Slowing growth leads to central bank cutting interest rates

In this week’s bulletin:

  • Global markets rally on news of China’s rate cut and supportive EU action for Spain
  • Eurozone policymakers announce a pre-emptive €100 billion rescue package for Spain’s banking sector
  • Spain avoids ignominy of full bailout by use of new EFSF powers to aid banks directly
  • Slowing growth leads to central bank cutting interest rates
  • Beijing determined to stimulate economy as growth slows to 8.1%
  • US Federal Reserve gives no indication as to next round of quantitative easing
  • Chairman Ben Bernanke asks Congress to share the burden of stimulating US economy via fiscal policy
  • Coming election on 17 June may still be inconclusive
  • EU leaders likely to respond firmly to protect eurozone

 

Market Eye

Global markets rally on news of China’s rate cut and supportive EU action for Spain

Notwithstanding a shortened working week here in Britain, the UK stock market made up for lost time by enjoying one of its best weeks for several months, with London shares rallying over 3%. Investors’ renewed appetite for risk was attributed to news from China and growing confidence that eurozone policymakers will step up to the plate, with more cash aimed at stabilising the Spanish banking sector. We discuss both these key issues in more detail below but there was no doubt that after weeks of fretting about global growth prospects and the euro, investors collectively decided that it was time to take a more optimistic outlook. This happier mood helped boost most developed markets, with Wall Street stocks leading the way by ending almost 4% higher. There was little change on the currency markets but commodities benefited from firmer prices, with both gold and oil rising.

 

Less rain in Spain

  • Eurozone policymakers announce a pre-emptive €100 billion rescue package for Spain’s banking sector
  • Spain avoids ignominy of full bailout by use of new EFSF powers to aid banks directly

After days of increasing speculation, it was announced over the weekend that eurozone ministers had agreed to lend Spain up to €100 billion ($125 billion; £80 billion) to help its banks. Analysts said the deal would buy time for policymakers to solve other problems facing the 17-nation eurozone. For some weeks Spain has been in denial about the need for help to tackle its financial crisis; the country is experiencing one of its worst recessions and one in four people are unemployed. Its problems stem from the collapse of its property sector which has left thousands of properties unfinished and unsold, ruined many developers and left its banking sector with billions of euros of failed loans. The banking sector’s woes have been further exacerbated by the fact that its banks have been using cheap loans from the European Central Bank, via its LTRO scheme, to buy up Spanish government bonds. For a while this worked by driving down yields as capital values rose, which meant it cost Madrid less to service its borrowing requirements and gave it a breathing space from bond vigilantes.

Unfortunately it became clear that Bankia, one of the country’s largest banks, which was created by merging many overstretched regional banks into one entity, was going to need state support; but Madrid insisted the government had the means to fund the €19 billion recapitalisation. Bond investors were sceptical and, as a result, yields on government bonds started to rise again close to the 7% level which most economists believe is unsustainable and has been the trigger point for previous bailouts of Portugal, Ireland and Greece. Back in April, Spain’s Prime Minister Mariano Rajoy said, “Talking about a rescue makes no sense…. Spain is not going to be rescued; Spain can’t be rescued. There’s no intention and no need so Spain will not be rescued.” Despite continued denials that Spain would need help from its partners, on Saturday, in answer to a question asking if Spain would need EU funds, the country’s deputy prime minister said, “There are some things that cannot always be answered as if they were test questions.”

With new elections in Greece on 17 June raising the possibility of it exiting the eurozone and thus undermining the credibility of the currency, it is clear that Berlin and Brussels wished to solve the Spanish problem quickly. Usually EU bailout money comes with stringent conditions in the form of austerity measures but this time the help has been nuanced. Rather than endure a full economic overhaul, Spain will take advantage of new powers – the so-called ‘recapitalisation tool’ – given to the eurozone’s €440 billion rescue fund, that allow loans to be channelled via the government directly into the struggling banks, so allowing Madrid to avoid a full-blown bailout. Germany has resisted direct capital injections and the European Financial Stability Fund (EFSF) precludes this in any event, so using the recapitalisation tool means Madrid will still ultimately be responsible for paying off the loans if any bank defaults. News of the bank bailout has, as one would expect, been well received by the financial markets this morning, with stock markets in Asia and Europe rising strongly as investors take the view that another crisis has been avoided leaving, for now, just the thorny issue of Greece’s coming elections to deal with.

 

China Chops Rates

  • Slowing growth leads to central bank cutting interest rates
  • Beijing determined to stimulate economy as growth slows to 8.1%

Last week China’s central bank took global markets by surprise by cutting interest rates for the first time since 2008, sending a clear signal that it is determined to stimulate the world’s second largest economy. The country’s growth rate slowed in the first quarter of the year to 8.1%, raising fears that its economy was set for a hard landing. With growth slowing more than expected and other key indicators pointing south, Beijing has been forced to prop up activity.

“Cutting the interest rate definitely shows they are concerned about downside risks to the economy”

Ken Peng, an economist with BNP Paribas

The People’s Bank of China (PBOC) cut the benchmark one-year lending rate by a quarter of a percent to 6.31% and also announced that it would allow banks to offer lending rates 20% below the official benchmark. However, some analysts believe that an increased focus on the very short term undermines the country’s structural reform agenda. As we have discussed previously, China’s economy has been driven by investment and manufacturing for export and there is a political desire for the country to shift to a growth model driven more by consumption than investment. Much of China’s previous stimulus measures have been credit-fuelled, causing property prices to spiral upwards and meaning most Chinese have no hope of buying their own home. Beijing’s hope is that cheaper money will result in businesses borrowing to increase capacity but there is evidence that industry is reluctant to take on new commitments. In the markets, investors cautiously welcomed the news, believing that China will remain one of the major growth engines for the global economy.

 

Wait and See

  • US Federal Reserve gives no indication as to next round of quantitative easing
  • Chairman Ben Bernanke asks Congress to share the burden of stimulating US economy via fiscal policy

Last week the US Federal Reserve dashed any hopes that it is about to embark on another round of monetary stimulus – dubbed QE3 – focusing instead on fiscal policy. In his testimony to Congress, the Fed’s Chairman Ben Bernanke made a strong plea for Congress to take action on fiscal policy rather than relying on monetary policy alone. Mr Bernanke went on to say that US growth looked set to continue at a moderate pace but he also made clear that the central bank was ready to respond to a eurozone crisis. Weak US jobs data over the last two months, together with turmoil in the eurozone, has led to rising expectations that the Fed will ease monetary policy at its next meeting on 20 June. But for now it seems Mr Bernanke is keeping his powder dry and investors guessing as to what action, if any, the Federal Reserve is likely to embark upon. Here in the UK, the Bank of England also kept interest rates on hold at 0.5% and it too gave no indication that it is likely to expand its own quantitative easing programme in the near future.

 

Greek Election

  • Coming election on 17 June may still be inconclusive
  • But EU leaders likely to respond firmly to protect eurozone

As mentioned, Greece will hold elections this coming Sunday after last month’s inconclusive outcome when the political parties failed to create a working coalition. There has been much speculation about whether the Greek people will also use this opportunity to treat the election as a referendum on continued membership of the eurozone. The Greek economy is in deep recession and harsh austerity measures have, unsurprisingly, led to calls for the country to leave the euro. This is despite numerous opinion polls showing that the majority of Greeks wish to remain in the single currency, despite the hardship EU bailouts have resulted in. Whilst there is little merit in speculating as to the likely outcome of the coming election, it is worth considering the probable market reactions to the various foreseeable outcomes of the election.

Economists see four most likely outcomes: pro-Troika, anti-Troika, euro exit, and euro exit with contagion. The ‘Troika’ are those effectively in charge of Greece: the European Union (EU), the European Central Bank (ECB) and the International Monetary Fund (IMF). The first outcome would most likely result in ECB support, alongside a modification of bailout terms allowing the Greek economy to stabilise over the medium to longer term. The second outcome might prompt signs of flexibility from EU policymakers alongside concessions to encourage Greece to stay in the euro, although uncertainty would likely continue. The third would cause defensive EU action and see the ECB install a ring fence around the rest of the eurozone whilst Greece goes its own way. The last scenario is the greatest unknown but would most certainly result in concerted ECB/IMF defensive action to prevent the risk of bank runs.

The latest help for Spain is a clear indication that policymakers will take speedy action to ensure eurozone stability; however we continue to question whether this extends to retaining Greece within the eurozone at any cost. Following this weekend’s actions by eurozone leaders and the markets’ response, it would seem investors are likely to be supportive over the medium to longer term in the event of the first two and possibly the first three scenarios unfolding. Regardless, we continue to recommend that the best strategy for investors is to maintain a broadly diversified portfolio of assets.

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