Market Risk-Reward Profile is Gradually Tightening
Investor sentiment has been uplifted in recent months due to policy action in Europe and some stabilization in economic activity. As a result, in a yield deficient world, a broad spectrum of financial assets has staged a sturdy performance. Yet, central bank liquidity alone is not a panacea. In order to keep risk asset volatility subdued, policy makers need to deal effectively with structural impediments across the Atlantic.
In the U.S., fiscal and entitlement policies need to be placed on a sustainable path sooner rather than later. In Europe, leaders need to deal with the ongoing economic divergences within the Eurozone. In addition, on both sides of the Atlantic, the functioning of the banking system needs to be safeguarded whilst leverage is brought down steadily. Such challenges will clearly not be resolved overnight and episodes of volatility should be expected as the western economies deal with the triple risk of fiscal, credit and energy shocks. Political risk across the Atlantic is also a factor to consider. Therefore, in the context of these ongoing challenges, one should always weigh the risk-reward in the marketplace and be agile enough to take advantage of value opportunities.
On the U.S. front, as we can see below, the most encouraging metric has been the improvement in the labor market and the consequent recovery in consumer confidence. Yet, declining wage growth seems to indicate that the quality of job growth has been compromised. In addition, the U.S. consumer still has some scope to further reduce debt and replenish the personal savings rate. Lastly, rising gasoline prices pose a risk to a further consumer confidence recovery.
With regards to monetary policy, the Federal Reserve is not likely to pose a risk to the ongoing recovery but we note that the effectiveness of elevated liquidity to the real economy seems to be subdued, as evidenced by the declining velocity of money supply. In addition, low rates and low inflation have been important underpinnings to both the U.S. equity and Treasury market. Going forward, in terms of equities and Treasury valuation, the benefits from low rates and low inflation are likely to have a less pronounced impact.
On a more positive note, the U.S. corporate sector has been the bright spot of the U.S. economy. Given the competitive advantages of U.S. multinationals, the corporate sector has staged an impressive fundamental recovery since 2009 and as a consequence corporate balance sheets have been repaired. In a normal cyclical recovery, one would expect the Federal budget deficit to recover as well whilst the corporate sector ploughs profits back in the economy. Given the output gap in the U.S. economy one can envision further growth potential, driven by demand in the technology, energy and industrials sectors.
To sustain the recent improvement in leading economic indicators, U.S. policymakers need to provide corporations with a clear and realistic plan to deal with fiscal and entitlement spending. The big opportunity for the U.S. economy lies in the energy sector, as the U.S. has been blessed with substantial energy resources i.e. unconventional natural gas and liquids (oil). As highlighted in our energy sector reports, natural gas and shale oil need to be exploited to the fullest and thus improve the country’s energy bill dramatically. Therefore, a more aggressive energy policy would be a boon to the economy and a support to elevated economic expectations.
On the European front, the ECB’s liquidity measures have alleviated cost pressures in the sovereign debt markets and inter-banking lending. A further round of liquidity is expected tomorrow (~ 500bn EUR) which will likely further support the banking system. Yet, increased liquidity comes with some collateral effects. Banks may delay deleveraging of their balance sheets and investors are now facing the sub-ordination impact that ECB loans are bringing to the debt markets i.e. ECB loans are becoming senior to e.g. unsecured lending. Thus, ECB loans may create a crowding out effect that may damage credit creation from unsecured lending. Therefore, there are limits to what liquidity can do and policymakers need to focus on resolving the core issues of competitiveness within the Eurozone.
Given the upcoming elections in Greece and France, investors need to keep in mind that political risk will probably create more volatility down the road. The attempt for very tight fiscal control in Europe is likely to be met with political resistance. Therefore, it is premature to call for the end of the sovereign debt crisis in Europe.
Over the coming months, the market is likely to focus on growth in the core European economies such as Italy. The country still has substantial levels of debt (120% GDP) and its borrowing costs (5.3% on 10 year debt) are still disproportionate to the level of GDP growth. Moreover, on the currency front, the Euro still needs to be devalued materially in order to offset fiscal austerity. Therefore, challenging debt and growth dynamics are still a risk factor for the Eurozone.
In conclusion, we recognize the positive fundamental factors that have been priced in the marketplace and we look ahead to the ensemble of risks and opportunities that the market and the economy are likely to encounter. Therefore, in light of the current tightening risk-reward profile of the market, we maintain a balanced portfolio of income generating assets and undervalued securities.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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