QE plans on hold?

In this week’s bulletin:

  • The US equity market hits a four-year high but ends the week disappointingly
  • US unemployment falls, but expectations are too high
  • Nicolas Sarkozy is ousted as Francois Hollande is voted in, becoming France’s first socialist President since the 1980s
  • In Greece, a clear majority of the population voted for parties opposed to budget cuts imposed by the European Union
  • Irish home values unchanged in March; the first month without a fall since August 2010. Ireland is benefitting from facing up to problems early


A week for the bears

  • US market hits a four-year high but ends the week disappointingly
  • US unemployment falls, but expectations are too high

Last week saw debate rumbling on over whether the UK is truly in recession, but analysts also remain undecided on the US economy and the sustainability of its recovery. Both sides of the Atlantic experienced disappointing data and uncertainty increased over whether further central bank support for markets would be forthcoming. A weak US unemployment report triggered falls in equity and commodity markets, fuelling demand for US and German government debt. This came after the Dow Jones Industrial Average Index reached a four-year high earlier in the week.

Only 115,000 US jobs were created in April, far fewer than the expected 170,000, adding weight to the bears’ argument that the recovery is running out of steam. Whilst positives can be taken from the jobless rate falling to a three-year low of 8.1%, expectations have risen so high that any disappointment was likely to see a negative reaction from markets. To further complicate matters, there was a general view that, despite the disappointing jobs data, the economy was not yet showing sufficient signs of weakness to warrant a further round of quantitative easing from the Federal Reserve.

The FTSE 100 Index closed the week at 5,655.1, down 4.7% from the 2012 high in April, as resource stocks took a beating and commodity prices saw steep declines. Crude oil saw falls of over $4 per barrel on Friday alone, while losing more than $7 for the week. There is significant concern about over-supply as US inventories stand at 21-year highs on the back of reduced demand, while senior members of OPEC have repeatedly voiced displeasure over price levels. Among other commodities, the price of copper fell significantly while gold dropped $18 per ounce to $1,640.


Key European elections

  • Nicolas Sarkozy ousted as François Hollande is voted in
  • No outright winners in Greece as angry voters deliver a stinging protest vote

Elections were always going to play a key part in the short-term future of the eurozone and the result in France could be as important as any other. On Sunday evening, François Hollande celebrated victory, becoming France’s first socialist president since François Mitterrand in the 1980s, earning around 52% of the vote. Nicolas Sarkozy became the first French president in over 30 years to fail to win a second term, damaged by poor approval ratings amid the country’s economic woes, and will now leave politics entirely. The younger vote was crucial to the result after spending cuts caused widespread anger amongst this most politically active section of the population. The French debt problems remain the same but Mr Hollande is thought to offer a renewed hope to the younger generation, promising more jobs and better salaries. He wants to raise the minimum wage, hire an extra 60,000 teachers, and reduce the retirement age from 62 to 60. The president-elect also promises to raise taxes on big corporations, as well as individuals earning in excess of €1 million a year, with tax rates of up to 75% being mooted. In his victory speech to tens of thousands of supporters in Paris, Hollande said:

“Europe is watching us; austerity can no longer be the only option. I am the president of the youth of France; you are a movement that is rising up.”

While optimism sweeps certain sections of France, Mr Hollande must act quickly to reassure key European partners that he will face up to the considerable challenge he inherits. German Chancellor Angela Merkel congratulated him by phone and is thought to have invited him to Berlin for talks as soon as possible. It is anticipated that he will visit Germany on 16 May, the day after he takes office. With the president-elect talking many times in his campaign about a renegotiation of budget treaties, Angela Merkel wants this settled quickly and a special EU summit will take place within four weeks. He has pledged to push for less austerity and many other policies which the German Chancellor would oppose, including delaying the deficit-reduction plans and renegotiating the fiscal treaties signed by all but the UK and the Czech Republic. Mr Hollande is convinced that he can lead a coalition, including Spain, to press for more EU spending, including direct intervention from the European Central Bank.

In Greece, a clear majority of the population voted for parties opposed to the budget cuts imposed by the European Union. No coalition government could be formed, prompting the need for another general election, most probably on 17 June. The two main parties that came together last year to implement the austerity programme were severely punished, having their total vote slashed by half. This leaves the two parties that have dominated Greek politics for decades struggling to renew their coalition and implement plans for €11.5 billion of fresh cuts at the end of June as demanded by the EU. This election was the first opportunity for the Greeks to express their views on the terms of the bailout after a planned referendum was cancelled under EU pressure. The doubts surrounding Greece’s continued participation in the single currency will loom large over the coming days, with economists at Citi raising their odds on the country leaving the single currency to 75%.

Reaction to the Greek result has been predictable. Angela Merkel immediately warned Athens to stick to reform plans agreed under the bailout plans, while Christine Lagarde, managing director of the International Monetary Fund, echoed other policymakers in acknowledging the importance of economic growth in Europe. She said:

“There’s no avoiding the need for a brake in fiscal adjustment; but if calibrated correctly, we can make sure it doesn’t do too much harm to growth.”


In terms of how this directly affects the UK, the French news in particular was not necessarily positive. David Cameron had publicly backed Nicolas Sarkozy in February and refused to meet with François Hollande while the candidate was visiting London. Looking forward, a shift in focus by Brussels towards growth would be welcomed in the UK, depending on how it is achieved. In addition, the proposed 75% tax rate on those earning more than €1 million per year could see many French people looking for a new home for their wealth.

Uncertainty is not what is required for markets. Market reaction to the election results saw Asian markets fall, European equities experience a sharp sell-off in early Monday trading, and the euro slide against other major currencies. At the time of writing, these reactions had been substantially reversed as a result of improving German manufacturing data, reflecting the fact that a weak currency may actually benefit certain sectors of the eurozone. It also suggests that, reassuringly, investors may still be focussing on fundamentals rather than politics. However, major concerns remain over the future of the euro – the election results clearly show that voters are not feeling good about the austerity measures, which are at the heart of a resolution to Europe’s debt problems. As we have always stated, this will be a long road to recovery and there are likely to be many more political problems to solve in the short term. Investors need to step aside from the media headlines and focus on the global news at a company level which, on the whole, continues to surprise on the upside. That the two major economies of the eurozone appear to be at odds with one another will not help the immediate global situation. Editorial comment in The Times summed it up stating, “Mrs Merkel must recognise the new political reality, but Mr Hollande must accept the unchanged economic reality”.


Viva Ireland

  • Irish house prices stabilise
  • Ireland shows signs of benefitting from early action

Whilst the Southern Europe contingent of the often-quoted ‘PIIGS’ nations (Portugal, Ireland, Italy, Greece, Spain) continue to be mired in political and economic uncertainty, Ireland’s association with the other countries now seems somewhat dated. Last week, news was released showing that Ireland’s residential house prices were static in March – the first time values have not fallen since August 2010. In Dublin, house prices rose by 0.7%.

The problems created in Spain and Ireland were similar as cheap credit fuelled a construction boom. Building projects were started that relied on demand remaining sky-high, with Spanish prices doubling between 1995 and 2005 and Irish prices quadrupling between 1997 and 2007. Many in Spain believe the demand is still there and assert that once the economy gets back on track, the oversupply will be absorbed. However, the problems the Spanish face are 24.4% unemployment (a 20-year high), recession and forecasts for the economy to shrink by 1.8% in 2012. The Spanish real estate problem is one of the eurozone’s biggest tests – Spain’s economy is twice the combined size of those of Portugal, Ireland and Greece.

The key difference between Spain and Ireland was the speed of response to problems. Spain has procrastinated but Ireland faced up to the challenge. In 2009, Ireland created the National Asset Management Agency (NAMA), an entity through which bonds could be used to buy commercial real estate loans from the banks. The loans had a face value of €74 billion, for which NAMA paid €32 billion. Banks needed capital, leading the state to provide liquidity and nationalise five of the largest lenders in the country. NAMA is now seeking investors for the assets it can sell, and forcing debtors to rent out some of the remaining properties to produce revenue. Michael Noonan, the Irish finance minister, recently told the Parliamentary Committee, “The big knock to the domestic economy was the fact that building and construction completely collapsed, meaning 20% of the economy was immediately gone.”

“It is beginning to move once again; there are very tender shoots of growth at the moment.”

Due to early intervention, the International Monetary Fund has forecast the Irish economy to expand by 0.5% this year and 2% in 2013.


QE plans on hold?

This week, the Bank of England makes a decision on increasing the £325 billion stimulus programme, signalling whether it is more concerned with high inflation or Britain’s return to recession. Most economists always believed the May meeting to be crucial due to the Bank having completed the February £50 billion round of bond purchases. The decision by the Monetary Policy Committee (MPC) has been made more difficult as weaker-than-expected economic data has combined with stubbornly high inflation – at 3.5% it is well above the February forecasts. Vicky Redwood, chief UK economist at Capital Economics, said, “For now, we think that the MPC will put more weight on the sticky inflation figures. Accordingly, we expect the MPC to pause but it will be a closer decision than looked likely a few weeks ago.”

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