Signs of coordinated central bank action

June was dominated by the continuing crisis in the Euro Zone (“EZ”).

The EU heads of state met on the 28th and 29th June and an “agreement” was reached. The initial reaction, namely the perception that Mrs Merkel’s gave in to the demands of France, Italy and Spain and accepted a looser fiscal policy in the EZ, was surprising to say the least and, indeed, far from the truth. Yes, Spanish banks are to be recapitalised through the EFSF and subsequently the ESM and, as a result, the bail out will not increase Spain’s debt to GDP. In addition the funds will not rank in priority to existing private sector debt. However, the bail out funds will need to be guaranteed by the Spanish government. In Italy, Mr Monti’s claim that the EFSF/ESM would buy peripheral debt in the markets, whilst theoretically possible, is far from being agreed. The Dutch and, in particular, the Finns oppose such a move and though they cant block such action in an emergency, are unlikely to be contradicted by their ally Germany. The EZ heads of state did however agree to allow the ECB to supervise EZ banks, with details to be released by the year end. However, there was no agreement on an EZ wide bank deposit guarantee scheme and/or Euro Bonds or, for that matter, a debt redemption scheme.

The reality of a “less than a cave in” by Mrs Merkel is now dawning upon the market and Spanish 10 year bond yields, having declined sharply following the 28/29th June meeting, are back around 7.0%, with Italian yields some 100bps below. Mr Monti (who was under severe domestic political pressure ahead of the EU Summit), has persuade his cabinet to implement further cuts both this year and into 2014 (E4.5bn, E10.5bn and E11bn in 2012, 2013 and 2014 respectively), though had to admit that this years budget deficit target was going to be difficult to achieve – now expected to be 2.0%, rather than the 1.7% originally targeted, though I believe it will be closer to 2.75% to 3.0%. Portugal is also having difficulties with their targets and Spain, in spite of enacting further cuts, will miss their target of a budget deficit of just 5.3% of GDP this year, by a significant margin – possibly coming in closer to 7.0%. Mr Hollande announced a supplementary budget for this year, which is forecast to raise E7.2bn and proposes revenue increases/spending cuts of E33bn next year – to maintain the budget deficit target of 4.5% this year and 3.0% next. However, French GDP forecasts have had to be slashed to just +0.3%/0.4% this year and the 2013 forecast of +1.0% looks optimistic. The only one of the PIIGS countries which is on target is Ireland and last week, Ireland returned to the international capital markets, raising E500mn through the issue of 3 month bills at a yield of 1.8%. In addition, Ireland was the real winner of the EU heads of state meeting and the (likely) possibility of removing bail out loans for Irish banks from the governments balance sheet could reduce Ireland’s debt to GDP to around 90%, from an expected 110% otherwise. It must make sense for the EZ to want to claim some success and further help for Ireland is likely. Whilst the woes of the majority of the PIIGS continues, the German fiscal position keeps improving, with debt to GDP expected to reduce to just 0.5%, from 1.0% previously.

However, far more importantly, Mrs Merkel was deemed the loser at the EU heads of State meeting, a PR disaster for her at home. As a result, she faced considerable pressure at home, though with the help of the opposition SPD and the Greens managed to pass the necessary legislation in respect of the fiscal compact and the ESM. However, not all members of her own coalition supported her as she did not gain a majority from her party and her coalition partners . Most importantly, the German Constitutional Court is set to opine on a number of these matters. Analysts expect that they will not block the measures, but if they do, all hell will break loose. More positively, a recent poll suggests that Mrs Merkel’s standing in Germany has risen by 8 points to 66%, the highest of all German politicians, which will quieten down opponents and make her far more comfortable. The biggest problem that I see in Germany, is Mrs Merkel’s continued reluctance to tell her people the truth – namely that Germany will have to open up its cheque book to ensure fiscal and, ultimately, fiscal, banking and political union, in addition to the existing monetary union. I fear that this reluctance could well backfire on Mrs Merkel.

