Inside Insights 26 July 2010

Investment Intelligence|Inside Insights

A weekly, in-depth yet concise report on the most important recent market movements and economic developments.

Added on 26 July 2010 @ 10:23 AM

Stressed, but not really tested

The markets began the week precariously after U.S. Federal Reserve chairman Ben Bernanke’s semi-annual testimony to Congress. Bernanke, who coined the oft-used phrase “green shoots of recovery” last year, said the world’s largest economy faced “unusually uncertain” prospects, a phrase analysts and commentators seized on. Bernanke emphasised that while the Fed did not foresee a double-dip scenario, it nonetheless remained “prepared to take further policy actions as needed." The market reacted negatively to the comments. The antidote to macro worries continues to be strong corporate earnings reports from U.S. companies, several of whom have exposure to fast growing emerging markets. General Electric’s results, in particular, boosted sentiment. Better-than expected U.S. housing data, and an improvement in European manufacturing and services activity also helped.

Markets were nervous ahead of Friday afternoon’s release of the results of stress tests conducted by regulators on 91 banks across the European Union. Many European banks still have fragile balance sheets following the recession and the collapse in the property market. The tests were meant to see whether banks had enough capital to withstand another economic downturn. However, many analysts expressed doubt that the tests would be rigorous enough to be meaningful. When the results were released, only seven banks were found to have inadequate capital, less than expected. A further dozen scraped through. However, while many banks also have massive exposure to potentially shaky government debt from the likes of Greece and Spain, the worst case scenario assumed for the tests did not include a sovereign default confirming the suspicions of many sceptical analysts that the tests were too easy. The entire purpose of the official tests was to restore confidence in the European banking system, and it is unclear if that goal was achieved. Fortunately, many of the banks released data on their holdings of sovereign debt, allowing analyst to run their own scenarios, and the initial market reaction can best be described as cautiously optimistic. It might take more time for markets to fully digest the implications.

Rates unchanged

The Reserve Bank’s Monetary Policy Committee (MPC) decided to leave the repo rate unchanged at 6.5% and the prime rate at 10%, in line with the consensus expectation. However, the equity and bond markets hoped for a cut - possibly reading too much into governor Marcus’ recent pessimistic statements on growth prospects - and fell back somewhat in disappointment. The MPC’s statement said that, although the immediate concerns over Europe’s government debt crisis have receded, “significant longer term risks and uncertainties persist.” Nonetheless, the local economic recovery was continuing, but the risks were to the downside. The MPC noted that despite the moderation in inflation, expectations of future inflation among business and unions remained elevated. This is potentially a big risk area: unions are demanding (successfully in many instances) wage increases well above inflation. Businesses might initially absorb the extra cost in a weak economy, but when the environment improves businesses will pass the costs on to consumers. The other big threat to the inflation outlook, which the MPC placed a lot of emphasis on, is administered price increases, such as electricity tariff hikes.

Nonetheless, the MPC’s statement highlighted that its inflation outlook remains favourable, with CPI growth expected to average 4.5% in the third quarter of 2010, before picking up slightly thereafter but still remaining within the 3% - 6% target range until the final quarter of 2012. This suggests that interest rates will remain low for the foreseeable future. The possibility of a final cut in this interest rate cycle cannot be ruled out entirely, though, but this will depend on the usual mix of factors: the rand, the oil price, and the strength of the economic recovery. The rand in particular has benefited from capital inflows in search of higher interest rates than those available in the developed world – the so-called carry trade. This could continue as long as ultra low interest rates prevail in the likes of Europe, the UK and the US. The strong rand keeps inflation low. But it also harms exporting industries including manufacturing, mining, agriculture and tourism.

The Week Ahead

• It will be a busy week in terms of local economic data releases, kicking off with the Reserve Bank’s Composite Business Cycle Indicator for May on Monday.

• StatsSA releases the results of the second quarter’s Labour Force Survey, which measures employment from the household perspective, on Tuesday. The survey indicated that 171000 jobs were lost in the first quarter, taking the unemployment rate to 25.2%.

• StatsSA releases June consumer inflation data on Wednesday and producer inflation on Thursday. Year-on-year CPI growth slowed to 4.6% in May, and is expected to have slowed further in June to 4.5%, the exact midpoint of the Reserve Bank’s 3% -6% target range. It will be interesting to see whether prices were pushed up significantly across the country during the World Cup. PPI inflation rose to 6.8% in May, and is expected to have increased to 7.4% in June, largely due to higher fuel and electricity prices compared to June 2009.

• The Reserve Bank releases June private sector borrowing (PSCE) and money supply growth numbers on Thursday. Credit extension is expected to have increased only marginally on a year-on-year basis in June from May’s 0.8% rise. Borrowing in the private sector remains muted, as households and firms focus on repairing balance sheets. By all accounts, banks are also relaxing lending standards only very gradually.

• SARS releases the June trade balance numbers on Friday.

• Global data releases and events of note this week: US June new home sales and May Case-Shiller home price indices; Fed Beige Book; US Q2 GDP data; eurozone money supply data and inflation.

Fairbairn Capital | Old Mutual

Investment Intelligence|Inside Insights