By Norman Villamin, Head of Investment Strategy, Asia at Coutts
Though we are encouraged that policy- makers have responded to the market concerns expressed in the market turmoil of early-August, much remains for them to do. We believe stability in the euro-zone financial system and in US and global growth prospects is achievable and are encouraged that policy-makers have put the necessary measures on the table. But the roadmap for getting there is complex, and reinforces our view that investors should expect volatility to remain high in the weeks ahead.
The seemingly modest 1% decline in global equities masked the volatility and anxiety in the markets through the course of last week. The bond and money markets tell a more telling tale, with US 10-year yields falling 0.30 of a percentage point (pp) over the week, and as much as 0.45 pp at the lowest point during the week. European inter-bank lending rates (the cost European banks incur in lending to each other) moved out to 0.67 pp, about where they were just before Lehman brothers filed for bankruptcy in September 2008.
However, though they remain under pressure, policy-makers have begun to respond to the challenge laid down by global financial markets with:
1. The ECB stepping in to buy both Spanish and Italian debt in the secondary market.
2. The US Federal Reserve (Fed) indicating that it will keep rates low (0-0.25%) until mid-2013.
3. China strengthening the renminbi to the strongest levels seen since its 1994 devaluation.
While we believe these steps were certainly necessary to stem the growing alarm in markets, we do not believe they are sufficient in themselves to resolve the challenges facing the global economy.
Concerns about US growth and euro-zone financial stability need to be resolved, and Asia needs to boost its contribution to global growth by ending its monetary tightening phase. A number of key policy responses are needed, and there are significant events along the way to watch out for. They are as follows:
Throughout September: Euro-zone countries must vote individually to approve expanded powers for the European Financial Stability Fund (EFSF). Expanded powers of the EFSF would help address our concerns about capital needs of the euro-zone banking system.
US policy and growth prospects
August 26: Jackson Hole conference at which Fed Chairman Bernanke is expected to provide more detail on potential Fed policy responses, much as he did at the 2010 conference, possibly laying the groundwork for the 3rd round of quantitative easing (QE3).
September 1 (and the 1st of each month going forward): Institute of Supply Management manufacturing survey should provide additional insight into the US economic outlook.
September 2 (and the 1st Friday of each month going forward): US non-farm payrolls survey; job creation remains the key political issue and economic hurdle to a more sustainable recovery.
September 16: First meeting of the US Joint Committee on Deficit Reduction to agree on reductions in spending/increases in taxes in the US federal budget totalling at least $1.2 trillion over 10 years.
November 23: US Joint Committee on Deficit Reduction must complete its hearings and must vote to agree on recommendations to make to the broader US Congress.
December 23: The US Congress must vote (without amendment) on the recommendations made by the committee. If $1.2 trillion in cuts/revenue increases are not agreed upon, across the board cuts to the US budget will be implemented beginning in fiscal 2013 (October, 2012).
Asian policy easing
August 31: Japans Diet session ends. Funding for post-earthquake fiscal stimulus is still being debated. Global growth would benefit more from a stimulus which was not funded by tax increases. Such tax increases, however, remain under consideration.
September 1: China’s purchasing managers index (PMI) released. The Chinese PMI should provide further evidence of a slowing Chinese economy, which if confirmed should continue to add to the expectation of an easier policy bias in China going forward.
September 9: Chinese inflation for August released. Though July inflation was above expectations, with much of the surprise the result of base effects rather than a month-on-month worsening of inflation. Indeed, non-food inflation eased for the first time since mid-2010, while month-on-month food inflation trends continue to be encouraging. Should headline inflation ease visibly, increased policy flexibility should be available to the Chinese government in the months ahead.
Expect continued volatility
Against this backdrop of policy uncertainty, investors should continue to expect meaningful volatility in global markets, in both directions, as hopes for positive outcomes from the above-mentioned events rise and fall.
With the necessary measures on the table and under consideration, the primary risk for investors is in their actual implementation and the efficacy and longevity of the policies themselves.
What we believe global financial markets are currently pricing in:
US 10-year Treasury yields at 2.25% are pricing in GDP growth of less than 2% for the US economy, also assuming inflation stays low.
US equities are pricing in GDP growth of between 1.9-2.1% for the US economy.
Chinese equities are increasingly pricing in a recession in the Chinese economy.
Uncertainty in the West, but increased visibility from China
While we do acknowledge the uncertainty surrounding US and European policies in the weeks ahead, increased rather than decreased clarity appears to be emerging surrounding China’s policy. Much as it did in 2008, China appears to be laying the groundwork to lead global policy action. In particular, by allowing its currency to appreciate at the third fastest weekly pace seen since it de-pegged its currency in 2005, China appears to be taking a stance which is supportive for global growth and potentially a prelude to further action.
Such action may include a gradual shift in its priority toward protecting growth versus fighting inflation, which has been the policy objective over the past nine months. We would expect the initial stages of such a shift to focus on fiscal stimulus, targeting consumption, social housing, small and medium enterprises (SMEs) and strategic industries. Moreover, while outright cuts in interest rates may not be immediately forthcoming, we also expect to see less stringent bank credit control with credit easing for SMEs a likely focus.
But as the above list highlights, it will be a complex road to stability, with plenty of potential for ups and downs along the way. Still, we remain encouraged that the necessary measures to achieve the near-term objectives of stability in the global financial system are at least on the table.
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