Last week was awkward for equity markets with at least one 90% down day in the US. However, volumes were relatively light. The conclusion of the US Financial Regulation Bill was relatively benign for banks and bond yields fell further in major developed markets. The UK produced a substantial fiscal austerity package, which restored some credibility to UK fiscal policy. Sterling strengthened and UK gilt prices rose. On Friday, bank share prices in the US rallied quite sharply.
For the last 6 weeks, equity markets have reacted to macro economic data. The second calendar quarter earnings reports from companies will not become available until mid July at the earliest. Markets, therefore, have been moving in an earnings vacuum. However, something of a slower ‘growth phase’ is emerging in North America.
Over the course of the quarter, growth expectations for the United States have receded somewhat and first quarter US GDP statistics have been revised modestly downwards. The language of the most recent FOMC communication similarly was somewhat more muted. Meanwhile, there has been broader recognition by governments that continuing relaxed monetary policy will be necessary and that central banks in the face of fiscal austerity packages will have to do more of the heavy lifting.
There has also been a move to delay the implementation of the Basel III capital provisions for banks.
The consensus take on the US Financial Regulation bill, including press commentary over the weekend, is that it is not as bad as feared. Banks may continue to manage funds (and thus earn fees). Banks that own hedge fund management companies will probably be able to retain those investments and, while the new rules may curb some risk taking and boost capital buffers, it is unlikely to fundamentally reshape Wall Street’s largest banks (or prevent another crisis).
Goldman Sachs may have to make some changes but it will have 7 years to implement any adjustment. As far as derivatives are concerned, the consensus view now is that banks will only have to segregate 10%-30% of their derivatives businesses into a separate subsidiary. Interest rates and foreign exchange derivatives can stay. Commodities, stocks, and CDS on non-IG debt will have to be moved into a separate subsidiary.
On Basel III liquidity reforms, it looks as if the proposed new changes will be delayed – Finance ministers appear to be prepared to delay implementation until the beginning of 2013 and to stagger the process over at least three years.
A five-year timetable is likely, delaying full reform until perhaps even 2018. The reason is obvious. These changes require banks to retain more capital. Every dollar of additional capital retained has a substantial, leveraged negative impact on banks’ ability to lend.
On Tuesday last week, the UK Chancellor of the Exchequer outlined a fiscal tightening budget, which by 2014-15 envisages that Government expenditure will be £84 billion lower than previously planned, with £29 billion more being collected in taxation. Cuts in state spending are expected to shoulder most of the burden of fiscal adjustment, rather than taxes.
Under these plans, the annual deficit falls from £149 billion this year to £20 billion in five years’ time. UK still stays in deficit. On the tax side, VAT goes up 2.5% in January 2011 to 20% netting around £13 billion per annum. Corporation tax, meanwhile, falls 4% over 4 years at a cost of £6.4 billion.
There are big unanswered questions in terms of spending cuts. £11 billion of the £84 billion adjustment will come from lower welfare expenditure with capital spending expected to come down by £28 billion. However, there is little clarity about the balance. That will have to await the completion of the UK government’s Spending Review in the autumn.
The G20 and G8 meetings in Toronto were largely a non-event notwithstanding the self congratulatory tone of the communiqué. G20 participants made no commitments in conflict with their prior intentions. On fiscal policy, the developed economies apart from Japan, which was recognised to be a special case, pledged “at least” to halve budget deficits by 2013 and ‘stabilize or reduce’ government debt/GDP ratios by 2016.
Even the US, where the Administration had expressed concern ahead of the meeting that too rapid a fiscal retrenchment might derail the global recovery, was planning to meet that schedule. President Obama’s 2011 Budget called for the deficit/GDP ratio to fall from 10.0% in 2010 to 4.3% by 2013. Mr Cameron has hailed the G20 statement as vindication of the tough line his government is taking on the public finances, but Mr Darling’s March Budget plans would also have met the terms of the latest G20 pledge.
G20 leaders would, doubtless, argue that their latest text on bank reform represents a refinement of previous commitments to enforce new regulatory standards. Previously, the G20 had been aiming to implement the Basel III regime of enhanced bank capital and liquidity ratios by end-2012, this target has probably slipped. The latest G20 communiqué repeated the aim of implementation by end-2012 but added the phrase ‘and a transition horizon informed by the macroeconomic impact assessment of the Financial Stability Board (FSB) and BCBS’.
