Central Bank Watch – October 2014

Principal Global Investors has released its monthly Central Bank Watch for October 2014.

The report outlines key concerns of the Reserve Bank of Australia which includes the slowing momentum in the Chinese economy, the strength of the Australian dollar and commodity prices.

The report includes graphs and analysis of current monetary policy in the US, England, Europe, Japan and Canada.

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Net inflows for Europe.

ETFs and ETPs listed in Europe received net inflows of US$5.4 billion in January 2014, according to findings from ETFGI’s January 2014 Global ETF and ETP industry insights report.

The pattern for net flows in January was very different for ETFs and ETPs listed in the United States which suffered net outflows of US$15.5 billion with Equity ETFs/ETPs having the largest net outflows of US$15.9 Bn, followed by commodity ETF/ETP net outflows of US$1.2 Bn, while fixed income ETFs/ETPs gathered net inflows with US$566 Mn.

European listed ETFs and ETPs net inflows of US$5.4 billion in January were composed of Equity ETFs/ETPs gathering net inflows of US$4.0 Bn, followed by fixed income ETFs/ETPs with net inflows of US$2.1 Bn, while commodity ETFs/ETPs experienced net outflows of US$705 Mn.

“The buying patterns of European based investors indicates that they are more confident about developed markets including the US than investors based in the US in January 2014.” according to Deborah Fuhr, Managing Partner at ETFGI.

Equity ETFs/ETPs experienced the largest net outflows with US$11.8 billion, followed by commodity ETFs/ETPs with US$1.9 billion, while fixed income ETFs/ETPs gathered the largest net inflows with US$2.9 billion.

Providers in Europe

In January, UBS gathered the largest net ETF/ETP inflows US$1.8 Bn, followed by iShares with US$1.3 Bn and Lyxor with US$1.2 Bn net inflows while ZKB experienced the largest net ETF/ETP outflows in January with US$223 Mn, followed by Deka with US$179 Mn.

Index providers in Europe

STOXX has the largest amount of ETF assets tracking its benchmarks with US$105 Bn, reflecting 25.6% market share; MSCI is second with US$92.7 Bn and 22.6% market share, followed by S&P Dow Jones with US$43.4 Bn and 10.6% market share.

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• The past week saw global shares continue their upward drift helped by mostly good economic data, good news regarding Iran and more favourable developments in Europe.
• The nuclear deal with Iran is a big positive as it substantially reduces the threat of a disruption to the 17 million oil barrels a day that flows through the Straits of Hormuz and hopefully will lead to Iran’s 1.5 million barrels of oil per day coming back on line. So potentially less upwards pressure on oil prices and this is good for global growth.
• There was also good news in Europe with: Merkel and the Social Democrat Party agreeing a coalition which (if ratified by SDP members) will see a minimum wage introduced which will help boost German consumption; the Greek budget deficit falling faster than targeted and on track for a primary surplus this year; and Berlusconi being expelled from the Italian parliament but with little consequence as the Government retained support.
• Chinese 10 year bond yields slipped over the last week, but are still up 100 basis points over the last six months adding to fears China is undergoing another growth threatening monetary tightening. I am not so worried though as: the back-up this year in Chinese bond yields just looks like a catch up to similar increases in global bond yields; it has resulted in a steeper yield curve (long rates rising relative to short rates) which is actually positive for growth; and not much corporate borrowing occurs in the bond market anyway (with corporate bonds only making up 15% of the total bonds outstanding in China) as corporates rely more on bank lending.
• In Australia, despite comments by RBA Deputy Governor Lowe indicating that the threshold for intervening to push the $A down was “fairly high”, the threat that it may occur has continued to weigh on the $A, which is just what the RBA wants to see. And it is worth noting that the RBA may be selling more $A/buying more foreign exchange in the months ahead simply to allocate the $8.8bn capital boost it received last month. Meanwhile Lowe re-emphasised the point that with the terms of trade boost to national income largely behind us, Australia will need to focus on boosting productivity in the years ahead if it wants to continue to see decent growth in living standards. This is not a new message but he is right. To this end proposed tax changes that will cost nothing but encourage state governments to privatise assets are a move in the right direction.
• Meanwhile, the Government’s decision to block the GrainCorp bid and possible plans to buy a stake in Qantas in preference to allowing foreign control will no doubt lead some to fear that Australia is less open to foreign investment and may be returning to a past of greater government involvement in the economy. The initial dip in the Australian share market and the $A in response to the GrainCorp announcement suggests this is the fear. But while one can debate the merits of such decisions, both should be seen as isolated cases reflecting particular circumstances and do not set a precedent. Just as the Woodside decision a decade ago did not signal a precedent. This is particularly so given the proposed tax agreement with the states to encourage the privatisation of more assets, which points to less government involvement in the economy, not more.

Major global economic events and implications

• US economic data was mostly okay. On the negative side pending home sales and durable goods orders both fell in October, but may have been affected by the shutdown. Against this though permits to build new homes rose strongly in September and October, house prices continue to rise, timely consumer confidence measures rose, the leading index rose, initial unemployment claims fell and a new Markit services sector PMI rose strongly. Overall this is consistent with a slight pick-up in the pace of US economic growth this quarter.
• Eurozone economic confidence measures rose for the seventh month in a row, but money supply and lending growth slowed further reminding that growth will remain weak and that further ECB help is likely required, a message the ECB seems with ECB officials alluding to the possibility of further monetary easing.
• Japan saw more good economic data with solid gains in industrial production, the manufacturing conditions PMI, the job to applicant ratio and household spending and core inflation rising further to 0.3% year on year, adding to confidence that Abenomics is working and deflationary pressures are fading.

