UAE. The European problem refuses to go away and there is no JP Morgan. Over the last three weeks, two large news events designed to placate the pessimists have produced one session rallies. (Greek voters chose austerity over the threat of chaos and Spanish banks received US$125 billion in funding).
Even the US Federal Reserve’s extension of its bond-buying programme, nicknamed Operation Twist, failed to improve the market mood as it contains no net new money. All eyes now are on the European summit of 28 June for evidence that the continent’s leadership is moving in the direction of a Europe-wide system of cross-guarantees for bank deposits and fiscal policies.
Germany’s premier has gone quiet in the last few weeks and the smart money now believes that Germany is slowly coming on-side. How long it takes the fiscally conservative leader to assuage the concerns of her electorate remains to be seen, but from a tactical perspective risk assets need it to happen sooner rather than later.
The timing of the intervention by the Bank for International Settlements yesterday therefore couldn’t have been bettered. With growth wobbles appearing in OECD leading indicator series – particularly for China – the BIS declared that unconventional monetary policy may be bad for the global economy.
The BIS’s logic is, as always, superb in that quantitative easing leads the G7 nations down the same path as Japan – in precisely the direction that US Federal Reserve Chairman Ben Bernanke said he would do everything to avoid.
The problem is that the velocity of money has fallen to its lowest level in the US since the last quarter of 1964 just before US defense spending went haywire during the US offensive in Vietnam. (Velocity is simply how quickly money changes hands). Monetarists such as Mr Bernanke see the need to print money in order to stop velocity slumping further. Left unchallenged by monetary loosening a slump in velocity leads to a drop in demand.
It is critical that this is where we now find ourselves. OECD leading indicators show the outlook for China has deteriorated, although our tactical opinion continues to view the coming policy-loosening as a positive for asset prices. Over the last week, data points from developed markets have been poor.
The survey of expectations by the US Federal Reserve Bank of Philadelphia was -16.60 in June. While this is nowhere near the -40 levels seen after the bust of Lehman Brothers, it’s not far away from the -22 figure that appeared during the massive risk aversion breakout of last summer.
This should put caution in the minds of risk takers. Also exports orders recorded by the US have fallen. The new US Markit PMI indicator, while not a great leading indicator as yet, fell in June.
It should come as no surprise that the surveys of consumers and businesses in Europe are a bit downbeat. What is surprising is the slump in outlook in Germany. The ZEW economic sentiment series in Germany was -16. Market expectations had looked for a reading of 2.3, down from 10.8. It’s not the decline that is troubling, but the pace.
The reading for the survey at the beginning of the year was above 20. The pace at which German expectations appear to have declined is faster than during the collapse of 2008/09. Perhaps this is a reason to be positive. Often when austerity is a shared experience, there is more chance of mutual co-operation.
From a tactical perspective, it remains the case that avoiding all European risk-assets is paramount until a clear signal comes that either fiscal consolidation is being under-written by all taxpayers of the European Union or the European central bank is willing to start flooding the markets.
The former option would be much more potent for global markets as it would represent the first concrete sign of progress. Countries which have cross border guarantees are less likely to face solvency crises if those guarantees are binding. Everybody wants the latter.
It isn’t hard to understand why markets have a difficult time in believing that Europe’s problems are being addressed from a fundamental perspective. The countries doing the borrowing are the same ones doing the lending. For example, the third largest supplier of funding to Europe’s bond buying programmes will be Italy behind Germany and France. Spain comes after Italy.
Nevertheless, a policy inflexion point could prove a short-term buying opportunity for risk assets. Equities remain at a substantial discount to bonds throughout the G7. The S&P dividend yield, quoted by Bloomberg, sits at 2.1% compared with a yield of 1.6% on 10 year US government bonds – the alleged risk free rate for USD investments.
The yield gap between bonds and equities is positive in all of the major G10 countries with the exception of Italy where ten year bonds yield 5.8% but the equity dividend yield is only 4.5%. The gap between 10 year government bond yields and equities is 50bps in the US, 90bps in Australia, 170bps in Switzerland and Japan, 215bps in France, 240bps in the UK and a massive 273bps in Germany.