Market Review 6 July 2010

Markets have been pressurised in recent weeks by growing evidence that growth will slow down in the second half of this year, by fears that the monetary authorities in Europe are more concerned about their exit strategy than the continuing need to provide an appropriately stimulative monetary policy. Fears of banking contagion have surfaced again and concerns about the robustness of growth in China have been voiced.

The case for an economic growth slowdown in the second half of this year is relatively straight forward. The comparisons with a year ago are considerably more difficult. It is unlikely that the inventory accumulation of last year will be repeated this year and a number of stimulative programmes such as cash for clonkers or interest rate subsidies for housing have been phased out.

The Nouriel Roubini view is still that this is likely to be a growth slowdown, not a “double dip” but the distinctions between the two are not completely clear. It may be that things will feel worse than they actually are. The Roubini team’s expectations suggest that growth in the United States will slow from an annualised rate in the first half of this year of 2.5%-3% down to 1.5%-2% in the second half. He expects growth in the Eurozone to slow from 0.8% to between 0.5% and 0% in the second half of this year. In Japan, he expects growth to drop from a 1% rate to a 0.5% rate and in China, he expresses the thought that growth will slow to 7.5% in the second quarter.

The savings rate in the United States has ticked up and the level of consumer indebtedness has stabilised but not yet begun to fall. New house building remains dormant in the US. Governments in Europe have moved into a fiscal consolidation mode, unwilling to risk the treatment meted out to the likes of Greece, which can no longer access the bond market.

If growth in the two major sources of autonomous global demand, the USA and China, is softening, it will have an impact elsewhere. In other economies, policymakers have been relying primarily on exports to drive their recoveries from the 2008-09 slump. However, not all economies can rely on export growth at the same time. The number of economies that are expecting to do so is increasing.

Indeed, for the euro zone and the UK, which together account for more than 26% of world GDP, fiscal retrenchment is now the declared priority. As a result, this region is unlikely to generate much domestic demand in the immediate future and will be especially dependent for economic expansion on improvement in net trade, which may be more difficult to achieve.

In the USA, a range of employment and housing market statistics have pointed to weaker activity. Manufacturing, which had been relatively resilient, appeared to lose momentum last month. The other growth hub, China, is still expanding strongly, but perhaps not at quite as rapidly as at the start of this year.

Anecdotal reports of slowdown in China’s industrial growth have received a measure of corroboration from the results of purchasing managers’ indices (PMIs). The official composite PMI for China’s manufacturing industry fell in June from 53.9 to 52.1, which, apart from what may well have been the holiday-affected February index, was the weakest reading since June 2009.

However, compared with the dark days of the first quarter of 2009, all of this still represents a huge improvement. At least trade credit is flowing again. The financial markets’ disappointment lies in the global economy’s apparent failure to sustain recovery on a smooth upward trajectory. Earlier this year, consensus opinion expected an uninterrupted arc of expansion, so far below trend had the financial crisis left output.

However, in a world subject to massive structural shifts in production and where credit has remained severely constrained, the prospect of recovering the rhythm of economic activity sufficient to get it back to what it had been before the crisis is more difficult. In these ‘new normal’ conditions, it seems more plausible to suppose that ‘output gaps’ will remain wide in the so-called ‘advanced economies’, where financial systems are damaged and from whence industrial activity has migrated to lower-cost and seemingly more stable centres in the emerging nations.

The difficulty is that monetary stimulus has been reduced too early. China’s central bank sought to tighten credit conditions from the middle of January onwards. The year-on-year growth in Chinese banks’ yuan loans has slowed from 29.3% in December last year to 21.5% in May this year. China’s broader measures of money supply have shown a similar deceleration. Coincidental with these monetary developments, the markets in Chinese risk assets fell back. The US equity market peaked within a month of the cessation of the US Federal Reserve’s programme of mortgage-related asset purchases.

At the same time, some of the world’s smaller central banks have also turned off the liquidity taps for the time being. The Bank of England decided on an indefinite pause in its asset purchase programme at the end of January. Probably, central bankers in the USA and the UK believed that the stock of their asset purchases, rather than the flow, would be the crucial factor affording support to capital markets and the economy. They thought that an expanded central bank’s balance sheet would go on delivering a monetary boost because a greater volume of commercial bank reserves would encourage those institutions to expand their lending.

This thought is probably a mistaken assumption. Banks are generally conservative, not reckless, whatever the ‘bubble’ experience of 2006/7 may have suggested to the contrary. They are, moreover, only part way through the process of rebuilding the quality of their balance sheets. Commercial banks are still disinclined to lend. Many banks still have unresolved and unmarked down property loans.

Furthermore, the various initiatives to require banks to raise more capital have been proceeding without much regard for the impact on banks’ willingness to lend.   

In practice, it will probably turn out that the flow of central bank asset purchases has been more important than the size of the resulting stock of central bank asset holdings. The implication for central banks that have engaged in asset purchases is that they have to keep at it, if they want to keep up the stimulus to capital markets and economies. The moment when their asset purchasing ceased was the time when markets in high-risk assets became vulnerable to setbacks.

The difficulty is that the process of bank repair has not proceeded far enough. As the Bank of England pointed out in its recent report on Financial Stability, banks internationally face a substantial refinancing challenge over the coming years, as private sector funding matures and extraordinary public support is withdrawn. Globally, banks are estimated to have at least US$ 5 trillion of medium to long-term funding maturing over the next three years.

In the United Kingdom, the largest banks will need to refinance or replace around £750 billion-£800 billion of term loans and liquid assets by the end of 2012. That equates to over £25 billion each month on average, more than double the average monthly issuance achieved so far this year. UK banks also need to extend the maturity of their wholesale funding, around 60% of which falls due within one year.

Our own view is quite straight forward. We believe that the arguments about fiscal spending or saving are largely irrelevant. One of the reasons for fiscal deficits is that governments spend too much too wastefully. Cutting excessive pension entitlements reduces spending but also boosts the incentive to work. We believe that effective growth policies depend rather on improving marginal incentives. Cutting marginal rates of tax is a much more important stimulant than people think.

Here western governments are on weak ground. They are often guilty of raising these marginal costs as part of a ‘political’ compromise designed to make cost cutting more palatable to a wider public. In the Far East, a more rigorous regime of tax cutting is in operation, which is likely to reinforce incentives and growth.

We have anticipated that economic growth in the west would be investment led not consumer led. We are positive about the flexibility and profitability of companies. Indeed, as we go into the second quarter earnings season in the US, we are impressed that analysts have been revising their earnings estimates up even in the last fortnight.

In the last week, US corporate earnings ex-financials have been revised upwards by 40bp so that we are now anticipating 27.7% growth in earnings year-on-year. As the equity market has fallen, it has become cheaper and the prospective price/earnings ratio for the S&P500 this year now stands at 12.5x – down from 15x in mid April.

We have always believed that the greatest risk to markets this year was the possibility of a policy misjudgement. A failure to maintain the stimulus is such a misjudgement. However, in the face of a slow down, we would expect this to be corrected in the second half.

In light of the higher volatility, we have cut our equity weighting somewhat and for lower risk balanced portfolios included some 10-year, high quality government bonds.

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.