Australian economic events and implications

• Australian business investment data for the September quarter provided good news. Construction investment rose solidly in the quarter pointing to a favourable contribution to September quarter GDP growth, but more importantly there are signs of life in the outlook for non-mining investment. To be sure the current financial year is likely to be pretty flat for business investment, but the last three months has seen the projected outlook rise from a 1% fall to a 1% gain. And the turn up is coming from non-mining investment, with investment in what the ABS calls “other selected industries” projected to grow 3%, compared to a projected 3% decline just three months ago. This adds to signs already evident from housing indicators and consumer and business confidence that interest rate cuts are getting traction and that the economic outlook is brightening.
• In other data, new home sales fell in October, but this followed a strong gain and with the HIA reporting another rise in housing affordability and housing finance commitments continuing to rise, the trend in new home sales is likely to remain up. Private credit growth remained weak in October, up just 3.5% year on year.

Major market moves

• Most global share markets pushed higher over the last week helped by good economic data, good news regarding Iran and favourable developments in Europe. Australian shares remained in correction mode though
• Commodity prices were little changed to down, with the oil price falling to a six month low.
• The threat of intervention continued to hang over the $A, helped along with fears of less foreign investment in Australia after the GrainCorp decision.

What to watch over the next week?

• In the US, the main focus will be on the payroll data due Friday as it will likely be important in determining whether the Fed will start to taper at its December meeting. The consensus is for a 185,000 gain which may not be strong enough to be decisive but if its 200,000 or above expect the probability of a December taper to rise significantly. Unemployment is expected to fall back to 7.2% after the distortion caused by the shutdown in October. Meanwhile, expect the manufacturing ISM (Monday) and the services ISM (Wednesday) to remain around levels consistent with reasonable growth, new home sales (Wednesday) to remain solid and September quarter GDP growth (Thursday) to have been revised up to 3.1%.
• After cutting its official interest rate last month the ECB may well do nothing at its Thursday meeting. But there is some chance it will go further and cut the deposit rate it pays on reserves to -0.1% in order to further encourage banks to lend. Inflation is running well below target in and this is likely to be concerning the ECB.
• China’s official PMI (Monday) is likely to fall slightly but remain at levels consistent with 7.5% or so GDP growth.
• In Australia, the RBA is expected to leave interest rates on hold at 2.5% when it meets Tuesday. Yes it retains an easing bias but it is only a mild one and in any case since the last meeting there has been more evidence the economy is responding to interest rate cuts and the Australian dollar has fallen in value, in part due to jawboning by RBA officials. So with things going in the right direction there is little reason for the RBA to cut rates again in the week ahead. We remain of the view that while the risk is on the downside for interest rates, they have most likely bottomed and will likely remain on hold out ahead of eventual rate hikes late next year.
• It will be a busy week on the data front in Australia. Expect a 2% fall in building approvals (Monday) after a 14% gain the previous month but retail sales (Tuesday) to continue the modest recovery evident in recent months. September quarter GDP growth (Wednesday) is expected to be around 0.7% quarter on quarter or 2.6% year on year helped along by modest growth in business investment and consumer spending and a small contribution from net exports. The AIG’s PMIs along with data for house prices will also be released Monday.

Outlook for markets

• Shares are at risk of a consolidation or mild correction phase after very strong gains from early October lows which have left them vulnerable. This appears to have already commenced in Australia with a rash of capital raisings not helping. However, this is likely to be just a pause ahead of the resumption of the rising trend as valuations are reasonable, monetary conditions are set to remain very easy, profits will improve next year as global & Australian growth picks up and there is still a lot of money sitting in cash and bond funds. The Australian share market remains on track to hit 5500 by year end, with a little help from a Santa rally. Note that the first half of December is often flattish for shares with the Santa rally usually starting around Christmas.
• Government bond yields are likely in a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering eventually occurs. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead. However, dovish forward guidance from central banks is likely to help ensure the rising trend in yields remains gradual.
• Expect the $A to be buffeted in the short term between signs Australian rates have bottomed but talk of Fed tapering and RBA jawboning. The medium term trend in the $A is likely to remain down to $US0.80.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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The key points are as follows:

• An inconclusive election in Italy, which has put a cloud over whether it will continue with economic reforms, has seen the return of worries regarding the Euro-zone.
• Uncertainty is likely to linger for several weeks, but as we have seen in recent times in Europe there is a danger of overreacting as blow ups have tended to settle down without the feared collapse of the Euro.
• Our assessment is that while the correction in share markets may have a bit further to go, not helped by Italy, the broad rising trend in markets will likely continue.

To read this edition of Oliver’s Insights, please click here.

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This latest move is unlikely to be the magic bullet markets are looking for to resolve the crisis, however, it should help contain peripheral yields at the shorter end of the curve.

Key features

• Bond purchases will be conditional: the ECB will only buy the sovereign bonds of countries that have entered an agreement with the euro area rescue vehicles (EFSF and ESM). The aim is to keep the interest rates of Spain and Italy from spiralling.
• No yield targets will be set: the ECB have stopped short of setting yield targets, apparently due to the difficult issue of deciding where fair value lies, and will intervene at their discretion.
• The ECB’s holdings will not have seniority over private creditors.
• Unlimited purchases will be contained to maturities from one to three years: A large part of this debt is already being used as collateral under various liquidity operations, so the ECB are effectively promising to purchase an unlimited amount of a limited stock of outstanding debt.
• The OMT program is intended to repair distortions in government bond markets caused by what ECB President Mario Draghi described as ‘unfounded fears over the reversibility of the euro’.

