Market stability is contingent on global policy performance
Risk assets, such as U.S. equities, continue to climb the proverbial wall of worry. Systemic stability and gradually improving economic fundamentals have enabled an increase in risk attitudes. The challenges stemming from global economic imbalances will take time to be resolved and one has to appreciate the importance of continuous policy execution on a global scale.
In Europe, the ECB’s 1 trillion EUR refinancing operations have filled to a large extent 2011’s policy vacuum. Sovereign debt markets have bought some time in the face of challenging refinancing schedules. In addition, on the back of the Fed’s extended EUR/USD swap lines, the cost of USD funding has declined. Intra-banking funding costs (EURIBOR-OIS spread) have also declined. As the OECD has urged today, Europe needs to focus on growth initiatives and reforms that will improve competitiveness in Southern Europe e.g. via liberalizations, privatizations and labor flexibility. Policymakers also need to safeguard credit creation in the face of tight capital rules and lending standards.
As we can see below, deposit outflows from financial institutions seem to have been curtailed but banks are still hoarding cash on the ECB’s balance sheet i.e. money is not turning into credit. Loan to deposit ratios are declining in Spain and Italy, in an attempt to meet the June capital ratio target of 9%. Thus, policymakers need to balance capital requirements with challenging growth and credit dynamics in Spain and Italy. Lastly, on the currency front, the ECB has to devalue the Euro in order to offset fiscal austerity pressures across the Eurozone.
On the Asian growth front, China has to execute on its monetary accommodation plan. Manufacturing orders in China/Singapore/Taiwan indicate that an upturn in global manufacturing activity is in the cards. This rebound in activity probably comes after the easing of credit conditions in Europe; China’s largest export market. The pick-up in German business expectations seems to confirm this view and the IFO survey may be a leading indicator for a rebounding German industrial production. Therefore, pro-active global policy execution matters.
On the U.S. front, as we discussed in last week’s article, housing stability, job growth and the energy sector’s renaissance are important levers of growth. For example, our channel checks indicate that there is an ongoing expansion and labor hiring in the chemicals industry on the back of very low input costs i.e. natural gas. Manufacturing as a whole seems to be on an upward trajectory as companies seek to take advantage of very low U.S. energy costs. In addition, as emerging market labor costs increase, the new secular trend is for companies to relocate their operations in the U.S. as they seek higher-skilled labor to operate more automated manufacturing processes. Therefore, U.S. leaders are best served to make full use of shale oil and natural gas resources which can put U.S. manufacturing at a competitive advantage to global peers. Moreover, the slowdown in the Chinese economy would justify a lower oil price and the current price premium is largely attributed to declining Iranian supplies. Expanded oil drilling on Federal lands would alleviate the U.S. trade deficit and ease elevated Brent crude prices. A more aggressive energy policy and a higher GDP growth profile would help deal with fiscal challenges. Visibility on tax policies and economic growth prospects would encourage the corporate sector to reinvest its recovering profits. Therefore, in the face of the upcoming 2013 fiscal consolidation, policymakers need to clear the policy fog that is forming amidst an uncertain election outcome and congress impasse.
At the U.S. equity level, the S&P 500 has recently benefited from upward earnings revisions and from an improvement in leading economic indicators such as the ECRI weekly index. Moreover, the decline in equity correlations has rendered the equity landscape to be more conducive for stock-picking.
In conclusion, at this stage in the economic recovery, we have a preference for late-cycle exposure e.g. commercial aerospace, software - that offer more earnings and cash flow visibility i.e. through recurring or contracted revenue streams. Moreover, in an ongoing zero-rate environment, we continue to harvest yield from income generating securities (MBS, preferred shares) and from defensive equity sectors e.g. telecoms, utilities, healthcare and consumer staples.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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