Latest Market Watch from Redmayne Bentley

On Tuesday evening the FTSE 100 Index closed below 5000 for the first time since September, as investors grew increasingly concerned about growth prospects in Europe and the effect that this could have on global growth. The fear is that it will derail an increasingly confident recovery in the United States.  Contrary to its stated goals, investors are concerned that Europe has not produced an economic zone of shared prosperity and that, increasingly, certain countries are becoming dominant and the weaker ones increasingly dominated.  Added to this, while European citizens may not be particularly antagonistic towards each other, nations are becoming increasingly so, as austerity measures are enacted and governments look to protect jobs.

 

During the week Italy announced an austerity package, worth some €21 billion, or around 1.6 per cent of GDP for 2011-12 and the Danish government announced plans to curb spending.  The Italian measures include a three year freeze for civil servants and a crackdown on tax evasion.  Whilst Italy has kept its budget deficit down to 5.3 per cent of GDP, well below the EU average, the austerity drive aims to slash it to 2.7 per cent by 2012 as the government increasingly worries that it may find the ability to fund more difficult and the cost of doing so will inevitably rise due to difficulties elsewhere.  Italy plans to reduce its shortfall to within the EU ceiling a year before Spain and Portugal, and two years before Greece. Its budget shortfall was 5.3 % of GDP last year; this was less than half of Greece's, Ireland and Spain, the region’s three highest deficits although it has the region’s biggest debt at 115.8 % of GDP. The Italian measures, worth 1.6 % of gross domestic product, aim to bring the deficit within the EU limit of 3 % of GDP in 2012. In France, President Sarkozy has also run into trouble as French unions hit back over his plans to change the right to retire at 60.  The French government has insisted that the French will have to work longer to receive a full pension and President Sarkozy, who made pension reform one of his central electoral themes two years ago, highlights the fact that France has a lower retirement age than almost all of its European neighbours, whilst facing the same pressures of an ageing population and a ballooning budget deficit.  Over the week end François Baroin, the French Budget Minister, told local French television stations that holding on to the country’s AAA rating would be a “stretch”, although other government members have played down his comments.

 

The Spanish government came very close in the week in being unable to get approval for its €15 billion austerity programme being passed into law.  The bill was approved by 169 votes in favour to 168 against, after the opposition popular party voted against the move.  More alarming for the government was the fact that it was only saved by ten centre-right Catalon nationalists abstaining from the vote, after having criticised the bill.  If the austerity vote had not been passed, I believe it would have caused havoc in the market, plunging Spain into a Greek style crisis.  The closeness of the vote has lead a number of political commentators to question whether or not the present Spanish Prime Minister can continue and he may be one of the first Prime Ministers to loose his position following the European debt difficulties. During the week the International Monetary Fund raised concerns about Spain’s economy, saying far reaching reforms are needed to ensure its recovery.  It said that the country faces severe challenges, including the need to urgently reform a dysfunctional labour market and its banking sector.  The IMF comments came after Spanish authorities had rescued a regional lender at the weekend. One of Spain’s biggest banks over the weekend announced that it was negotiating a possible merger with five smaller rivals as part of the government’s effort to restore confidence in the troubled economy. Madrid, the country’s second-largest savings bank is hoping to beat the June 30 deadline to utilize a €99 billion (£84 billion) government bank rescue fund. The Spanish government wants the 45 regional caja banks to shrink to 15. Spain was hit by a credit downgrade on Friday, sending the euro lower. The currency faces further pressure from Greece, which is studying plans to restructure its debt despite a multi-billion-euro bailout from Germany, France and the IMF. The Spanish central bank at the end of the week told the country's lenders to own up to bad debts and set aside reserves of up to 30% on property holdings in a bid to restore global confidence in the Spanish financial system after the recent lack of confidence in it. Spanish lenders need to refinance 125 billion Euros ($153 billion) of bonds by the end of next year and the cajas have to repay about half the 46 billion Euros falling due for banks this year and the 79 billion Euros maturing 2011, according to analysts. The new rules target the savings banks or cajas that account for the majority of the €445bn (£377bn) of property debt collected during the credit boom. Currently even the strongest banks Santander and BBVA are paying a large premium to borrow, with reports that BBVA has been unable to roll over €1bn in commercial paper. It is believed that new rules will force lenders to write down bad debts within a year instead of six years as is currently allowed under Spain’s accounting rules. Adding to Spain’s issues private debt is 211% of GDP; in Britain it is also high at 213%. Fitch Ratings cut Spain's credit rating on Friday saying the government's efforts to reduce debt will hit economic growth in the months ahead. After the events earlier in the week this was another blow to Prime Minister Jose Luis Rodriguez Zapatero's efforts to underpin confidence in the state finances. The ratings agency cut the country's rating one notch from AAA to AA plus, saying Zapatero's efforts to close the budget deficit "will materially reduce the rate of growth of the Spanish economy over the medium term".  Standard & Poor lowered Spain's credit rating for the second time to AA last month but Moody’s, the other major ratings agency, has maintained the rating at AAA. The latest move by Fitch calls into question whether the EU's strategy of forcing countries into austerity measures to create stability and appease markets has backfired. Fitch said the inflexibility of the labour market, as well as the restructuring of Spain's savings banks, would hinder the rebalancing of the country's economy. It said Spain's government debt is likely to reach 78% of gross domestic product by 2013, compared with less than 40% of GDP prior to the financial crisis. Spain's problem is not so much the annual budget deficit but that it has been so reckless in the past about the structure of its cumulative national debt. Just like Lehman Brothers and Royal Bank of Scotland, it has borrowed short term, in the belief that as a member of the euro zone there would always be buyers for its euro-denominated bonds. Spain has to refinance half its national debt every three years. As every debtor knows when confidence is high it is easy to refinance but confidence can evaporate very quickly and when it does it is then impossible. To maintain debt solvency Spain must squeeze public spending, but this policy reduces the potential of recovery and this causes a further loss of confidence and this is the downward spiral which is looking increasingly likely or a number of European nations.