Potential issues

• If a member state fails to comply with the conditions for aid agreed with the rescue funds, the ECB can stop making purchases or may even sell the bonds they have already bought.
• The key risk remains that a country enjoying the benefits of the regime could subsequently renege on its commitments, triggering potential market panic.
• The Bundesbank has remained openly opposed to the plan, refusing to move away from its established doctrine that central banks should focus solely on price stability.
• Focus could quickly shift to Spain’s reaction to the plan and its ability to set the terms of a widely anticipated rescue package.

Fidelity European Sovereign Credit Analyst, Tristan Cooper, said: “Draghi seems to have met market expectations today, which is positive given fears of a disappointment. Peripheral bond markets are appropriately rallying in response. The ball is now firmly back in the court of Spain, which must now sign up to a program or ‘enhanced conditions credit line’. Any prevarication would lead to a big sell-off, which Prime Minister Rajoy can ill-afford.
“Then the spotlight moves to Italy, which will find it very difficult to stay out of the program if Spain goes in. Why would anyone buy Italian bonds if the Spanish curve is being supported by the ECB and the EFSF?

“Draghi’s comments were marginally negative for Portugal and Ireland. Much of the recent buying in those markets has been premised on the ECB stepping in, in the short-term. However, Draghi stated that ECB support would only be forthcoming at the time when bond market re-access was envisaged under their existing Troika programs, which is next year for both.

“On balance, though a positive day for peripheral Europe.”

Fidelity Director of Asset Allocation, Trevor Greetham, commented: “The markets are right to respond positively to the potential for unlimited ECB intervention in peripheral bond markets with no seniority.

“It’s a good step towards debt mutualisation via the ECB balance sheet. Intervention, when it comes, could also trigger a pick up in business confidence in core countries as fears of a break up recede. The catch is that intervention to lower financing costs doesn’t make the periphery competitive and, in this debt crisis, austerity has generally led to economic weakness even when interest rates are zero.

“Banking union of some form could help spread the pain of peripheral economic and asset price weakness across the euro area, but my concern is that we’ll continue to see chronic economic divergences. In the end this is always going to come down to politics. Will lender countries keep lending? Will borrower countries stick to austerity? Does all of this engender full political union or deepen divisions?

“I expect Europe to muddle along but its economy won’t fire on all cylinders until these issues are resolved.”

Looking ahead
The US Federal Reserve Bank meets next week and Chairman Ben Bernanke will speak on Thursday. Investors are now wondering whether the Fed will also act – or continue to watch for improvement in the US economy and stubborn unemployment rate.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  2012 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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France
When you’re electioneering you can make lots of promises, but the reality is that France now has a choice between being a part of northern Europe or southern Europe. They can become the leader of the “problem children” such as Italy, Spain and Greece or they can become the heart of Europe with Germany. For the last 60 years, France and Germany have acted together to form a strong Europe.

The reality is however as much as President Hollande wishes to be pro-growth he must be responsible – he needs Europe to remain whole and not be broken up and he needs the support of Germany in this process. The only way he can spend more money is to issue more bonds. The only way he can issue more bonds is to keep the interest rate low, and the only way to do this is to keep Germany involved.

To achieve his goals, Hollande will have to get German chancellor Angela Merkel to agree to some inflation, to open the purse strings and at the same time keep Germany happy and involved, so that interest rates are low and France can afford to spend.

So we are at an interesting point now in terms of what Hollande has promised the electorate and what he will be able to deliver. The lesson of history is that Socialist leaders in France have not been irresponsible in terms of finances – we need to make a distinction between the political rhetoric and actual financial policy. Hollande will likely ask for some compromise from Germany but not too much, in terms of relaxing austerity. Hollande is a realist. He cares passionately about the French people and the average man on the street, he does not want to destroy France. We will see higher taxes and some people and companies potentially leave France. But I think Hollande is pragmatic.

Greece
Greece is a much more dangerous situation. Here the two main political parties have lost all support. Basically anyone who agreed with the main body of Europe beforehand has lost the backing of the people. Now we have all of these small factions growing in strength and they all want to re-word the deal with Europe over their support. This may well be the cause that will see Greece break away from the rest of Europe. All of the new parties are saying they are willing to tear up the deals signed beforehand.

Greece needs to make spending cuts of around US$3 billion (A$3bn) in the next few weeks. Unless these are agreed, Greece won’t get the next tranche of funding from Europe, and if this doesn’t happen the situation becomes very dangerous.

I think most people realise that this is a tragedy for Greece but has very little impact on the rest of the world or even Europe, it is very small – but only as long as this problem can be isolated from Italy and Spain.

The risk of a disorderly exit of Greece from the eurozone has increased yes – because there is no political cohesion, Europe doesn’t know who’s in charge. It’s very hard now to get an agreement, with so many different parties and so many different deals, making it difficult to negotiate. Mrs. Merkel must be thinking what to do. If a deal is done, the government could change in a matter of weeks and we’re back to square one, it’s very tough.

However, these events have largely been priced into the bond market. The reconstructed bonds in Greece are trading way below the issue price, about 50% below. The market doesn’t believe these bonds are going to be repaid in full, but in reality there are very few retail and institutional investors involved in this market.

What is the likelihood that Greece will exit the eurozone? 

That’s a difficult question, I’d say around 50:50, but with this type of thing it’s all about politics and it’s not something you can analyse too much. Politics changes things. Public opinion is driving the agenda. If you’re a politician in Greece you must listen to the public otherwise you don’t have a job. The public are saying we don’t want anything to do with Europe.

Portugal has issues, but we believe they will stay within Europe, as will Ireland, because the support is strong and there are very few other elections coming up in the near future.

On the whole people need time. The problems of the eurozone will need working out over a number of years. We need growth, we need a re-pricing of labour in Italy and Spain, and some banks probably need more help with restructuring and bad loan portfolios. It’s very hard to see this sorted out in less than 3-5 years.

