Inside Insights 5 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 05 July 2010 @ 10:26 AM

The big fiscal squeeze

In recent weeks, the big European countries - France, Germany, the UK - have announced tax increases, spending cuts, or both, in an attempt close budget deficits, following the lead of the more peripheral economies of Ireland, Latvia and Greece. Japan’s new prime minister has been pushing for a consumption tax hike. In America, Congress has blocked the Obama administration’s new mini-stimulus package as fears about deficits becomes a political issue even as consumer confidence and especially unemployment numbers continue to disappoint China has been deliberately cooling its fast-growing economy, and excitement over the new flexible currency policy died down very quickly. Austerity has become a fad, as The Economist points out. No wonder markets are worried about the strength of the world economy going into the second half of 2010. Talk of ‘double-dip’ and ‘deflation’ has resumed.

To make things worse, there are also worries about the health of European banks (remembering that much of the sovereign debt is held by banks, who were vulnerable to begin with). The European Central Bank announced on Tuesday that it would not renew one-year emergency loans to financial institutions, too soon many feared (but it turned out that banks had been borrowing less from the ECB than expected anyway). Still, financial markets fell sharply and the euro fell to an 8 ½-year low against the Japanese Yen. US shares dropped to a 7-month low. Financial shares declined 4.5% in Europe and almost 4% in the US. The only good news for shares came when Australia abandoned the proposed “super profits” tax on the mining sector, in exchange for a lower resource rent tax, which lifted resource shares. Commodity prices, though, fell sharply during the week with crude oil losing 7.69%. Safe-haven assets such as US Treasuries rallied: the yield on the 2-year Treasury fell to its lowest level since inception in 1976, while the 10-year Treasury yield fell below 3% (the rally in US Treasuries makes a bit of a mockery of the ‘bond vigilante’ fears; if the market was so worried about the US’s debt pile, bond yields would be rising, not plunging.)

Given that risky assets are not cheap to begin with, they may decline in value further if economic growth does splutter. On the other hand, interest rates remain extremely accommodative worldwide, emerging markets are growing nicely and a weak euro might offset some of the impact of fiscal austerity in Europe. So the end is by no means nigh, but caution is nonetheless warranted.

Equities

PMI’s point to cooling manufacturing

The latest batch of purchasing managers’ indices from around the world did nothing to lift the gloomy global sentiment. The JP Morgan Global PMI for June was 55.0, down from 57.0 in May. While still consistent with expansion (a level above 50 points to growth), the pace of output and especially of new orders declined slightly. Looking at the various countries’ PMI’s, the US ISM fell back to 56.2 In June from 59.7 in May. China’s PMI also slowed to 52.1 in June from 53.9 in May, in line with the authorities’ attempt to cool the economy. The UK’s PMI slipped to 57.5 in June from 58.0 in May, while the eurozone PMI fell slightly to 55.6 in June from 55.8 in May.

South Africa’s Kagiso PMI fell below the key 50 level mark in June to 48.4 on a seasonally adjusted level. Having surged in February, the local PMI now seems more realistic, if a bit overly pessimistic. While reduced productivity during the World Cup may be at play, along with ongoing rand strength, it is clear that expectations of future business conditions in the local manufacturing sector have deteriorated. Manufacturing was the first sector to collapse in the global recession that followed the Lehman Brothers collapse, and also led the world out of the recession. This was largely due to the inventory cycle: faced with collapsing global demand post-Lehman, firms ran down their stocks and cancelled new orders. But because one cannot run down your inventories forever, restocking has to take place, even demand is still weak. This inventory rebound was a large factor behind the V-shaped recovery seen across the world and SA in the last months of 2009 and first half of 2010, but the impact was always going to be temporary and fade away during the course of the year. Sustainable growth requires rising demand. The PMI’s reflect slower growth in the future, but on the whole, for now, they remain in positive territory.

PMIs

The Week Ahead

• This week sees the release of manufacturing and mining production data for May by StatsSA. Manufacturing production has increased steadily on a year-on-year basis over the past few months, somewhat at odds with the falling PMI. However, given the PMI’s long-term reliability as a leading indicator for the manufacturing sector – the country’s second largest – one would expect the pace of manufacturing growth to slow down in the months ahead. The Bloomberg consensus forecast is for an 8% year-on-year expansion in May, which is still quite robust, following April’s 8.7%.

• On Wednesday, the Reserve Bank releases foreign exchange and gold reserves for June.

• The South African Chamber of Commerce and Industry (SACCI) releases its Business Confidence Index on Wednesday. The index is a composite of 13 indicators, including the rand-dollar exchange rate, the JSE All Share index, retail sales, the gold and platinum prices, new vehicle sales and the prime interest rate.

• Global events and data releases of note this week: US markets will be closed on Monday for the 4th of July weekend; interest rate decisions in the UK and Australia; German Ifo survey and CPI inflation; Japanese trade balance and current account balance.

Fairbairn Capital | Old Mutual

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