 

Even though Germany is regarded as the best creditor nation within the single currency zone, it came very close to a bond auction failure in the week, when the issue of a new five year bond attracted bids, worth just 1.1 times the amount on offer, compared with a more normal 1.5 times.  Worryingly, the success was only achieved after the German Central Bank reduced the amount of issuance by 22 per cent.  However, a number of commentators have suggested that it is not the credit worthiness of the German government that was the issue, but the fact that the average yield on the bond was 1.47 per cent, compared with similar offerings only a month ago, when the yield was 2.2 per cent.  Fears that European banks will be crippled by their sovereign debt exposure are increasing their borrowing costs and whilst the situation is not critical yet and Central Banks will act to prevent a repeat of the post Lehman crisis, increasing lending rates could derail a very fragile economic recovery.  Regulators have learned their lessons from the 2008, which saw a closure of whole sale funding markets.  So far the European Central Bank has pumped hundreds of billions of extra euro denominated funding into the banking system and revived with the US an emergency dollar funding line.  It is encouraging, therefore, that this has not been drawn on, suggesting that the situation may not be as critical as some are suggesting.  There is little room for complacency and concerns over euro zone governments’ finances will continue, and I believe are likely to continue to spread.  Banks globally need to refinance around $7 trillion worth of debt by the end of 2012 and a rising in funding costs could cause problems, with a number of thinly capitalised European banks likely to need more capital.  Ultimately, investors know, and fear, that many European banks have either not recapitalise or confess to their difficulties.  This uncertainty will continue to undermine the situation and push up lending costs.  This can be seen through ever rising LIBOR rates. European borrowers have become addicted to some of the easiest monetary conditions in history and these will not continue forever and I believe higher bank lending rates are likely to push the euro zone into a double-dip recession.  The rate that banks pay for three-month loans in dollars fell on Friday for the first time in 13 days. The London interbank offered rate, or Libor, fell to 0.536 % from 0.538 % on Thursday. Concerns over the financial stability of Dubai re-emerged last week when its government-owned investment arm requested a three-month extension on its debt repayments. Dubai International Capital, which has total debts of $2.5 billion (£1.7 billion) has a $1.25 billion loan due for repayment in June and says that it has reached agreement with a committee of six leading banks to delay repayment of the loan until September 30. DIC said it would use the delay to put forward a proposal extending the maturity of other loans to allow its struggling portfolio to regain some of its value. The announcement comes after Dubai World, the state-owned conglomerate at the centre of the emirate’s recent debt crisis, reached agreement with its main banks to restructure $23.5 billion of debts over eight years. Dubai World plunged international markets into turmoil in November, when it admitted it was unable to repay its debts. Last year, its oil rich neighbour Abu Dhabi helped Dubai with a $20 billion bailout loan.