This weeks EZ finance ministers meeting will be fraught, as Spain presses its case (which will fail) for a condition light bail out for its banks. In due course, (within 3 months or so?) Spain itself will require a bail out – its current borrowing rates are impossible to sustain, even as it issues more and more shorter term debt, in an effort to deal with higher borrowing costs. The problem is that Spain remains in denial, refusing to accept that its economy is in deep trouble and that it is going to be impossible to manage without support for much longer. In coming months these delusions will be impossible to sustain and Spain will need a full bail out programme.

The EZ is moving towards political union, the key German policy. For that to occur, fiscal and banking union (and quite frankly a transfer union) will need to be put in place, in addition to the existing monetary union for the EZ countries (ex Greece, I continue to believe). The key problem country will be France, which wants the EU to remain a confederation of countries, rather than a supranational state. The French will be loath to agree to political union and will fight tooth and nail to avoid such an outcome, but in reality, do they have a choice. Personally, I don’t think so. Economically, France has slid down the rankings tables for years and will continue to do so. As a result, its ability to resist a political union is much diminished. In addition, Mr Hollande may well be less difficult to persuade, rather than if Mr Sarkozy was President. However, all of these measures will take time and are certainly not without risk, though will the market allow the EZ the time – personally, I doubt it, which suggests that a number of these policy initiatives will need to be put in place far faster than most believe. Political union in the EZ will be a major problem for the UK – I just cannot see how the UK will join, but that’s for another day.

In the UK, the LIBOR fixing scandal has taken centre stage. The CEO of Barclays, the 1st bank to admit wrongdoing, has had to resign, following pressure from the BoE and others – he was grilled by an UK Trasury Committee last week. Numerous global banks are involved and this will drag on for years. However, this scandal will result in further calls to reform (and further regulate) banks, which I see as being inevitable. The financials will come under pressure, though personally, they have been whacked so much, the downside may be limited to say another 5% to 10% in most cases.

The ECB’s (as expected) reduced interest rates by 25bps to 0.75%, though, in addition, cut deposit rates by 25bps to zero. Further cuts are likely, but as the zero interest rate policy (“ZIRP”) policy runs out of ammunition, the ECB will be forced, kicking and screaming (especially by Germany), to launch a QE programme – clearly positive for markets. The ECB remains the only major central bank which has not introduced a QE programme to date – unsustainable in my view.

Whilst the main focus has been on the EZ, economic conditions in China, in my opinion, are deteriorating far faster than forecast by most analysts. Whilst some banks have cut Chinese GDP growth to below 8.0% for this year, my own view it that current expectations are still far too high. Achieving 7.0% GDP growth for the current year is going to be a challenge, unless the Chinese government stimulates the economy far faster than they have to date. Last Thursday, the Chinese unexpectedly cut interest rates by 31bps (1 year rates are now at 6.0%, though the government has allowed banks to offer loans at a discount of up to 30% of this rate), with the deposit rate cut by 25bps to 3.0%. Together with the ECB’s rate reduction of 25bps, down to 75bps and the BoE’s increase in its QE programme of £50bn to £375bn on the same day (allegedly coincidental !!!!!), it sure smells of coordinated central bank policy action to me – though denied, officially. However, the Chinese interest rate cut went down like a damp squib. Markets turned lower, a rather alarming outcome – which suggests to me that markets are increasingly sceptical of China.

The Chinese are to change 7 out of 9 members of their Politburo (the guys who run China) in October this year. They will not want to face economic problems at this time of major political change. As a result, even more stimulus, RRR cuts etc, etc are on their way, especially as inflation is declining. One positive, though very early sign, is that Chinese residential property prices seem to be stabilising. If prices do indeed stabilise, or even better, start to pick up, the Chinese economy will come out of its recent downturn, pretty fast. However, in the medium to longer term, I remain bearish on China. I simply do not believe that a (grossly distorted) command economy can sustain the rates of growth previously experienced, for an extended period of time. The problem is that China needs at least 7.0% GDP growth per year to keep unemployment from rising materially which, if it does not achieve, will create social tensions – the No1 worry for the current leadership. I’m afraid I just don’t see those levels of growth being maintained. China’s 2nd Q GDP numbers will be released this Friday.

