Granite Hills Investments - Weekly Market Overview 02 May 2012
Is the old saying “Sell in May and go away” going to haunt equity markets again in 2012? Certainly today’s equity market action would signal that. There are a number of factors which are contributing to this outlook. The main factor though remains the Eurozone. The situation in the Eurozone remains critical. While the US economy looks to be stabilizing and some economic data do look rather positive the question is whether it is strong enough to offset the potential dire situation coming from the Eurozone. The answer is that the growth in the US economy is not powerful enough to withstand the effects of the Eurozone crisis especially as it now appears to deepening and spreading more to the core countries.
The recent data released from the Eurozone paints a bleak picture. Unemployment remains at an all time high and manufacturing is weakening. This is not only true for peripheral Eurozone countries where it was definitely expected but it is also now spreading to the core. Both German unemployment and manufacturing data recently released provided a negative surprise. This has sent both Eurozone equity markets and the Euro currency lower. Furthermore, political divisions are growing among Eurozone countries regarding the austerity measures being forced on a number of countries both large and small. There is a swing to the left taking place in the general political views across the Eurozone. As can be seen by the May Day rallies across many Eurozone capitals populations are beginning to tire of the austerity measures been imposed on them over the past two years.
The question remains how the crisis can be mended. There, is clearly no simple solution. Probably the two best solutions are also the two most dramatic solutions:
1. Allow the Eurozone to break up.
2. Force a much deeper political and fiscal union among the Eurozone members.
The in-between moves have at this stage been tried and tested. There will probably be one last move before one or other of the two solutions above will need to be chosen. This will be the imposition of a growth pact to work along with the fiscal discipline pact which is going to be implemented by March 2013. If a growth pact is going to work it is going to need to be extremely aggressive as aggressive as the austerity measures. With the current generation of political leaders in Europe it is hard to see such an agreement taking place. As stated in this report over and over again one of the biggest failures affecting the Eurozone is the complete inadequacy of the politicians. Again and again they come out and make big and bold statements only to fall well short when it comes to implementation. Too many Eurozone countries have had it far too good for too long. Public sectors have grown far too large. A prime example is France over 50% of the economy is made up of the public sector. Social welfare systems are far too generous allowing too many people to retire at a very young age. The Eurozone can no longer afford these comforts and scraping at the edges will not achieve anything.
If a growth and austerity pact do not work in tandem the inevitable will one of the points mentioned above a demise of the Eurozone or a much greater political and fiscal union.
The demise of the Euro would bring catastrophic effects to Europe. Helmut Kohl former German Chancellor recent wrote "The evil spirits of the past have by no means been banished, they can always return. That means: Europe remains a question of war and peace and the desire for peace remains the driving force behind European integration". This clearly shows how the former Chancellor views the situation regarding the Euro. If the Euro breaks the threat of war again in Europe will definitely increase. Looking through the history of Europe the seeds of war have often come from dire economic situations leading to protectionism and ultimately leading to war.
Proponents of a breakup of the Euro always point to the fact that the Eurozone economy is too diverse to fit the region especially the North/ South divide. They argue that the best path to economic recovery for countries such as Greece is to leave the Euro and introduce a massively devalued new currency. While this is potentially a solution if it could be orchestrated, the problem is the probability of a smooth transition is very small. In the short term exiting countries would be starved of foreign capital into the new currency and would be able to pay for day to day spending further adding to a collapse in the domestic markets and society as a whole.
The alternative solution is closer political and fiscal union among Eurozone members. This would allow for programs such as fiscal transfers from rich to poor zones. The main drawback for this solution is the fact; within the Eurozone countries still hold a strong sense of national identity. Furthermore, given the way the crisis has been dealt with to date many of the richer countries see no benefit of closer political and fiscal union. They view it simply as a way to see their tax-payers cash going to support countries that have lacked fiscal discipline and got themselves into this mess.
The Eurozone crisis continues to be the largest threat to the global macro environment. It is large enough to derail any potential growth coming from other global regions. It continues to cause great instability at both a political and economic level.
Major government bond markets remain very well supported. The two major forces supporting these markets are the ongoing Eurozone debt crisis and the questions relating to global economic growth both of which are closely linked.
As bond yields continue to fall (prices rise) the potential medium/ longer term large fall in bond prices increases all the time. Bond markets are simply acting as a safe haven.
In particular German Bunds are now looking very over-valued. 10 Year Bund yields are currently trading at historic lows of 1.61%. While domestically within Germany there is a clear upward trend in inflation developing through increasing wage settlements and increasing house prices. While this may not be an immediate problem for Germany many commentators and politicians are showing increasing signs of worry especially as the ECB holds rates low and will potentially decrease them further as well as the unorthodox tools the ECB is using such as unlimited three year bank loans and bond purchases.
It is though still too early to start thinking about shorting Bunds or any other major bond market.
Major currency markets remain very much range bound. The resilience of the Euro continues to surprise. Given the developments going on within the Eurozone it would be very realistic to think that the currency should be significantly weaker than it currently is. The situation in Spain looks increasingly shaky especially after the downgrade of Spain to BBB- by rating agency S&P. The potential turbulence which is likely to follow this Sunday’s second round presidential election in France and Greece’s general election will also add to the woes of the Euro. The overall climate for the Euro looks poor and while at the moment it has not fallen substantially it has also been capped at around the 1.32 level versus the USD. The fundamentals certainly for the short term are very much stacked against the Euro.
The USD has recovered from its 2011 selloff as measured by its trade weighted index. This has more to do with risk averseness and less to do with positive data from the US. In times of uncertainty investors want safety and the USD being the only global reserve currency is perceived to provide this safety for the moment!
Equity markets are showing real signs of divergence with markets such as the DAX and S&P500 outperforming both the Nikkei and Eurostoxx.
The potential for a bigger move in equities this week will come on Friday with the release of the US non-farm payrolls and unemployment rate for the month of April. The early indications are not too positive with today’s release of the ADP private payrolls showing a less than expected increase of 119,000. The previous reading was 201,000 for March. While this points to a weaker non-farm payrolls number on Friday the correlation between the two data sets is not particularly strong.
The decision by the Reserve Bank of Australia to cut interest rates by 0.50% came as a surprise with most analysts expecting just 0.25% cut. This indicates that the Australian central bank is more worried about the state of the domestic economy than previously thought. This will keep the pressure on Australian equities over the short to medium term.
Overall equity markets are under pressure. The very positive sentiment of Q1 2012 is drying up. The level of uncertainty in markets is growing as the Eurozone debt crisis remains and the threat it is posing to overall global economic growth.
Commodity markets remain under pressure with the exception of oil.
Oil has performed well over the past two days based on the better than expected manufacturing data released yesterday in the US. Manufacturing appears to be bucking the trend showing resilient signs of growth in an otherwise economy of mixed data. With manufacturing performing well the demand for oil is likely to increase as the industrial sector manufactures more goods.
The overall global macro environment in the short term remains very uncertain for commodities. However, the longer the crisis monetary policies remain in place by central banks around the world the more likely inflation is to become a worry and therefore longer term commodities will likely stage a powerful recovery.
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