BCBS is the Basel Committee on Banking Supervision. Presumably this means that if the banking industry can successfully lobby its supervisors, with the argument that tighter capital and liquidity controls will inhibit economic growth, the full rigours of the new controls will be deferred. In fact, banks will always argue that tighter constraints on their behaviour will have negative effects on the economy and, if presented with reference to the short-term outlook, they will almost always be valid.
Greece continued to make headlines. Greek credit default swaps rose to a record high last week. Greek stocks fell sharply and the Greek bond risk spread over bunds widened to its highest level since 7 May in Thursday trading. The Greek 10-year bond spread rose to 782 basis points, up 10 basis points from Wednesday. Greek bonds have fallen now by 19% in 2010, the worst performance in the EU, while bunds are up 6.5% year-to-date. Greek credit default swaps rose 145 basis points to a record 1077 basis points per year. The Greek Parliament votes on cuts in pension benefits next week.
On Wednesday, the US Federal Reserve suggested that “financial conditions have become less supportive of economic growth on balance, largely reflecting developments aboard. The pace of economic recovery is likely to be moderate for a time” and on that basis the FOMC expects to maintain its plans to keep its policy rate “exceptionally low for an extended period”. The Fed changed its description of the economy from “continued to strengthen” in April to the recovery is “proceeding”, and cited slowing inflation.
Part of this weakness is due to housing. Existing home sales in May fell 2.2% from April to 5.66 million annualized units, reacting to the end of $8000 home buyer government incentives. Sales were still 19.2% from a year earlier. Median sales prices rose 2.7% from a year earlier to $179,600 but that may reflect the absence of subsidy-based buyers who tend to buy lower priced properties. Unsold inventories fell 3.4% from April to 3.89 million units, or 8.3 months of sales, down from 8.4 months in April.
May new home sales, though, fell 32.7% from April to a new record low of 300,000 annualised units (history back to 1965), partly due to the end of government tax subsidies but also reflecting the general lack of new mortgage lending. Sales fell 18.3% from a year earlier. Recent sales were revised lower. Unsold inventories rose to 8.5 months of sales, the highest since June 2009. Median sales prices were $200,900, down 9.6% from a year earlier. It does not look as if the US house building industry is going to revive in a hurry. Indeed, in May building permits, a leading indicator of housing starts, fell 5.9% to 574,000 annualised units, the lowest in a year and up 4.4% from a year earlier.
The second revision of first quarter real GDP growth involved a cut to 2.7% annualised growth from the previous quarter, down from 3.0% in the May estimates. Final demand was revised lower and more of GDP growth came from rebuilding inventories. Inventories accounted for 68.4% of revised first quarter growth (2.7%) up from 54.3% of the May report (3.0%).
Whatever Mr Obama believes about Federal government spending, individual US states are busy cutting. Their combined deficit is projected to reach $112 billion (£74 billion) for the fiscal year to June 2011 or 0.7% of GDP. Gross state government spending is currently 12% of GDP or about $1.8 trillion. Illinois and California have the lowest credit ratings.
The state deficits are being held down in 2009 and 2010 by the Obama $862 billion fiscal stimulus package but that end in January 2011. State and local governments have un-funded pension liabilities of $5 trillion. Their tax revenues have fallen each quarter since the fourth quarter of 2008. All of this suggests that they will go on cutting.
What is the bottom line? The pace of expansion has slowed a notch but the corporate profit outlook remains good. Lower bond yields make equities look cheaper. The savings ratio in the US and elsewhere is rising and inflation is still slowing. Indeed, we expect inflation to slow further in the US over the course of the year, to a 1.0% year-on-year pace by year end.
This on-going disinflation should support household purchasing power and real spending especially in an environment of rising incomes and falling mortgage rates. There is no attraction in holding cash and monetary policy will remain loose and, indeed, could ease more. A double dip is highly unlikely. Very gently, we have been buying European equities. For our sterling global accounts, we have now a 90% sterling exposure.
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.