 

The Centre for Economics and Business Research an economics consultancy that is advising the Athens government, said over the weekend that Greece would be unable to escape its debt trap unless it devalued its currency to boost exports. Greek politicians have played down the prospect of abandoning the euro, which investors fear would be the start of the break-up of the single currency. Bill Gross, speaking in the week, said restrictive lending rates and austerity measures, particularly in Greece, leave it with “no way out” of debt restructuring.  “The growth required in order to shoulder Greece’s debt burden is so excessive and the fiscal restrictiveness being imposed on the country is so restrictive, they will have no way out” he said in an interview on Bloomberg.  “Restructuring at some point down the line, perhaps a year or two down the road, will take place”.  His views are the same as mine and this means a debt default, which will not go down well with markets or investors. Mundell won the Nobel in economics in 1999, the year the euro was introduced, for his work on exchange rates and capital mobility and is credited with playing a significant role creation of the shared currency said reworking debt may be “inevitable” for one or two countries that share Europe’s common currency in the next five years. The euro's fall is hitting economies around the world with the single currency down 25% against the dollar since last October making life more difficult for US exporters to Europe. The pound has fallen 12% against the dollar during the past six months, but it has appreciated 11% against the euro. Because  Britain does over three times more trade with the euro zone than it does with the States,  the euro's decline has hit the UK's trade-weighted competitiveness, undermining  hopes of an export led rebalancing/growth in the economy.

 

Whilst the Office of National Statistics in the week raised its estimate for Gross Domestic Product in the first quarter from 0.4 per cent to 0.3 per cent, this was lower than the market had expected.  Most analysts had pencilled in 0.4 per cent.  The more rapid growth came as industrial production recovered faster than it first thought, growing by 1.2 per cent.  The service sector experienced slower growth, with output rising 0.2 per cent compared with a 0.5 per cent rise in the previous quarter.  Poor weather and rising prices saw UK retail sales fall in the early part of May, adding concerns that consumers are refraining from spending, as they are increasing nervous about potential house price declines, tax rises and pay squeezes.  In its monthly survey the CBI said retail sales slid in May, with the report’s headline figure showing the lowest reading in more than a year.  Mortgage lending rose at its lowest rate for nine years during April, as the housing market remains under pressure.  Net lending, which strips out redemptions and repayments, was just £1.83 billion during April, the lowest level since April 2001, according to the British Bankers Association.  Mortgage approvals remained low during April at 35,729, up marginally on the previous months figure, but well down on the 45,822 seen in December.  The figure was down from £2.3 billion in March and the average for the six months prior to April of £2.7 billion.  The number of mortgage approvals for house purchases was also down on the previous six month average of 39,309.  Net consumer credit lending shrunk by £0.3 billion in April and this was driven by loans and overdraughts, where repayments outstripped new lending by £507 million, with the money advanced for new loans in April 18 per cent lower than in the same month a year ago, although credit card lending rose slightly.  Bank lending to British companies fell again in April but at a slightly slower rate than over the past six months.  The British Bankers Association said that lending to non-financial companies, regarded as the backbone of the economy, fell in April by £1.1 billion, a slower rate than the £1.6 billion average decline seen in the past six months. 