It also depends on how fast the US, Chinese and other external economies grow. If you look at recent German industrial production data, it’s quite good, the German economy is doing well. A relatively weak euro is good for Germany, so we’re seeing a transfer of assets from Germany to southern Europe. Germany is paying for a cheap euro by subsidising the periphery.

Fiscal integration would be the ultimate goal so you can have a harmonisation of taxation, fiscal policy and budgetary responsibility. That takes time and it takes time for the electorate to realise that it’s in their interest.

I think the risk of the whole eurozone system collapsing is small, as it would cause so many other problems and the cost would be huge.
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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That’s nice, so I can now go back to worrying about Greece in peace. Or maybe not. In fact it’s starting to feel a bit like Ground Hog Day for investors. Here we are with another year that started fine with share markets up on optimism about an improved global outlook, to now be in May and see the same old worries back with a vengeance. Europe seems to be falling apart again, worries about a Chinese hard landing are back and US economic data has become mixed with worries it will fall off a “fiscal cliff” next year. So far since their highs this year global shares have fallen 8% and Australian shares by 5.5%. 

Europe
Quite clearly Europe remains at the head of the worry list with increasing signs of a backlash against fiscal austerity, fears Greece is about the exit the euro and increasing concerns about Spanish banks:

• The Socialist victory in France and the fall of the Dutch Government are probably less of a concern as even Chancellor Merkel is likely to agree to some easing of the pace of fiscal austerity following her own coalitions’ electoral losses and the EU seems to be moving towards a more relaxed enforcement anyway having realised that austerity is just making things worse. (That’s the downside to Austrian economics!)
• Greece is far more problematic. It is now headed for a new election with Greeks seemingly schizophrenic in wanting to stay in the euro but thinking they can substantially renegotiate the terms of their bailout. It seems that each successive crisis in Greece is taking it closer to exiting the euro, whether its via a new Government rejecting the bailout deal or if several months down the track it fails to meet its agreed deficit reduction targets. An exit from the euro would mean complete chaos for Greece – a 50-70% collapse in its new currency, the inability to fund its budget deficit and hence even worse fiscal austerity, a banking system collapse, etc. For the rest of Europe a Greek exit would be far less problematic than might have been the case a year ago as private sector financial exposure to Greece has been substantially reduced and firewalls have been strengthened. But uncertainty would still be intense in the process of Greece exiting and this may result in more market turmoil, as investors will look around for who will be next to leave – Portugal? Spain? 
• Spain being much much bigger is more of a worry, with a recession and falling property prices making the situation of its banks more difficult risking the need for a public sector bailout. Some estimates put the requirement at €100bn which would add 10 percentage points to Spain’s public debt to GDP ratio which would take it to around 80% of GDP. This would still be below the Euro-zone average of 87% and normally wouldn’t be a problem but these are not normal times. And if Spain gets into deeper trouble, investors will likely focus on Italy again.

This has all resulted in a renewed blowout in bond yield spreads between Spain and Italy on the one hand and Germany on the other. Despite Europe stagnating in the March quarter rather than confirming recession as expected, we continue to expect a 1% contraction in Euro-zone GDP this year. Whichever way you cut it Europe is a mess and it is still hard to see the way out. However, several things are worth noting.

First, while the sovereign crisis in Europe has returned anew, interbank lending spreads remain under control suggesting the risk of banks not being able to fund themselves and hence a systemic banking crisis, threatening a re-run of the GFC and a huge blow to global growth, is currently low. This is thanks to the provision of cheap ECB funding for banks.

Second, the experience of the last two years where fears that European blow-ups would trigger a return to global recession and financial meltdown highlight that policy makers have the power to calm things down. Right now Europe needs a slowing in austerity and much easier monetary policy. The odds are that European authorities will move in this direction. But as always it may take more bad news before they get there.

China
A month ago, Chinese economic data was showing signs of bottoming, but this vanished with official data for April showing a further sharp slowing in industrial production, retail sales, fixed asset investment, imports, exports and bank lending. While this contrasts with business conditions indicators pointing to a stabilisation in growth it nevertheless suggests that growth could dip to 7% in the current quarter.

Fortunately with inflation and the property market having cooled there is plenty of scope for further policy easing in China which we expect over the next few months. China doesn’t have the debt constraints that the US and Europe have and so growth should stabilise over the second half. 

The US
Until about a month ago US economic data was universally surprising on the upside, but recently it has been a bit mixed with notably soft readings on employment. However, current indications are that the US is growing around 2 to 2.5%. The real concern for the US is an impending fiscal tightening that will follow the end of the Bush era tax cuts and various stimulus measures at the end of this year. The fiscal cutback, commonly referred to as a “fiscal cliff” will amount to around 3.5% of GDP next year. While this is likely to be reduced to 2% of GDP, it is hard to see Congress and the President agreeing to do this until after the presidential election in November and naturally uncertainty regarding it may intensify into year end.

Some positives
While the risks are significant it is worth noting there are several positives compared to 2010 and 2011, when shares fell roughly 15% from their April high in 2010 and 20% from their April/May high in 2011.

• Firstly, business conditions indicators, notably the US ISM index, have improved after last year’s falls but haven’t yet reached the cyclical highs they got to a year ago. In other words, having not increased that much, there is not as much downside. Right now they are at levels consistent with modest global growth.

