Greece pleads case for remaining in the Eurozone

In this week’s bulletin:

  • Investors take stock as latest news from the US and eurozone fails to provide direction for markets.
  • Greece pleads case for remaining in the Eurozone as stress tests of Spanish banks are expected to signal a formal bailout request from Madrid.
  • UK deficit reduction plans appear to be faltering but leading commentators suggest “light at the end of the tunnel” for the UK economy.

Equities pause for breath

  • Investors take stock of the last three months
  • Mixed results from the US give no real guide as to short-term market movements

Since market lows in June, there has been a marked improvement in investor risk appetite, aided by recent central bank action; but last week saw a sharp pause for breath. As usual, the reason was concern over prospects for global economic growth. US and European stocks closed the week little changed while UK stocks fell around 1%; although the ‘risk-off’ attitude was more tangibly demonstrated by a weakening of commodity prices and the euro, as well as gains for highly rated government bonds. A further reason for the more cautious tone was Spain’s apparent lack of urgency in seeking a full sovereign bailout, despite reports on Friday that EU officials and the Spanish government were working on another rescue package. Market reaction would suggest scepticism that this will address the important issues related to Spanish fiscal policy.

The matter of underlying economic growth, not just in Spain, was an important theme in markets as doubts started to emerge over whether recent moves by the Federal Reserve and the European Central Bank (ECB) would be sufficient to address weak fundamentals. The Bank of Japan joined in last week as it announced an additional 10 trillion yen of asset purchases, although the move seemingly had no immediate market impact away from Asia. Focus instead remained on the Federal Reserve’s decision to launch another round of asset purchases, initially targeted at mortgage-backed securities, and on the ECB’s conditional offer to buy unlimited amounts of short-dated peripheral government bonds. Meanwhile, US manufacturing data and weekly jobless claims offered little cheer, but there were bright spots: US home starts hit their highest levels for two years and US house-builder confidence returned to pre-crisis levels.

The problem seems to be that the market is now used to this sort of intervention, and a bounce in the market now tends to last less than 24 hours. The Federal Reserve’s recent stimulus programme, known as QE3, is massive in terms of size and running time but the stock-market response was muted when compared to earlier packages. UK shares rallied for about an hour of morning trading before dipping in the following sessions. There could be several reasons for this mild reaction, not least the belief that these stimulus packages may ultimately be unable to deliver the economic punch intended. However, the key reason could be investor sentiment. Both QE1 and QE2 were announced when the mood was extremely pessimistic and the initial announcements caused a euphoric rush into shares. This time around, investor sentiment is already relatively positive and has been for much of 2012. Also, unlike the first two initiatives, the announcement of QE3 was not a surprise: whilst the precise details were unclear, the announcement was probably already priced into the market.

The FTSE 100 closed the week at 5,852.62, down 1.1%, helped late in the week by Vodafone’s largest rally in two months as analysts played down fears of a dividend cut. The company’s 7.6% dividend yield is the biggest of London’s blue chips and accounts for 3% of the total dividend for the index. Concerns centred on whether European problems would affect Vodafone’s prospects, and potential over-reliance on its stake in US venture Verizon Wireless; but most analysts now expect the dividend to remain unchanged.

Concern over Europe rumbles on

  • Greek Prime Minister emphasises importance of a solution
  • A stress test of Spanish banks will show the extent of the problems in Madrid

The Prime Minister of Greece, Antonis Samaras, warned fellow European leaders that a Greek exit from the single currency would spell trouble for all of them. At a summit in Rome, he stressed:

“An exit from the eurozone is not a choice for Greece: it’s a nightmare. For us it’s not an option: it’s a total disaster. It’s not going to be easy for the rest of our partners, because once a country is out of the eurozone, speculators will start picking on the next weakest link, then the next one.”