 

The Bank of England should raise its key interest rate to 3.5 per cent by the end of 2011, with monetary tightening and a scaling back in quantitative easing starting in the second half of 2010, according to a paper issued in the week by the OECD.  In its Economic Outlook Report it said that loose monetary policy was appropriate to support economic activity, but the Central Bank should start normalising policy soon to respond to a likely gradual rise in underlying inflation and help preserve credibility.  It acknowledged that the recent increase in VAT had added to the recent upturn in inflation and more rapid spending cuts in the UK would “create room for a more gradual normalisation of monetary policy”.  The report marks a change in the OECD’s view on the UK.  In its November Report the body said that the Bank of England should not begin contracting monetary policy until 2011 and that it should consider extending quantitative easing to promote further economic recovery.  It now believes that the Bank of England should undertake no further quantitative easing.  The Think Tank also recommends that the US Federal Reserve, Bank of Canada and the European Central Bank should start to a tighten policy this year, but in the latter case it said by no more than a 1 per cent from the current 1 per cent would be warranted by the end of 2011.  It believes that UK inflation will average 3 per cent this year before dropping back to 1.5 per cent in 2011 and UK interest rates should be lifted from their emergency level of 0.5 per cent in the second half of the year. 

 

During the week, Chancellor George Osborne and his Liberal Democrat Deputy, David Laws, presented the first wave of cuts, paving the way for still more severe reductions in the autumn and it is understood that officials are drawing up plans to cut as much as 25 per cent from some government departments.  Under the £6 billion in spending reductions announced, ministerial and civil service perks will face an immediate crackdown and the government is implementing a recruitment freeze across the civil servants service immediately and posts will be left unfilled.  Vince Cable’s Business Department has been hit the hardest and will be looking to save £900 million.  The extent of job losses from the eventual austerity measures are highly debatable, although a consensus seems to be growing around the 300,000 level.  As a rule of thumb, the Conservatives have said that they plan to achieve fiscal consolidation with four fifths through spending cuts and one fifth through tax rises.  In practice, the element taken up by spending cuts is unlikely to be as high as this but, even so, we are probably looking at £60 billion worth of cuts and therefore the announcement made in the week is just a small element of the possible pain to come. To ease the decrease in public spending going further and reflecting the increasing demographics of the population, the government intends to speed up the raising of the State pension age from 65 to 68 as part of its first reforms.  The State pension age is already scheduled to rise to 68 in stages between 2024 and 2046.  They also intend to restore a link between the basic State pension and the rise in average earnings from 2011.  In total Britain is cutting about £18bn this year after the government agreed to push through £6bn of cuts on top of £12bn already instituted by the previous Labour administration. On a positive note the British Chambers of Commerce in a forecast released over the weekend predicted borrowing of £147 billion this year, falling to £116 billion in 2011-2, compared with Treasury forecasts of £163 billion and £131 billion. It also cut its growth outlook for next year to take account of likely spending cuts, the need of households to cut debts and stubbornly high unemployment. Its latest economic outlook increased the 2010 GDP forecast to 1.3% from 1% but cut the 2011 forecast to 2.0% from 2.1%.The forecast also assumes that VAT will be raised to 20% within the next18 months and it believes that Unemployment will increase in the next 12 months but at a much slower pace. The new forecast envisages that unemployment will rise from 2.51 million to a peak of 2.65 million (8.4% of the workforce) in the first quarter of 2011. Monetary Policy Committee member, Adam Posen, has warned that the UK could be braced for Japanese like bout of deflation, which the UK is less equipped to deal with.  In a speech at the London School of Economics in the week, Posen said that the UK has less room for fiscal manoeuvrability than Japan had. Whilst his comments may come as a surprise, particularly following recent inflationary numbers, I believe his prognosis is very real and is one of the reasons why inflation will be encouraged into the system. U.K. consumer confidence unexpectedly dropped to a five-month low in May as Britons worried about  the prospect of government spending cuts and became more pessimistic about the economic outlook, GfK NOP said. There index fell to minus 18 from minus 16 in April, it had been forecast that the gauge would be unchanged.

