Market Review 21 February 2012

Commentary: I Gotta Dance to Keep From Crying

Last week the NASDAQ was at its highest level for a decade, topping its previous pre-credit crunch 2007 peak and reaching a level it last achieved on the descent from its dot com bubble.  There’s still a (long) way to go before that point even appears on the horizon, and there are few other indices that are hitting – or near – significant highs (Indonesia, Malaysia, Philippines, and Venezuela are the contenders).

Apple’s extraordinary share price performance, topping $500 per share, has been a significant part of the NASDAQ story, but while short of new highs, the other major US indices have been motoring higher over the last six months. The NASDAQ is up 13% so far this year, leading the S&P at 8% and Dow at 6%. Equity returns have been positive elsewhere: in Europe the DAX is up 16%, the CAC40 nearly 9%, and in the Far East the Nikkei is up 11% and the Hang Seng is just shy of 17%.

Last week saw further good data on US activity and employment in the Philly Fed’s survey, with the average working week jumping to its highest level since April last year and the week ended with Congress passing an extension of the 2% payroll tax holiday.  Further signs of stimulus appeared elsewhere. The Bank of Japan announced a 10 trillion yen bond buying programme, and explicitly targeted an inflation rate of 1% after years of deflation.

At the weekend the People’s Bank of China announced a 50bps cut in the Reserve Requirement Ratio, boosting lending capacity across Chinese banks. The month will end with the final round of the European Central Bank’s LTRO programme, anticipated to provide another 600+ billion euros of liquidity to the European banking system.

Markets have clearly been responding to policy easing (actual or prospective) across the world, and better economic news in the United States, where GDP grew at an annualised rate of 2.8% in Q4 2011. But lying ahead as a challenge to this stimulus is the prospect of softer corporate earnings. Significant parts of the world are struggling economically. Japan’s GDP shrank at an annualised rate of 2.3% in the fourth quarter of 2011 as weak external demand, a strong yen, and the Thai floods all took their toll.

In Europe, Belgium, Greece, Italy, Netherlands and Portugal all saw their GDP contract and after two consecutive quarters of negative growth are in recession. Germany had its first negative quarter since 2009.  Moody’s cut the credit ratings of Italy, Portugal and Spain, and put Austria, Britain and France on “negative outlook.” It is the potential lack of growth which may begin to weigh on investors valuation of stock markets once the uncertainty premium of the eurozone crisis has been removed. The Italian ten year bond yield has rallied 140 bps so far this year.

The levels of indebtedness of some European nations clearly brought the eurozone crisis to a head, but the United States has a higher level of debt to GDP: 80% versus 94% at the end of 2010 according to The Economist.  And President Obama’s latest budget projected debt levels rising from 2023 as retiring baby boomers required more and more health care.  But whilst America faces an inefficient and expensive social infrastructure compared with Europe with long term debt implications, it’s latest GDP data shows the massive difference in competitiveness between the US and Europe.

At the heart of Europe’s problems are significant differences in competitiveness across eurozone member economies, with poor productivity and rigid labour markets having killed growth in the less competitive members. The desperate fire fighting in Europe over the past 18 months has been to stem the immediate symptoms of this: first a credit and then a liquidity crisis. The real challenge is to solve the competitiveness crisis.

Measures announced last week by Spain’s new Prime Minister Mariano Rajoy show that this attempt is under way. They include more flexibility for companies to lay off workers and to negotiate hours and wages outside collective bargaining arrangements. These may start to shift the culture and practice of corporate Spain and begin to improve productivity and competitiveness and finally attack the 23% unemployment rate.

In Italy Mario Monti’s government is struggling to reach agreement between employers and unions, first on unemployment benefits then on legislation effectively preventing firing and lay-offs.  March is the target for announcements.

And finally early today the sickest member of the eurozone, Greece, received the agreement of eurozone finance ministers to a 130bn euros bail-out package. Greece will avoid bankruptcy and can now pay off maturing government debt on March 20th. Private investors in Greek debt have accepted nominal losses of 54%, and face an economic loss likely to be 70%.  Greece has accepted unprecedented EU bureaucratic oversight of their commitment to reduce Greece’s debt/GDP ratio to 120% by 2020 from its current level of 160%.

They are embarking on a series of constitutional changes to put debt repayment ahead of other government spending, and last week adopted salary and pension cuts as well as cuts in health care and defence spending. In the short-term the euro should strengthen.  The longer-term concern must be whether, entering its fifth year of recession, Greece as a nation can sustain the struggle its bail outs require of it without a political or social collapse.

Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton