SINCE the beginning of the second quarter, the mood in financial markets has darkened once again, prompting a retreat from equities – particularly from shares most directly exposed to the eurozone crisis.
The causes of the increased nervousness are easy to see, being negative developments in all three key elements of the bullish prognosis for risk assets – namely a “muddle through” in Europe, a “soft take-off” in America and a “soft landing” in China.
Least worrying to us is America, where faith in the economic recovery has been shaken by recent employment data. Although this bears watching, a broad range of indicators still point to a run rate of 2-3% real GDP growth, including consumer confidence and housing, both previously sources of concern.
Similarly, although we find China’s politics to be intriguing, we are highly un-alarmed by the deceleration of the economic growth to 8.1% in Q1 and the re-stating of the official target of 7.5% growth for the full year.
Such a “landing” may feel hard to those used to double digit rates, but it should not cause global GDP forecasts to be meaningfully downgraded from current levels.
Which brings us back to Europe. The eurozone is facing its first serious tests since the European Central Bank’s (ECB’s) widely applauded Long Term Refinancing Operations injected over one trillion euros of funds into the banking system – averting a potentially catastrophic liquidity crunch.
The tests are coming from both political and economic directions. On the political front, imminent elections in France and Greece both have the potential to force the existing Franco-German road-map for achieving a stability to be re-drawn.
From the economic direction, Spain’s increasing borrowing costs following upon the new administrations’ repudiation of previous deficit reduction targets raises the spectre of another key European economy falling into a debt trap – where further austerity actually makes the problems worse rather than better.
Our view is that judging the health of the eurozone project by movements in financial markets on a daily basis risks losing the proper perspective. Although politics could de-rail the process, significant forward strides have been taken over the past 12 months. Crucially, all members of the zone have been forced into accepting that stability can only be achieved through fiscal sustainability, which in itself can only be achieved through increasing competitiveness (employment) and unwinding unaffordable post-war social security models (reduced expenditures and disincentives to work).
The nature of these tasks means that progress is not linear or steady – the mandate for progress is difficult to win against entrenched interests and the effects of measures taken are difficult to quantify.
Bearing this in mind, we view the recent “pain in Spain” with less alarm than the Italian situation at the end of 2011. At that time, the overall European plan was less clear, the support of the ECB was less certain, safety nets less defined and the nature of the problem was not agreed (then by the Berlusconi government). With Spain, markets are simply debating the speed of progress and keeping pressure on the Rajoy administration to deliver, not threatening to abandon all faith – as was the message to Italy.
On a more optimistic note, although Europe is currently enduring very high levels of stress as the price of an Austrian solution to the sovereign debt crisis, there are good reasons to expect a more forgiving environment after the middle of the year.
Aside from a clearer political picture, the most important of these is the passing of the July deadline for European banks to hit their required “stress tested” capital adequacy levels, set by the European Banking Authority .
Once this hurdle has been jumped, European banks’ inclination to lend will increase and the credit crunch will ease. If this is accompanied by a more favourable external economic environment or (however unlikely it seems now) a more pro-growth policy mix within Europe (led by Germany) investors in European sovereign debt could quickly view the glass as half-full once more.
In the meantime, we must expect volatility to continue, matching our commitments to the markets with our stomach to tolerate it and our inclination to look past it.