 

The US economy grew at an annualised rate of 3 per cent in the first quarter, slightly slower than previously estimated, as consumer and business spending made smaller contributions to output compared to an earlier estimates. The downward revision disappointed economists who were expecting the commerce department to increase its estimate of first-quarter growth from 3.2 per cent to 3.4 per cent. Although the revision was relatively small, it shows the US economy was heading into this month’s market turmoil and concern over the European sovereign debt crisis in a weaker position than had previously been thought.  Sales of U.S. previously owned homes rose in April to the highest level in five months as buyers took advantage of the last weeks of a government tax credit. Purchases increased 7.6 % to an annual 5.77 million rate, figures from the National Association of Realtors showed. They were forecast to rise to 5.62 million. Sales were the highest since November; the month the incentive was first due to expire.  Demand is expected to hold up next month as buyers who close on a deal by June 30 will still be eligible for the credit worth up to $8,000. Even after the better numbers there are still more than four million unsold houses in the States, 3% more than a year ago, and equal to almost 8.5 months' supply at current sale rates. Home prices in 20 U.S. cities rose less than forecast in March from a year earlier, a sign the housing recovery is cooling. The S&P/Case-Shiller home-price index of property values in 20 cities increased 2.3 % from March 2009, when analysts had expected 2.5 %. Adjusted for seasonal variations, the 20-city index was unchanged in March from February. Unadjusted, the gauge dropped 0.5 % from February, the sixth consecutive decrease. The unadjusted data showed 13 of the 20 cities in the S&P/Case-Shiller index decreased over the prior month, led by a 4.1 % drop in Detroit. Confidence among U.S. consumers increased in May to the highest level since March 2008 as Americans became more upbeat about job prospects, another report showed. The Conference Board’s confidence index rose to 63.3, exceeding expectations. In April it was 57.7 in April.

 

Japan’s Social Democratic Party left the government after Prime Minister Yukio Hatoyama dismissed its only Cabinet minister, weakening the ruling coalition less than two months before parliamentary elections. This is as Japan’s unemployment rate unexpectedly grew in April as household spending fell and deflation deepened, signalling domestic demand is holding back recovery. Exports fuelled Japan’s 4.9 % annualised expansion in the three months ended March. Exports in April jumped 40.4% from a year earlier to 5.9 trillion yen ($65bn; $45bn), marking the fifth straight monthly year-on-year increase but the jobless rate rose to 5.1 % from 5 % when no change was expected. Consumer prices in Japan were down by 1.2 per cent in April from a year earlier but there is evidence that the underlying pressure of deflation is continuing to weaken. The fall in prices was faster than the 1.1 per cent recorded in March but that was due to the Democratic Party of Japan administration’s abolition of high-school tuition fees. That caused the education component of the consumer price index to plunge by 13.2 per cent from the previous month. The figures suggest that Japan is still on course to escape deflation but it will not happen quickly. The Bank of Japan’s policy board forecasts that inflation will turn slightly positive in the year to March 2012. On Monday China’s cabinet said it had approved a plan from the state planning agency to “gradually push forward reform” of the country’s property tax regime. it  has been  interpreted  that Beijing may clamp down further on the country’s booming real estate market, possibly by introducing an annual tax based on the value of housing. higher down-payments and mortgage rates, has already contributed to a steep drop in housing sales volumes but this app eras  not to have been enough  as prices have continued to move ahead.

 

 Oil for July delivery, the most active contract closed at $73.97 a barrel on Friday. The price declined 14% in May, the worst monthly decline since December 2008, with May's decline breaking three straight months of gains. During the week oil was up 5.6% as the US National Oceanic and Atmospheric Administration predicted 14 to 23 named storms this season, suggesting it could be the most active season since 2005, when Katrina hit. Gold prices were on the rise during the week, recapturing and steadying above the US$1,200/oz mark as safe haven demand remained strong. It finished at US$1,215/oz. 

