Inside Insights 3 May 2010

Investment Intelligence|Inside Insights

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

Added on 03 May 2010 @ 10:24 AM

Not quite Lehman 2.0

For a moment it seemed that world markets were gripped by fear reminiscent of Lehman’s collapse. While South Africans were celebrating Freedom Day on Tuesday, ratings agency Standard & Poor’s cut Greece’s sovereign rating by three notches to what is known as ‘junk status.’ In other words, Greece’s government is now viewed as a more risky debtor than most companies (even though governments can raise taxes to pay creditors) and several emerging markets (including SA). Portugal’s rating was also cut by two levels, as was Spain’s by one on Wednesday, leading investors to worry whether these countries would be able to roll over their debts. Greece has to repay €9bn of its €300bn debt pile by 19 May. The bond market punished Greece, pushing 2-year yields towards 20%, and 10-year yields above 10%, worried that Greece would not be able to meet its repayment obligations. Such a defualt would have serious consequences for those banks across Europe (particularly in Germany) that hold Greek debt. Another round of debt write-downs and a sell-off of bank shares could ensue, and the euro itself would also remain under severe pressure.

Market nerves were soothed by the assurance from the EU and IMF that they were working on assistance package, which was finalised over the weekend (at €120bn over three years, it is the largest sovereign bail-out ever, but requires Greece to cut public spending by €30bn). The decision of the Federal Reserve’s Open Markets Committee to keep interest rates low ‘for an extended period’ further improved sentiment. The FOMC also noted the improving economic situation in the US, confirmed by Friday’s GDP number (US Q1 GDP grew 3.2%, with an improved showing from consumers). Company earnings released during the week were also encouraging for the most part. This is probably the key difference between the current scenario and those dark days after Lehman’s collapse: the economy is recovering off a low base, there is plenty of liquidity in global markets and policy remains expansionary. But plenty of uncertainty remains, as is evidenced by the spike in the volatility indices (SAVI and VIX).

Over the longer-term, the economic growth outlook in Greece, Portugal, Spain and the eurozone as a whole will be harmed. Since Europe is a leading destination for South Africa exports, this will affect us too. But on the other hand, capital will tend to flow away from highly-indebted slow growing economies (including Japan, the UK and US) towards more dynamic economies with lower debt levels and solid growth prospects. South Africa falls squarely in this category.

No inflation surprises

Local analysts who could tear their attention away from Greece had a lot of data to chew on. The Reserve Bank’s composite leading indicator continued to rise in February, to 125 index points. While the year-on-year growth rate slowed to 18.4% from January’s 18.8%, it nonetheless points to a continuing, albeit moderate, economic recovery. There were no inflation surprises. Consumer inflation (CPI) in March slowed to 5.1% year-on-year from 5.7% in February, driven by slowing food inflation and the stronger rand. Producer inflation picked up slightly to 3.7% from 3.5% on a year-on-year basis, largely due to higher energy costs. Reserve Bank Governor Gil Marcus recently commented that “the scope for further easing is limited.”

And while the inflation numbers will confirm that view ahead of the MPC’s next meeting on the 13th of May, the latest credit data suggests that the MPC might want to consider cutting rates again once in the cycle. Private sector credit extension contracted by -0.69% year-on-year in March, falling for the sixth consecutive month. This was slightly worse than consensus expectation of -0.3%, and reflects the ongoing weak demand in the economy and strict bank lending criteria. Fortunately there are tentative indications that we are at the bottom of the credit cycle, with mortgage and other asset-backed loans having risen over the quarter. Changes in interest rates affect credit demand with a lag (as the graph shows) and credit demand is likely to remain weak for the remainder of the year while household balance sheets are repaired, unemployment stabilises and business conditions improve.

The Week Ahead

• Kagiso and the BER release the manufacturing purchasing managers’ index (PMI) for April on Monday. March’s PMI fell back to 55.6, but remained above the key 50 index points level. April’s reading is expected to be slightly higher than March’s, and still in expansionary territory. This week also sees the release of global manufacturing and services PMIs.

• Naamsa releases local new vehicle sales data for April on Tuesday.

• StatsSA releases unemployment data as per the quarterly Labour Force Survey on Tuesday.

• Also on Tuesday, US pending home sales numbers for March will be released.

• The petrol price will rise by 14c/l on Wednesday due to high global petroleum prices during the past month.

• The Australian Reserve Bank announces its interest rate decision on Tuesday, and the European Central Bank announces its rate decision on Wednesday. While the ARB is slowly busy returning interest rates to more normal levels, in all likelihood, the ECB will leave rates unchanged. However, the Frankfurt-based ECB will be faced with a dilemma soon: whether to start raising rates from present ultra low levels to contain inflation in as the core economies of the eurozone (including Germany) are recovering, while the peripheral economies (Greece, Portugal and Spain) are still mired in recession.

• The UK general election takes place on the 6th. Should there be no conclusive winner (a so-called ‘hung parliament’), the pound might take a battering as markets will worry who is taking responsibility for reducing Britain’s enormous public debt pile. The latest polls out the Conservatives in front.

• The Reserve Bank releases gold and foreign exchange reserves data for March on Friday.

• Key US non-farm payrolls and unemployment rate data on Friday.

Fairbairn Capital | Old Mutual

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