• Second, the US economy is looking better in three key areas: the housing sector looks like it is bottoming; manufacturing is experiencing a renaissance and US oil production is surging thanks to shale oil. 
• Third, the global economy hasn’t been hit by the supply chain disruptions that flowed from the Japanese earthquake in March last year. This time a year ago the US economy was already slowing partly due to this.
• Similarly, the rise in oil prices this year hasn’t been as great as occurred early last year in response to the “Arab Spring”. Consequently the blow to household income hasn’t been as great.
• Global monetary policy has been easing, whereas a year ago it was being tightened. This was notable in the emerging world where inflation in China was on its way to a high of 6.5%, but also evident in Europe and in Australia the RBA was still threatening to raise interest rates. Now monetary policy has been easing, notably in most emerging countries and in Australia. 
• At their April highs this year shares were cheaper than at their early 2010 and 2011 peaks in terms of the earnings yield pick up they provide over Government bonds. This can be seen in the next chart.

• Finally, it seems everyone is fearful of a re-run of the last two years where shares fell 15 to 20% after highs in April or May. When everyone expects something, sometimes it doesn’t happen.

On balance, while the tenuous situation in Europe along with normal seasonal weakness from May into the third quarter points to the likelihood of further weakness ahead, there are some positives suggesting the downside in markets won’t be as great as the 15-20% falls seen in 2010 and 2011.

What does this mean for Australia?
There are several implications in this for Australia.

• Firstly, while recent domestic data for retail sales, building approvals and employment suggest that the chance of a further June rate cut has fallen, the uncertainty regarding the global growth outlook and weakness in China which has pushed down commodity prices suggest that further interest rate cuts are likely to be justified. We continue to see the cash rate falling to 3-3.25% over the next six months.
• To the extent that global shares remain vulnerable over the next few months, Australian shares will as well. However, the combination of monetary easing (in contrast to the higher rates and threat of further tightening a year ago) and a weaker $A provide some buffer. We continue to see share markets higher by year end, notwithstanding the risk of further downside over the next few months.
• The growth sensitive Australian dollar, like share markets, is vulnerable to further weakness in the short term, possibly taking it down to last years low of around $US0.95. By year end it is likely to be back above parity though as it becomes clear that global growth is continuing, possibly helped along by more quantitative easing in the US (QE3) and Europe which will reduce the value of the $US and euro..

Concluding comments
Renewed uncertainty regarding the global growth outlook, particularly fears around a Greek exit from the euro and worries about Spanish banks, mean that further downside is possible for share markets over the next few months. However, key differences compared to the last two years including a stronger US economy, global monetary easing and cheaper share markets hopefully should help limit the downside in shares and help result in a better year end.

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Apparently, the ECB felt that the Euro patient was by then well enough to cope without the ECB but, within days, the Euro Zone commercial banks, which had previously been crowding into the Greek yield curve (and in so doing had allowed the Greeks to finance a burgeoning budget deficit), began to exit their positions as they feared a potential rise in their own funding costs.  Within weeks, this exit from the Greek debt markets had turned into a rout.  Within months, this had accelerated to become the PIIGS (Portugal, Ireland, Italy, Spain) crises.  Now, 24 months later and following countless Euro Zone summits, the crisis continues unabated and, in many respects, it has become notably worse rather than better.  Rather than recovering his health, the Euro Zone patient is now firmly on the critical list.

The basic problem within the Euro remains the fact that there is a wide competitiveness differential between the core countries and the periphery.  This situation is not new; in the early days of the Euro a similar differential existed between the core and the periphery but the other way around, in that the core was uncompetitive but the periphery competitive.  This differential was ultimately solved, not by Germany deflating (it is an urban myth that this occurred) but by the periphery inflating, in part under the influence of huge capital inflows from the cores (the Euro Bubble theme of the late 1990s which favoured Ireland, Spain et al).  Germany regained its competitiveness not through its own deflation but rather through inflation in its Euro partners but unfortunately the latter continued to the point at which the periphery became hugely uncompetitive.

One might argue that Germany should now agree to suffer a depreciation of the Euro and an increase in its own inflation to ‘repay the favour’, thereby allowing its neighbours to regain some of their former competitiveness. However, its political and demographic structures, coupled with the capital adequacy problems in its banks, have ensured that Germany has not inflated and to all intents and purposes, the Euro has not fallen on the foreign exchanges.  Moreover, judging by the latest data this situation is unlikely to change in the medium term and hence, the onus of adjustment has been placed firmly on the periphery, which is being asked to deflate on a scale not witnessed since Asia in the late 1990s Crisis.

At one level, we can suggest that the fiscal austerity regimes and the fact that Spain, Greece and Italy are suffering depression-style contractions in their economies at present is proof that they are attempting to adjust.  However, this adjustment is proving hugely painful as unemployment – and particularly youth unemployment soars.  Indeed, Italy’s (albeit unelected) prime minister recently voiced concern that Italy’s predicament was threatening to make the country ungovernable and that to continue along this path risked giving populist fringe political parties that would leave the euro a greater say in running the country.  At an economic level, the countries might finally be moving towards the deflation that the system requires in order to regain its equilibrium but the social and political costs are immense and perhaps untenable – the euro has already shown itself to be an incumbent government killer and by doing so it risks sowing the seeds of its own political destruction.  In fact, we believe that if the ECB continues on its present course and Germany does not inflate or the euro currency weaken, then the Euro will fracture within the next three years.  Crucially, this notion seems to be becoming a more common view within the Euro itself.

In fact, as Greek and other residents of Europe’s embattled periphery have increasingly come to fear a possible breakup of the Euro, they have begun to view holding bank deposits in their own banks as a reward-less risk.  Hence, huge deposit flight has begun and the situation in the regions’ banking systems has become ever more precarious as a result. 

