Key points
- The on-going sell-off in global equity markets and the rush to safe assets are pricing more economic and political bad news than we can see.
- The slowdown in US and Western European economies is more serious than anticipated, but is unlikely to degenerate into a full-blown recession.
- Emerging economies are growing at a robust pace and the threat of inflation is receding.
- The US downgrade by S&P, although opening a new chapter in the history of sovereign debt, does not add anything to what we already knew. It is unlikely to move US treasuries and should have limited consequences for other US markets.
- ECB purchases of Italian and Spanish government bonds is consistent with the 21 July agreement and constitutes a new step toward a more comprehensive solution to the euro debt crisis. We think that the ECB could buy up to €150bn worth of government bonds without jeopardizing long-term price stability.
- A long-term solution to the Euro Area’s woes will include the issuance of Eurobonds. There are nevertheless significant political and technical hurdles on this road going forward. Sovereign credit spreads are likely to remain quite volatile until Euro Area policy-makers move forward more decisively.
- Overall, we believe that the sell-off in global equity markets went too far. Equities do not appear expensive. Investment grade corporate bonds have proven resilient and remain our favourite asset class. On the other hand, government bonds benefiting from a safe haven status look extremely expensive.
The recent sell-off in global equity markets is, in our view, not justified by either economic or political fundamentals. As of the day of publication, the MSCI world index had fallen by 13.3% since July 22nd, and 10Y Treasuries yields had dropped by 70 basis points (see table). Three factors are behind this dramatic sell-off: a higher perceived risk of recession in the US and Europe, new uncertainties created by the US downgrade, and slow management of the euro debt crisis. In this note, we review these three factors.
Slower for longer, but no second dip
Business cycle conditions have significantly deteriorated over the last three months, both in the US and Europe. In the second quarter of the year, US output growth all but stalled, and, based on company assessments of current business conditions, Euro Area third quarter GDP growth may also be close to zero. Both regions are suffering from an excess of either private or public debt that accumulated over the previous cycle. This debt level will not go away easily and, for this reason, we expect the recovery to remain sluggish in both regions over the next few years. However, sluggish growth does not imply recession. In the US, July employment data, as well as upward revisions to previous months, came out better than expected. The non-financial corporate sectors in the US and Europe are profitable, not excessively leveraged and eager to increase their investment spending. Outside of Atlantic economies, China and other Asian economies are growing robustly; Japan is recovering faster than expected; and Central and Eastern Europe, the Middle East and Latin America are expanding.In China, GDP growth in Q2, at 2.2%qoq, showed that the economy is more robust than what the manufacturing PMI survey suggests. Arguably, industrial production is suffering from the necessary adjustment of excess inventories built up at the end of 2010. But this process is likely to reach its end by September or October, and then a rebound in production could take place, driven by strong domestic demand and lower inflation. The recent fall in commodity prices would certainly help, as would the appreciation of the RMB against the USD. Moreover, Beijing still has a lot of ammunition to support the economy, despite the growing (but still manageable) burden of local government debt. For these reasons, the Chinese economy is most likely to keep on growing by 8.5% to 9.5% in the next couple of years.
Against this backdrop, we expect the balance of strengths and weaknesses in the global economy to be positive for growth and earnings over the next year. Overall, we believe that the global economy is still in an early stage of its recovery from the ´”great recession” and that the economic slowdowns in the US and Europe will not last, though they do justify downward revisions to excessively optimistic economic and corporate earnings forecasts.
It is only in the event of another financial meltdown in the US or in Europe that the global economy could experience the much dreaded global double dip. This is why the US downgrade and the euro debt crisis are so important.
The US downgrade: mind the ripple effects
Starting with S&P´s decision to downgrade US debt from AAA to AA+ with negative outlook, it is fair to say that such a quick move was not expected by the markets and took us by surprise. However, it must be seen in a much wider context than the political quarrel in Washington DC about the debt ceiling. To some extent, it is the latest avatar of the long-term decline of the US$ as the anchor of the global monetary system, a story that started in 1971 when the US decided to ditch the Bretton Woods system. In the world of fiat money that emerged from this decision 40 years ago, “risk free” is a relative concept. In the medium term, other sovereign AAAs might follow, making AA+ a sort of new benchmark for ´risk free´ assets.
