to this in the current UK situation, although it may tie in with Mr Cameron’s ideas regarding the Big Society.

One important point to bear in mind is that Canada’s success eventually benefitted from the background of a prospering global economy. In the policy’s early stages, up to 1992, when the global economy was in recession, Canada’s budget/deficit ratio actually rose.

The US employment data for May added to concerns that the global economy could be heading for a second dip in activity after a brief recovery from the 2008/09 slide. However, to our minds, these data are difficult to interpret. There is a lot of monthly fluctuation in the payroll figures.

Another, rather more stable indicator of US labour demand, namely, the index of aggregate weekly hours worked in the private sector, rose by 0.3% in the month, following a 0.4% monthly increase in April. This measure is 1.9% above its trough in October last year but still 8.3% below its previous peak in December 2007.

These figures, though, set the ‘recovery’ in the US labour market in a rather clearer perspective. We have always believed that this US recovery was likely to be investment led not employment led. US private payrolls, which in this census year must be a more appropriate metric than the more widely-followed non-farm payrolls, actually rose in May for the fifth successive month, which is in the right direction at least.

Some market observers see these modest rises as a bit insipid. But to have expected more from the US economy this time, after the impairment of productive potential suffered during the downturn, was unrealistic. Indeed, future revisions may well show there has been even less of an improvement in the employment picture than current data suggest.

To summarise, the US recovery is likely to continue. US real GDP in the first year of this recovery has probably increased by around 4.0% and household employment ex-census over the past 5 months has increased a cumulative 1.3 million. The Case-Shiller house price index in March was +3.7% above its low. A year ago, none of this looked likely.

Another year of growth is likely. The yield curve is positive. Short rates in the US are close to zero. Profits have increased +31% year-on-year and corporate balance sheets are strong. Inventories are still very lean. Intriguingly, ISI’s retailers surveys last week bounced +5.7 to a strong 55.9, although that was still well below their March peak of 65.2. ISI’s other consumer related companies surveys continued to make new highs last week. Auto dealers, for example, surged +4.4 to 50.2, a five month high.

The difficulties clearly lie in Europe. Even Germany feels the need to cut public spending. The Merkel cabinet met over the weekend to tie up a “decisive” round of budget cuts that is expected to shape government policy for years to come.

Ministers apparently met for 11 hours until early today to identify potential savings of €10 billion. The measures include tax increases, cuts in welfare and jobless benefits and the loss of about 10,000 civil service posts. Utilities face €2.3 billion in higher taxes.

For the time being, we have a significant margin of cash. However, we continue to believe that a recovery is under way. In the longer-term, the switch from public sector to private sector is healthy. Corporate profitability is good.

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.