Specifically, if you as a Greek resident fear a probable dissolution of the Euro, then you would notionally want to borrow Greek versions of the Euro but at the same time hoard German versions of the Euro.  Hence we have seen (until recently) positive credit growth in Greece but negative deposit growth in the local banking system.   As a result, the volume of Greek private sector credit has increased by 27% since the PIIGS crisis first began but the volume of bank deposits has over the same period declined by almost a third.  Consequently, the Greek private sector debt burden has risen by almost a quarter since people first noted that it was too high and the banks’ loan to deposit ratio has also moved up dangerously.  We also find that as Greece’s economy has contracted, the budget deficit problem has proved predictably intractable with the result that public sector debt is now 20% higher than when the crisis first became noticed.  Hence, Greece’s debt predicament is worsening exponentially even as they try to do what is being asked of them.

Greece is, of course, an extreme example but the same type of arithmetic can be found in Ireland, Spain, Portugal, Italy and increasingly France, in which the banks have become dependent on ECB-sponsored financing (through the alphabet soup of rescue funds such as LTROs and, in particular, a system known as TARGET2 that obliges the German central bank to implicitly lend huge sums to the weaker countries).  Meanwhile, the German commercial banks have seen their loan to deposit ratios drop below 80% as deposits have piled up in their vaults but domestic loan demand has remained moribund. 

This may sound technical, but the widening divergence between the loan / deposit ratios in the core and the periphery is an important monetary manifestation of the serious competitiveness and balance of payments disequilibria that now exist within the Euro, as Germany amasses large surpluses (and hence its central bank is the one which is obliged to lend huge sums through TARGET back to the weaker states) but the periphery – including France – suffer large deficits and a consequent increase in their levels of indebtedness to the core, again, via the TARGET mechanism.  Perhaps the best way to think of TARGET is as a piece of wallpaper that is being hung over a particularly troublesome and ever-widening crack in the wall – it covers the damage but does not solve it.

Indeed, the fact that the ECB / EU’s policy responses to the crises have brought no improvement in underlying bank solvency or in any of the Euro’s other key flaws (such as the lack of a single sovereign state to guarantee it and the competitiveness differentials that we note above and of course the Region’s apparent inability to grow) is a damning indictment of the authorities’ potentially fatal failure to grasp the gravity of the situation.  

As to the whether the break up occurs sooner (which would be highly disorderly) or later (more orderly) is a more difficult question to answer.  In theory, if the German state sector is prepared to continue lending to its partners in what we have suggested is an almost clandestine way through the TARGET system, then the unsustainable situation in the Euro can presumably be sustained a while longer, albeit at the cost of a further deterioration in the underlying health of the banking systems and the finances of the German state. Germany is building huge contingent liabilities when it implicitly underwrites loans to the rest of the union.  In effect, the German wallpaper would be obliged to become ever wider to hide the cracks. 

What we do know at a practical level is that markets are latching on to the existence of the once obscure TARGET system. Various blogs and the newspapers are finally carrying the story with more frequency and this does raise the prospect of German political opposition mounting to the Bundesbank’s role as lender of first and last resort within TARGET and therefore becoming a destabilizing factor for markets.  Although the Europhiles would presumably retort at this point that the Bundesbank is notionally obliged by various treaties to keep lending via TARGET, come what may.

However, at a practical level, we wonder if this assumed lack of Bundesbank discretion over TARGET is really the case.  We do find it very interesting that when pro-Europe Axel Weber was Bundesbank President between 2004 and April 2011, this was the period in which the TARGET balances expanded dramatically.  However, when he stepped down (officially in April 2011), we found that under its new President and the “hard money” ECB economist Stark, the Bundesbank’s TARGET exposure suddenly leveled off (implying that it was no longer lending to the periphery) and the peripheral economies each then began to behave in the way in which one would have expected them to if their countries were facing a balance of payments crisis within the confines of a fixed exchange rate regime. That is, real interest rates soared, asset prices declined and the economies slumped.  However, once Stark also resigned in September 2011 (for ill-defined personal reasons), the Bundesbank began lending via TARGET to the periphery once again and the Euro Crisis has appeared to ease once again.

At the very least, the experience of the peripheral countries over the summer of 2011 at a time in which the Bundesbank seemed to become strangely inactive within the TARGET system shows the potential for the Euro Crisis to worsen and perhaps break the system if TARGET were to fail to continue expanding.  More intriguingly, we also wonder whether the mid 2011 episode also shows that, at a practical level at least, Buba (the German Bundesbank) does have some discretion when it comes to its involvement in TARGET. 

At present, we have no doubt that German Chancellor Angela Merkel and others will be pushing Buba to be fully involved, but if domestic German politics were to turn against the Bundesbank’s ever expanding involvement in funding Europe’s weaker states through the TARGET system, then we would then have to wonder if Germany might finally call an end to a project that is now causing economic misery to millions. 
In the long term, we believe that the Euro is doomed as anything other than a weak currency in which policy is set according to the needs of the weakest states.  Whether the Euro survives through 2012 however will depend on whether the Bundesbank chooses to, or is even allowed to, continue expanding its TARGET exposure.   We therefore advocate the monitoring of the news flow in Germany on the subject of TARGET, since this is the Euro’s Achilles’ Heel.  If TARGET fails, then the runs on the banks will become ever more extreme and from there we suspect that it would be a short step to the complete breakup of the Euro.

Andrew Hunt is the head of Andrew Hunt Economics and a consultant to van Eyk

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One only has to read the news headlines to understand that the weight of the region’s debt hangs heavy around its neck and the inability of its political leaders to get a grip on this debt crisis has compounded the problem. Investors, lacking confidence in a successful outcome, have avoided European equities. This year has, however, kicked off with more optimism, as indicated by the recent stronger performance of European equities.

Though risks remain: corporate margins are high relative to history and may come under pressure again as European economies face more austerity. There is, in extremis, still the risk of a disorderly disintegration of the eurozone. I believe, however, that the eurozone will stay together, as the cost of exit will be too great both for those who leave and for those who stay.