The reason S&P decided to downgrade the US debt seems to be that the 11th hour agreement between the US administration and the Congress (see our Special Flash “US fiscal deal just buys time”) did not match the US$4tn cumulative deficit reduction over the next ten years deemed necessary to invert the debt dynamics. Without taking sides in the acrimonious argument between the Treasury and S&P that is still going on, we note that there is nothing really new there. The markets know that government debts have jumped by 30 points of GDP post-2009 recession in the OECD, and that sluggish, post-bubble growth makes debt stabilisation even more difficult. The peculiarity of the US is that it is next to impossible to curb the longterm debt dynamics by cutting spending only, which seems to be the hard line of the Republican Party. If “visible” taxes are not raised at some point, then inflation, an “invisible” although quite real tax, will do the job.
This being said, US Treasury bonds (UST) remain unchallenged as the world´s safe and liquid asset of reference. Only well-designed Eurobonds could challenge UST, and this only once the stock of these hypothetical bonds have reached critical mass. We are not yet there. Therefore, we do not anticipate a significant shift in the UST demand curve and thus expect no significant impact on the US “risk free” rate of the S&P decision. In the short term, it could even be the opposite: if the financial markets see this downgrade as a step into unchartered and potentially dangerous territory, higher risk aversion could push UST yields even lower.
The potential ripple effects on Europe of the US downgrade are important. They will make their way through two channels:
i) By convincing politicians anxious to protect their rating to do more and more immediate fiscal tightening, which would worsen growth prospects and thus raise further doubts about fiscal sustainability. Italy is already caught up in this vicious circle;
ii) By casting doubts on the rating of the second most important AAA guarantee of the European Financial Stability Facility, i.e. France. Even though rating agencies, S&P in particular, have indicated that they are happy with a “stable” outlook for France’s rating, we have already seen the French CDS spread widening by 14bps since the US downgrade. Needless to say, downgrading France would make EFSF rescue actions more difficult.
Euro debt crisis: Italy will not default
This brings us to the latest developments of the euro debt crisis. Based on the most recent decisions of Euro Area policy makers, some investors may be drawing the conclusion that Italy will shortly need a bailout, and that Germany will block it. We do not share that view, for several reasons:
1. Italian debt is resilient
Although the weakness of Italy’s recovery (GDP growth has averaged only 0.9% p.a. since the beginning of the recovery) raises legitimate questions about the government’s longterm solvency, Italy is more resilient than recent market developments, at least until the ECB´s intervention, imply. Not only is Italy running a primary budget surplus, forecast at 0.8% of GDP this year, but its net external debt is also limited (20% of GDP, compared to 100% for Greece and 17% for the US). The average maturity of Italy’s government debt is high, just over seven years, above that of many AAA-rated sovereigns. So Italy could withstand high bond yields for some time.
2. Italian banks have strong balance sheets
Provided that their investments in Italian sovereign debt are not impaired, which is our assumption, they are well capitalised. If and when their funding might become stressed, the European Central Bank is ready to plug the gap, as illustrated by the ECB´s recent decision to re-open 6-months full allotment refinancing operations at fixed rates.
3. The ECB has respectable firing power
We have not detected any signs that Euro-area policy makers—in Germany in particular—are less committed to the single currency. On the contrary, the decisions taken on July 21 to strengthen the euro rescue fund, and the ECB’s subsequent decision to reopen its Securities Market Program, only provide further evidence of this commitment. Although the ECB´s action has been remarkably successful so far (at the time of this writing, 10Y BTP yields were hovering slightly above 5%, 100bps below their recent peak), perhaps because market participants were so incredulous, the potential size of the ECB´s intervention is a legitimate question. There are no theoretical limits to the money printing power of the ECB. In reality, the limits are political and linked to the mandate of the ECB, which is to achieve price stability. While it is difficult to estimate a political limit, it is easier to estimate the level of money creation that would undermine long-term price stability. To do that, we have calculated the gap between M3, a broad measure of money supply used by the ECB in its monetary analysis of long-term inflation risks, and its long-term trend, estimated over the period 1999-2011. In June, this gap stood at -8.9% (M3 is significantly below trend), or -€870bn. Elsewhere, the money multiplier (i.e. the ratio between broad money, M3, and the monetary base) has been hovering around 8.5 since the end of 2008. This means that, even if its interventions were not sterilised, the ECB could buy up to €100bn of bonds without inflating money supply above its long term trend. Back in October 2008, the money gap was positive and equivalent to €80bn in today´s terms. Without going that far (M3 was definitely overshooting), we think a slightly positive money gap, say €50bn, would be affordable for the ECB. This conservative estimate is certainly modest in comparison to what the Bank of England has purchased so far: £200bn, or 14% of the UK’s GDP and 25% of the outstanding stock of Gilts. Other things being equal, this would be equivalent to €1,300bn for the Euro Zone.