 

On Friday US Employment are forecast to have grown in May for a fifth consecutive month. Payrolls are expected to have climbed by 508,000 workers, the biggest increase since 1997 and the gain reflects government hiring of temporary for the census and a small rise in private. The Census Bureau had said it would take on 970,000 temporary workers from April through to June. The report will probably show that the unemployment rate fell to 9.8 % last month, from 9.9 %. It reached a 26-year high of 10 %. US purchasing managers’ indices for May from the Institute for Supply Management are also published this week, the manufacturing survey on Tuesday and the service sector report on Thursday. The manufacturing index is expected to fall slightly from April’s reading of 60.4, still indicating strong expansion. The services index has shown increased momentum since the turn of the year and is likely to have continued in May, with a reading of 56.0 forecast, from 55.4 in April

 

In the UK, the focus will be on the housing market. April data on mortgage approvals are published on Wednesday. A rise is expected this month, to 49,500 from 48,900 in March, about half the average level seen over the past decade. The Halifax measure of house prices for May will be published during the week, with the rate of growth in prices likely to accelerate sharply from April’s 6.6 per cent The May purchasing managers’ indices for the UK are also out: manufacturing on Tuesday and services on Thursday are expected to come in close to April’s values of 58 and 55.3 respectively.

 

The Dow ended down 7.9% for May, its biggest monthly drop since February 2009, when it was still on its way to the lows of the last bear market. The measure also snapped a three-month winning streak and set its worst %age performance for May since 1962. The NASDAQ lost 8.3%, its worst month since November 2008, when it dropped 10.8%, and its worst May since 2000, when it fell by 11.9%. The S&P 500 declined 8.2%, its worst month since February 2009, when it fell by 11%, and its worst May since 1962, when it declined by 8.6%. The FTSE 100 tumbled 6.6% in May, its biggest monthly fall since February last year. France’s CAC-40 tumbled 7.9% during the month, Spain’s Ibex dropped 10.2%, and Germany's DAX slid 3.1%. 

 

A report in the week that the largest creditor nation on the planet, China, was looking to possibly reduce its exposure to European bonds, unsettled markets and whilst this was denied towards the end, it did not help confidence.  Whether or not the Chinese met bankers to specifically talk about their euro zone concerns is unclear but the Chinese are always meeting with bankers and talking about their investments. What we do know for  certain is that the chief of China’s CIC sovereign wealth fund made it clear on Thursday that the fund remained “very concerned” about euro zone instability in the markets. Not purchasing further tranches of debt would be only slightly less problematic for the Euro zone, than China deciding to sell down existing debt, as both have very severe repercussions. Ultimately European nations are still growing deficits even after the austerity plans and they continue to rely on foreign capital and overly optimistic growth forecasts to fund existing debt which is being rolled over at increasingly shorter durations and their participation in freshly sought capital.  These borrowing nations are increasingly competing amongst themselves for scarcer capital, where the lenders are becoming increasingly concerned about borrowers’ ability to repay. The very real threat of a number having to restructure existing debt would ultimately leave lenders with significant losses. What overly indebted governments know is that they can't fiscally stimulate anymore as borrowing requirements need to be reduced and they can't cut rates as they stand at virtually Zero and this means we should expect more quantitative easing. What the debt crisis is telling us is growth over the last couple of decades has been artificially elevated by excess debt and we now have to start paying that excess debt back by having a couple of decades of subdued growth. Western economic policy has been driven by the belief of policymakers that inflation-targeting was responsible for the last few decades of good growth and low inflation when the downward movement on inflation was caused principally by the impact of cheap labour on the prices of imported goods. Indebtedness masqueraded as wealth also compounded the policy. The UK inflation target will be changed in the next few years if we avoid the deflationary downward spiral as more quantitative easing kicks in. The choices are stagnation, debt deflation or inflation. The least bad option, as the IMF's chief economist, Olivier Blanchard, has recently argued, is a modest and targeted increase in inflation. He suggests an inflation target of 4% I think we will be looking at a higher figure, possibly double.

 

Morgan Stanley on Friday increased its year-end target for the FTSE 100 to 5,800 from 5,000 although it also noted that it could revisit its March 2008 low of 3,600 if the sovereign debt crisis plays out along 2008 lines. The volatility in markets over the past week shows just how nervous investors remain and whilst some have used the opportunity of the FTSE 100 falling below 5000 as an opportunity to pick up value, I believe that fear continues to be the overriding theme and, as long as it stalks the markets, we are going to continue to trend downwards.  Whilst I believe there is value returning to the market, I suspect that over the summer months this value will become better and I am in no rush to invest cash en mass, and would look to pick up individual situations as they arise.