Austerity, and muddling through, is the lesser of two evils. As an equity investor, I am putting money into European companies not governments or economies. European companies are not, of course, restricted to doing business in the countries in which they are listed. Many of the companies I own are large, multinational enterprises whose fortunes are tied to the global economy rather than just the eurozone area.

European companies have, in fact, continued to grow their earnings and dividends, during this sovereign crisis, such that valuations ended last year at a historic extreme with an aggregate dividend yield approaching 5% which is a full 50% above the longer-term average for Europe over the last few decades.

This level of yield also appears very attractive when compared to ten year government bond yields of two percent, or less, in Germany or the UK. This suggests, to me, that much of the bad news is already priced in to European markets. Dividends may fall if economies falter and those high corporate margins come under pressure. They would, however, have to fall almost a third for the aggregate dividend yield on European equities to return to the long-term, multi-decade average.

During the financial crisis, when many banks reduced dividends from generous levels to nothing, aggregate dividends fell about a third cumulatively. This could happen again, of course, but I think it unlikely, especially when you consider that many large banks are still paying very little in dividends so there is not much left to cut! Yes, there are risks to forecasts but, in my view, these are discounted and so I believe there is fundamental value in European shares.

As always, risk and reward are common bed-fellows and the biggest rewards often come when risk appears to be high. From an investment point of view the key question is: what to do now?

Selecting cash-generative companies which have sound balance sheets, good business prospects and therefore the potential to deliver consistent dividend growth is a proven way to make money for investors. That a company is able to reward shareholders with a consistent and growing dividend is a sign of its good health and such companies are the bedrock of my investment philosophy because they deliver a consistent track record of outperformance. These sorts of companies may not sparkle in a sharp rally but they will deliver superior returns over any sensible investment horizon.

Take Hugo Boss, for example. This brand is well developed in European markets, particularly in its home market of Germany, but it has not been exploited to its full potential elsewhere. A newish management team, who were put in place a few years ago by majority owners Permira, are now delivering on this having done a good job in improving the basic operations of the company. Sales and margins are showing evidence of this improvement. Hugo Boss has low levels of debt and a high level of free cash flow, most of which it pays out in dividends so investors are enjoying a generous level of dividend and double-digit dividend growth.

Another example of this sort of company is Schibsted, traditionally a Norwegian newspaper firm but increasingly moving on-line with, in particular, some well-known on-line classified advertising sites in Scandinavia, France and elsewhere. Many of these on-line sites are number one in their national market and this is a business where the winner takes all, as evidenced by high margins and strong growth.

Schibsted generates cash, despite funding a high level of investment into its on-line business. It also has a strong balance sheet. The valuation is reasonable, particularly compared to on-line peers, and investors receive a reasonable dividend yield that is growing at a very attractive rate. These companies illustrate that there are ample opportunities for discerning European equity investors. The European economy is troubled but many European companies are in much better shape.

Investing in European equities is not the same as investing in the European economy and as a consequence, there are many good opportunities to be found across the continent. There are, of course, risks involved in investing in Europe, but risk and reward go hand in hand.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information. You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product. The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.  

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So while Greek issues are unlikely to go away any time soon and remain a source of volatility, they are unlikely to pose as big a threat to the global economy and investment market as was feared last year.

It would be nice to have a year without Europe’s debt woes constantly in the news. Sadly that’s still not the case, with Greece back in the headlines again lately as it seeks yet another bailout package. With its economy in tatters and social unrest on the rise, it’s natural to wonder if at some point Greece and maybe Portugal and Ireland will opt to default and leave the euro. Or alternatively, given it’s impossible to expel countries from the euro, a group of strong countries might decide to leave. 

What’s the current situation with Greece?
The Greek (and hence European) debt crisis has been raging since late 2009. Greece first received a bailout in May 2010. Last year it was recognised that Greece’s public debt at 165% of GDP and rising was unsustainable and private investors “agreed” to accept a write down. Over the last month or so, Greece has been negotiating with private investors on the size of the write down, and more recently with the so called troika (the EU, IMF and ECB) on additional austerity measures and reforms to boost its competitiveness in order to receive a second bailout package. This is necessary to make a €14.5bn bond payment due March 20.

Greece has since agreed to troika demands and its Parliament has approved an austerity package. The key elements of the deal are a 1.5% cut in public spending, the loss of 150,000 public sector jobs over four years, a 22% reduction in the minimum wage, pension cuts and a debt swap that would cut €100bn off more than €200bn of privately held Greek public debt.

However, the end to this Greek tragedy is a long way off. While Greece appears to have met all of the conditions set by the troika Euro-zone finance ministers are yet to approve the deal amidst talk it may be delayed further given the coming Greek election, some European Parliaments are to vote on the package including the German Bundestag, and it’s unclear whether private bond investors will be forced to participate in the 70% debt write down. Finally, to meet the objective that Greece’s debt falls to 120% of GDP by 2020 it’s likely the ECB will need to forego profits on Greek bonds it bought at a discount.  More fundamentally though, even if Greece gets its second bailout it will likely still struggle to meet its deficit reduction targets as austerity continues to bear down on its economy.

The Greek economy has fallen around 20% since 2008 and is likely to shrink a 5% more this year. Unemployment is 21% and is set to rise to 25% over the year ahead. With depression setting in and unrest escalating, an obvious issue is at what point the Greek people say enough is enough and decide to default and leave the euro. Or alternatively the rest of the EU decides it won’t provide further assistance given Greece’s constant failure to deliver on commitments.

What if Greece defaulted & left the euro?
If Greece (and other peripheral countries) were not part of the euro, the way to work through current problems would have been to allow monetary easing via an exchange rate collapse in order to offset fiscal austerity. This would allow it to trade out of its problems, much as the Asian crisis countries did in the late 1990s or Iceland is doing now. However, tempting as such an approach is, getting to it is problematic once a country is already in a currency union like Greece is with the euro.