In other words, we think that the ECB´s decision, which should soon be supplemented by EFSF interventions, is buying enough time for policy makers to work out a longterm solution for the management of funding for Euro Area governments. Our constant vision is that this will be the issuance of Eurobonds (see “Coping with a summer debt storm”, Weekly Comment no.562). The sooner Euro Area policy makers come to an agreement on the specifics of Eurobonds, the sooner volatility in financial markets will decline.
Asset allocation
1. Fixed Income
The immediate reaction of fixed income markets to the downgrading of US debt triggered a classical flight to quality movement, pushing US yields down (-24bps on the 10Y the first day after the S&P announcement) and amplifying the losses for riskier asset classes. The lack of an alternative “safe haven asset class”, combined with uncertainty on growth and the European debt crisis prevented what in theory would have been a normal reaction to this type of event: higher rates due to a higher country risk premium.
Therefore, we think that as risk aversion dissipates, yields should resume a “normal” path toward higher levels, in line with fundamentals. This is why we are keeping our underweight position. That said, the upside potential on yields is circumscribed on both sides of the Atlantic. In the US, the Fed has just announced that Fed Funds rate is likely to remain close to zero for at least another two years and continues to open the door to a more active management of the long end of the curve by adjusting the size (QEIII?) or the composition of its securities holdings. In Europe, rise in Bunds yields could also be limited since a decisive solution to the European debt crisis could take some time.
We are sticking to our overweight on credit, since IG credit markets have proven to be very resilient during the recent turmoil (especially non-financials and US credit). Because non-financial corporates have solid balance sheets, credit markets should not be overly affected under a scenario of sluggish growth (a double-dip scenario would obviously be another story). Conversely, HY bonds have suffered substantially due to their higher correlation to equity markets. Despite the higher volatility in HY markets, we still think that fundamentals are supportive, since refinancing needs are very low in the short term and default rates should remain low during the next 12 months. Therefore, valuation on HY spreads is now very attractive, and we continue to like HY as a long-term carry trade. However, we prefer higher ratings within the asset class and would avoid most distressed names.
2. Equities
After the sharp decline witnessed over the past couple of weeks, equity valuation has declined considerably. Today, global equities are trading on an 11x multiple, which is clearly in the lower part of what we would consider as fair value range (10 to 15x multiple). We are fully aware that the coming weeks will see substantial downgrades as far as earnings are concerned. Whilst we think that European earnings will indeed feel substantial headwinds from the ongoing economic malaise (we now think that European earnings over the coming 12 months will only grow by around 5%), we remain convinced that earnings momentum in the US and the rest of the major markets, including EMs, will remain relatively robust, albeit a touch lower. Consequently, we are trimming our earnings projection to around 10% for the US and EMs, in line with the above- mentioned economic settings.
Yet today´s valuation, when compared to the longer-term earnings projections, is closer to 1 rather than 1.2 a month ago. Basically, such a reading implies an earnings recession for FY 2 and 3. We think this is exaggerated. Consequently, we suggest that investors start increasing some equity positions on the strength of an economic recovery, economic policy action (particularly here in Europe), cheap valuation and a fairly oversold market. Having said this, we expect volatility to continue to haunt markets due to uncertainty concerning the S&P US downgrade and the Euro debt crisis.
Within Equities, we suggest increasing the weighting of EMs – an equity segment that has been suffering in tandem with global markets but that hasn´t got the same economic problems. However, we are sticking to our preference for the US over the Euro Zone.
