Market Review 29 March 2011

Last week saw a recovery in equity markets and in the US dollar. The recovery though was not uniform – Japan missed out but North America did particularly well. The MST Resources fund bounced sharply, followed by the Melchior North American Opportunities fund. There remain lots of reasons to be cautious – continuing difficulties in the Middle East, fears of nuclear fall-out in Japan and the on-going wrangling by Eurozone nations about how to handle the peripheral countries of the system – Greece, Ireland and Portugal.

Nonetheless, the economic data coming out of the United States remains positive despite the weakness of the US housing sector and interest rates remain anchored at a low level. There is also a lot of excess liquidity about even if the momentum of growth of this liquidity has slowed.

What seems to be happening in the US is stronger than expected employment growth accompanied by greater global economic momentum. Last week, the four week average of US unemployment claims declined to just 385,000, well below the 400,000 level for a fourth week in a row and much less than the 643,000 recession peak.

Last week, ISI’s company surveys were at a four-year high, led by auto dealers increasing to a strong 56.6 (a six year high), and truckers, which surged to 53.5. There was also strength in homebuilders, air cargo companies, apartment rents and restaurants. The rig count also surged higher again and is now up 3.9% over the past month.

Commercial and industrial loans by banks have continued to edge up and are up 0.8% over the past month. ISI’s credit card survey ticked up too. The US Federal Reserve’s balance sheet expanded another $13 billion and the AT&T/T-Mobile $39 billion deal showed that there is both lots of money and a willingness to put it to work.

The housing picture is clouded by two non seasonal factors – building control regulations in three large states (California, New York and Pennsylvania) which changed at the end of December, probably affecting the new home data – pulling activity into the fourth quarter at the expense of the first quarter. Secondly, the re-sale of re-possessed homes, which currently accounts for over 30% of such sales, do not respect normal ‘seasonal adjustment’ patterns. Lenders try to sell irrespective of seasonal peaks and troughs.

Over the weekend, Mrs Merkel’s CDU party lost control of the local region of Baden Wurttemberg. However, while the German press has hammered the CDU this morning for losing control of a state that they have run since the end of the war and asked whether Mrs Merkel’s position as Chancellor is under threat, the true perspective is probably somewhat different given that the winners of both the German local elections were the Greens and they were boosted by Japan’s nuclear catastrophe.

In broader terms, the two “people’s parties” both did badly and the FDP was ousted from the state parliament in the Pfalz, while the extreme left failed to make any inroads into states because their previous association with the East German PDS is still viewed, at best, with disdain. Mrs Merkel will probably get over this setback as there really is no alternative, although it seems clear that German politics is becoming more fractured – driven, on occasion, by particular issues.

The work of the Green Party founding fathers like Joschka Fischer has put the Greens in the centre ground of German politics in a way which they could never have imagined. For the Eurozone, the message is a simple one, if they want Germany to pay, then they will have to play it the German public’s way. Post-reunification Germany can be characterised as domestically focussed, other than in its pursuit of its trade interests, with overtones of pacifistic neutrality and environmentalism.

There were no major surprises from the EU summit. The final conclusion was broadly in line with expectations. EU governments again committed themselves to increase the lending capacity of the EFSF to €440 billion and expect “it to be in place in June”. With respect to the ESM, the main change, compared to the agreement reached earlier by finance ministers, is a lengthening of the schedule by which countries will need to provide paid-in capital to the mechanism.

The first tranche in 2013 will be now €16 billion instead of €40 billion and a further €64 billion will be paid over the following five years. In our judgement, the outcome of the German local elections is unlikely to have any impact on the upcoming vote in the Bundestag on the expansion of the EFSF and the establishment of the ESM. Despite hostile rhetoric, German MPs know that a rejection of the reformed rescue packages in the Bundestag would send massive shock waves through the system.

Meanwhile, Spain is taking steps to build a “firewall” to stem contagion from Portugal’s debt woes as it cuts the Spanish fiscal deficit and retools its economy. Interestingly, the gap in yield between German and Spanish 10-year debt narrowed for a second day on 25 March to 189 basis points, its lowest level since 4 February, while the spread on Portuguese debt widened, a sign that investors are becoming more positive on Spain even after the collapse of the Portuguese government.

The Spanish government is committed to cutting the fiscal deficit to 6% of gross domestic product this year from 9.2% in 2010. The Spanish government has also given lenders deemed to be short of capital about a year to bolster their balance sheets or risk partial nationalisation. The Bank of Spain, which says 12 banks may need a combined €15.2 billion ($21.3 billion) to meet new minimum capital requirements, has told them they must spell out how they intend to raise the money.

According to CrossBorder Capital, “the latest liquidity data shows a steady picture”. However, overall “liquidity is supportive rather than abundant”. The current shallow, sideways cycle is consistent with the periods that follow major banking crises, such as previously happened in the mid 1980s and mid 1990s. This is hardly surprising given the sheer scale of the surge in 2008/09.

The big change recently has been an upward step in emerging markets liquidity over recent months. In Australia, Britain and the US, “liquidity is slowly gaining traction.” The picture in Japan may have been altered significantly by the Bank of Japan’s recent, post tsunami policy moves. It will take a little longer to assess this properly.

It is perhaps not surprising that the Japanese should be nervous investors. Actually, they were nervous before the tsunami. The Bank of Japan’s latest Flow of Funds report for the end of December 2010 included a new record high for the liquidity of Japanese households. Their holdings of cash and deposits are now ¥820.67 trillion, up 1.3% from a year earlier.

Demand deposits, as a component of this total, rose 3.4% and time deposits fell 0.2%, all of this was despite, or possibly because of, very low interest rates. Bond holdings declined by 5.7% and holdings of investment trusts by 5.5%. Japanese individuals have been shifting back from investments to safety. They have not been rewarded to do so – total Japanese household assets in 2010 fell by 0.1%, a third consecutive annual decline.

Meanwhile, non-financial Japanese corporations cut their borrowings by 4.6% and financial institutions increased their holdings of Japanese government bonds by 6.8%. Their deposits continue to grow but they are unwilling or unable to make loans. Non-financial corporate cash and holdings of short-term securities rose by 4.0% to ¥196.91 trillion or the equivalent nearly 40% of Japanese GDP. There is no shortage of liquidity in Japan. However, the events of the last three weeks may have dulled the appetite for a while.

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.