A bearish backdrop but not all gloom

It’s easy to be bearish. Not much is going right and prospects for global growth continue to be revised downward. Leaving the eurozone aside for the moment, here is a short and by no means comprehensive list of worries:

  • First, the second quarter earnings season is now underway in the US and expectations are, or rather were, at low ebb. The estimates have already been revised up on the back of the few companies that have reported so far suggesting the surprises could be on the upside.
  • Second, the closer it gets, the greater it seems to become. Earlier estimates of America’s ‘fiscal cliff’ put it somewhere in the neighbourhood of 3.5 percent of GDP but recent estimates put it nearer 5 percent. Whatever the number, it is large enough to inhibit investment, employment and to create the weakness showing up in the new orders components of recent ISM and Fed regional manufacturing surveys. When CEOs, like Honeywell’s David Cote, writing in the Financial Times, are prepared to raise its profile and urge peers to speak out, there can be little doubt about its adverse influence.
  • Third, weather’s vagaries strike again. When the US Department of Agriculture came out with its estimates last week for crop yields, it not only cited the damaging impact on corn production of extreme and persistent drought and heat at an early stage of the growing cycle, but also the impact on global wheat production from the drought this May and June in the south of Russia. China has also reported lower wheat yields and so has Canada, though marginally so for the latter. The chart shows the impact on foodstuffs thus far of the rises in corn and wheat prices, but also the limited impact thus far on the more general CRB spot commodity price index. It is unlikely that the post-financial crisis boost to oil prices as well as wheat, course grains and various other commodities that spanned two years will be repeated and thus doubtful that inflation will accelerate as it did.
  • Fourth, China’s Shanghai Composite hit a new post-financial crisis low this week. In part that reflects the economy’s continuing loss of momentum, but the latter, in turn, reflects the weakness in the stock market and in the residential property market. China has just reported that home prices for a number of major cities (Beijing and Shanghai being among them) rose on the month for June, thus offering some encouragement that expansionary monetary policy may be helping to provide some stability for the residential property market and possibly for the economy.
  • Fifth, more obstruction is not what the eurozone needs. The progress eurozone leaders made on banking integration at June’s EU summit is being stonewalled by Germany’s Constitutional Court. The latest indication is that the Court will not rule until 12 September on whether the European Stability Mechanism (ESM) and the treaty underlying the fiscal compact compromise Germany’s parliamentary independence.

Equity markets see Europe as a lost cause for the global economy, but that is far from what they are discounting for the US and China. Both are losing momentum but both are expected to be supportive of the global economy and corporate earnings.

China’s Premier was emphatic in announcing last weekend: ‘… it should be clearly understood that the momentum for a stable rebound in the economy has not yet been established.’ But Wen did not to leave it there. He reiterated about government stepping up fine-tuning this year and also made the point that the authorities ‘must do everything possible’ to expand jobs.

At his testimony yesterday to the Senate Banking Committee, the Fed Chairman painted a disturbing picture for the economy noting the loss of momentum from a good start to the year, the higher degree of uncertainty now surrounding the Fed’s economic forecasts and two major sources of risk to the outlook for growth – the eurozone sovereign debt crisis and the fiscal cliff.

But in delivering his prepared comments, the Chairman also made it clear the Fed is prepared to take ‘further action as appropriate to promote a stronger recovery …’. Mr Bernanke effectively stuck to the message contained in the FOMC’s last set of minutes and while he did not repeat what was recorded, those Minutes were far more explicit: ‘If the economic recovery were to lose momentum, if the downside risks to the forecast (the Fed’s economic projections) became sufficiently pronounced, or if inflation seemed likely to run persistently below the Committee’s longer-run objective’, the Fed would take further action ‘to promote a stronger economic recovery and sustained improvement in labour market conditions …’.

Given the prevailing uncertainties it is hard to imagine that the US economy can regain momentum ahead of the election. This points to QE3 being a likely prospect when the FOMC meets in September. Furthermore, the reference in the last set of FOMC Minutes to the issue of liquidity arising from Operation Twist suggests that mortgage-backed securities are likely to be the focus of any more stimulus.

Finally, while eurozone may be a lost cause for the global economy, the equity markets look appealing on several counts. In the first instance they offer a significant yield premium to other major equity markets. Despite the economic difficulties, expectations for earnings growth match those for the S&P 500 and exceed that for the FTSE 100. That is not just because of Germany.

Second, the weakening euro is the eurozone’s best ‘growth pact’ going. This is especially in view of the commitment by the US and China to sustain their expansions. As for the ruling by the Constitutional Court, Germany’s Finance Minister, who is pretty hard-nosed himself, thinks the ruling will be favourable in spite of his warning about market turbulence and confidence.

Third, one of Germany’s five ‘Wise Men’, Peter Bofinger, was quoted by Reuters as saying that current yields on Italian government debt are not justified by Italy’s progress towards debt sustainability. Not only did he think that Italy’s position as it relates to the structural surpluses forecast by the OECD, was more favourable than that of Germany’s but, in referring to budget deficits as proportion of GDP, he also saw no reason ‘… why Italy should pay yields of 6 to 6.5 percent with an (expected) 1.7 percent deficit (for this year)’, while the UK, with an expected deficit to GDP ratio of 4 times as much can refinance its debt at much less much.

Coming from a member of Germany’s conservative policy establishment, this is a big statement, even if Italy’s budget deficit has recently widened somewhat and the autonomous region of Sicily looks as if it might default. It’s a bit like saying the markets have got their pricing wrong, at least when it comes to the peripheral bond markets. Needless to say, the view is far from German mainstream thinking. Even so, the Wise Man has a point. Not only that, if investors have got it wrong on a peripheral bond market, the obverse is that they may have it wrong on quality bond markets and, importantly, equity markets too.

With big internationals everywhere, investors buy into global growth. But with Europe investors can buy better yields and pay less for prospective earnings than for other major equity markets, all priced a more internationally competitive exchange rate. Europe is a tough sell no matter how one dresses it up, but against a bearish backdrop where equity markets are holding up reasonably well, eurozone equities are a strategically appealing proposition.

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