Talks were called off late last week with a decision still to be made over Athens’ request to extend the bailout deadline beyond 2014. Greece is struggling to reach an agreement between its coalition partners on a €11.5 billion package of budget cuts that is key to receiving the funds it urgently requires. Mr Samaras made these warnings just hours after reports that the Troika of central lenders – the European Commission, the European Central Bank and the International Monetary Fund – might delay its report on Greek prospects until after the US election on 6 November, in the hope of avoiding any global economic shocks. A European Union official was quoted as saying, “The Obama administration doesn’t want anything on a macroeconomic scale that is going to rock the global economy.”

Elsewhere in Europe, the Sunday Times reported that it expected Spain to lodge a formal bailout request for its banks within days, amounting to at least €60 billion. The paper stated Mariano Rajoy, the Prime Minister, has been preparing his latest budget with full consultation with Brussels. Spain has already agreed to a package in excess of €100 billion for the banks, though there are some commentators who expect it may only need €60 billion of that. Others suggest a figure in excess of €100 billion; in short, no one knows. A lot depends on the results of the official stress tests due this week which will measure exactly how over-burdened with toxic debts Spanish banks are, and which need to be recapitalised, restructured or shut down entirely. Expectation is of a dramatic deterioration from the stress tests that took place in June. While Mario Draghi, the President of the ECB, recently unleashed a massive bond-buying programme, he also stated that it would not be deployed to help Spain unless Madrid actually requested the help directly. The Spanish government has resisted thus far as it’s not prepared to accept stringent austerity measures similar to those imposed on Greece. However, it’s planning to increase the retirement age from 65 to 67, as well as pushing through €4 billion of spending cuts ‘voluntarily’.

Chancellor under increasing pressure

  • George Osborne’s plan to reduce the UK deficit looks to be off course
  • Economists expect GDP numbers to be revised upwards

According to reports, George Osborne is on course to borrow almost as much in 2012 as he did in 2011, highlighting the faltering progress towards deficit reduction. Public sector net borrowing may rise to around £140 billion in this fiscal year, according to the Institute for Fiscal Studies. This would be £18 billion more than official forecasts and the persistently poor public finances are reducing the hopes of putting the national debt burden on a downward trajectory by 2015/16. The Office for National Statistics (ONS) revealed that poor tax revenue was the main problem and not the failure to stick to spending plans. However, the Treasury insisted over the weekend that it was too soon to “second-guess” fiscal forecasts that will be issued by the ONS around the time of the Chancellor’s Autumn Statement on 5 December.

Sir Mervyn King has said these results would be acceptable if they reflect declining global growth, rather than a failure to implement fiscal consolidation measures. According to the Daily Telegraph, the Chancellor has also been told that most major institutional bondholders would not reduce their holdings if Mr Osborne watered down proposals to bring public finances under control. A majority of investors surveyed by Bloomberg suggested they would not punish the Chancellor by selling gilts and ultimately pushing up borrowing costs if the debt target was hit slightly later than planned.

There could be some respite for the Chancellor this week, as economists expect a further upward revision from the 0.5% decline reported for the second quarter of 2012. The revised figures, suggesting that the country’s double-dip recession has not been as deep as first feared, come as some high-profile commentators have reported signs of recovery. On Friday, Spencer Dale, Chief Economist at the Bank of England, said there was “light at the end of the tunnel”, echoing Sir Mervyn King’s assertions of a slow recovery. Looking ahead to the third quarter, the UK is expected to show growth of 0.5%, recouping the fall from the previous quarter. The preliminary estimate will be released on 25 October and is expected to show the country benefiting from the Olympics and improved industrial output. In an unusual move, Olympic tickets sales will appear as a separately stated constituent in the figure, and are expected to add 0.1% to GDP.

Nick Purves of RWC Partners, recently gave his perspective on what the low growth backdrop means for investors;

“Investors’ expectations have become more realistic over the past five years in appreciation of the difficult financial environment. Those with an expectation of equity returns in the region of low to mid-single digits are less likely to be disappointed in what will be a low growth environment for the next few years. The economic outlook remains very tough as central banks continue to buy bonds and push down interest rates. The deleveraging process will take time and needs to be done in an orderly manner. However, corporate profits have been strong over the last two years and my focus continues to be on companies with the ability to generate the sustainable cash flows that will be the major driver of shareholder returns over time.”

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