If Greece or any other troubled country opted to formerly default and leave the euro-zone, the following would likely occur: The countries new exchange rate would plunge, possibly by 50-70%; austerity would become more severe as no one would be prepared to fund the existing budget deficit; there would be a risk of a collapse in the banking system as local citizens sought to withdraw their euro denominated deposits ahead of the switch to the new currency; the plunge in the currency would likely result in severe inflation initially; and remaining euro-zone countries might seek to impose trade barriers on exports from countries that left on perceptions they have an unfair currency advantage. In short, the pain for Greece and other leavers could actually get a lot worse initially outside the euro than within. 

For the countries that remain in the euro, it wouldn’t be smooth sailing either. Banks would have to completely write-off their sovereign debt investments in the departing countries. Bond yields in remaining troubled countries, such as Portugal (if it doesn’t leave with Greece), Spain and Italy might come under renewed pressure as they might be assumed to be next. The euro would probably fall initially but maybe not by much as it might be seen as stronger once Greece and one or two others exit. The loss of export markets and ultimately a stronger euro could make life tougher for the remaining euro countries.

What if strong countries left the euro?
An alternative scenario would be where strong countries such as Germany, the Netherlands and Finland decide they have had enough and leave the euro. The outcome for such countries would be similar to that described in the last paragraph. The stronger countries new currency (or currencies) would likely surge in value. Interest rates would likely move higher. Lenders in such countries would face losses on their loans to euro countries given currency appreciation. Exports would suffer thanks to exchange rate appreciation and a if departure from the euro also means a departure from the EU trade bloc.

Finally it should be noted that the process of any country leaving the euro-zone is likely to be long involving referendums and Treaty changes and may take a year or so.

What’s the risk of this occurring?
Both of these scenarios would be very disruptive with a euro-zone breakup potentially weighing heavily on risk markets globally. But what is the chance of it occurring? Our assessment is that the risk of a euro-zone break up is low.

First, as is apparent above the transition out of the euro for both strong and weak countries would be quite painful, particularly for weaker countries like Greece. As such it is in neither side’s interest. Greece (and any other weak euro leavers) would face an incredible disruption as the lengthy adjustment occurred – its banks would potentially collapse and it would have to undergo even more austerity to bring its budget straight to balance as there would be no one to fund its budget deficit. On the other hand, stronger northern European countries would be reluctant to go down that path as its still not known whether the firewall to protect other larger countries such as Spain and Italy, and banks, from renewed contagion is strong enough yet, and more fundamentally because they would suffer from lost export markets and a stronger currency.

Second, polls indicate 75% or so of the Greek population want to stay in the euro-zone. A majority of the population in euro-zone countries, including those in Portugal, Ireland, Spain and Italy also want to stay in the euro-zone. And in Germany, the main opposition is more pro-euro & Europe than is the ruling coalition led by Chancellor Merkel.

Finally, European countries have immense political capital invested in the sixty year project of which the euro is a key part and their actions to date (eg, setting up a permanent bailout facility and the fiscal compact) are all about strengthening it. So it’s hard to see an about face.
Of course none of this is of any relevance if Greece descends into some sort of political chaos and effectively stumbles into a disorderly default or euro exit.

How strong is the European firewall?
Much of what has gone on in Europe over the last two years has been about kicking the can down the road until the rest of Europe is stronger and a firewall can be built so as to withstand a Greek default. While it’s doubtful we are at that point yet, there are some positive signs.

First, the move by the ECB to provide banks with dirt cheap 3 year funding under its Long Term Refinancing Operations program has removed concerns about the ability of European banks to finance themselves. As such the risk of a re-run of the GFC, during which bank funding problems were at the core, has been greatly reduced. While banks may not be using cheap LTRO funds to buy bonds in troubled countries at least they are less likely to be selling them. 

Second, the fire power of bailout funds that may be used in Europe is growing. By mid year the European Stability Mechanism (ESM) will be running with at least €500bn of its own funding and China and other key emerging countries seem to be moving closer to adding to rescue funds.   

Third, while many fret about Portugal going the same way as Greece and requiring its own debt write-down, there are signs Europe is feeling more comfortable with Portugal and is unlikely to let it go the same way as Greece. EU policy makers have backed away from forcing private sector investors to take write downs (as it only adds to the panic). Portugal is seen as delivering on its agreed reforms (unlike Greece), Germany has signalled a willingness to provide extra assistance and the amount of money required to fully fund Portugal for the next 3 years is low.
Fourth, bond yields in Italy, Spain & France have stayed calm through the latest bout of worries, suggesting greater investor confidence that Greek worries will be contained.

Finally, Europe as a whole does not seem to be plunging into the deep recession feared several months ago. Sure growth went negative in the December quarter, but by less than feared and business conditions indicators have since stabilised and hooked up.

Ideally, if Greece is going to have a disorderly default the EU would probably prefer it occur after the ESM is set up mid year. This is another reason why a deal on a second bailout or at least bridging finance is more likely than not by the March 20 bond payment. But the key point is there are several reasons to be confident over time the impact of a disorderly Greek default on the rest of Europe and hence globally will be more in line with its modest size, ie just 2% of euro-zone GDP and less than 0.5% of world GDP.
Concluding comments
The European debt crisis is still alive and well. Logic argues against a euro-zone break up, but a disorderly Greek default is a high risk. However, at least Europe is showing signs of being better able to deal with it were it to occur, particularly if its after new bailout funds are in place from mid year. So while European debt issues are likely to remain a source of volatility, they are unlikely to pose the threat seen last year.

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