Finally, the US. The economy seems to be bumbling along, though there are increasing signs of some weakness. Given the upcoming elections and the threat imposed by the fiscal cliff, US companies seem to be on hold, until the outcome of the elections is known. They are neither spending nor hiring. Economic data, including jobs data, has been weaker in recent months, though last Fridays non farm payrolls data suggests that companies are paying more in overtime payments (rather than hiring new staff) and that wages and salaries are rising, a positive sign for the future. However, until the outcome of the elections is know, I cannot see US businesses changing from their current pattern. At present, President Obama seems to have the edge over Mitt Romney, though anecdotal evidence suggests to me that Romney’s chances of being elected are improving. President Obama has lost the enthusiastic support of his base and most independents (the key constituency) seem to be moving towards Mr Romney. A Romney win will likely rejuvenate US business, who will be far more willing to spend and hire.

A number of analysts expect the FED to embark on QE3, though as we near the elections in November this year, the FED is likely to become far more reluctant, in spite of its independence. There is increasing evidence of a pick up in the US housing sector, which is of particular importance as it will rejuvenate the US economy. Indeed, there is a possibility that housing could make a positive contribution to US GDP this year. A pick up in the housing sector, accompanied by rising home prices will have a profound and beneficial impact on the US economy. The 2nd Q earnings announcements are upon us, and reports suggest that there will be more misses this time around – companies have already started blaming the situation in Europe, a pretty good sign that they will post lower numbers. Generally, analyst forecasts remain optimistic and the current record margins enjoyed by US businesses look as if they are going to be difficult to maintain. In the longer term, the increase in gas production and usage (the US in the last week of June generated the same amount of electricity from gas as it did from coal, 32% each – Source FT) in the US, could prove to be a massive and potentially a major positive game changer for the US economy, and indeed worldwide, as oil prices decline, given lower oil imports into the US. As a result, whilst I’m cautious to negative on US equity markets in the short term (in the current Q and early 4th Q), I certainly remain bullish of US markets in the medium to longer term. I continue to be positive the US$ though, particularly given the continuing uncertainty and problems in the EZ.

Last Thursday’s lack of positive movement following the unexpected Chinese interest rate cut was particularly worrying. You could argue that the ECB’s and the BoE’s moves were widely anticipated and, as a result, it was sell on the news event, but the Chinese rate cut was not expected and the negative reaction concerning. I remain long equities (particularly UK, European and a modest position in emerging markets, which I prefer to US for the moment) and short, long term (10 year) French and German bonds. Whilst I intend to maintain these positions, I must admit that I am far more cautious following last weeks reaction to the Chinese news. I cannot see any major positive news from either the EZ and/or the US in coming months, though further stimulus (ahead of the personnel changes referred to above) from China is certainly a strong possibility, which, I hope, will help this time around. If it happens and/or does not produce positive results, well, that’s when I will get far more concerned.

The Euro has been battered and is currently trading at US$1.2280 – no great surprise. It should be below US$1.20 at this stage, indeed closer to US$1.10. A weaker Euro is exactly what the EZ needs at the moment. However, there is mounting evidence that China is buying the Euro in size to help its export sector from facing an even more difficult market in the EZ – Europe, after all, is China’s main trading partner, with around 20% of its exports bound for the region. Nevertheless, I simply cannot see the Euro rebounding materially or, indeed, even holding at these levels.

Brent, having declined below US$90, traded above US$100 briefly, though is back up to around US$98, mainly due to better sentiment, though I suspect geo political concerns. However, it looks as if it will drift lower, ex any geo political issues eg Iran, which is good news for the global economy. There is more than enough supply out there and, indeed, supply is increasing. The decline in oil prices has reduced inflation globally and helped raise consumer’s disposable income – very much needed. Food prices, on the other hand, are rising as prospects of an El Nino weather pattern rise, which could mitigate the beneficial impact of a decline in oil prices. Recently corn, wheat and soy prices have been rising – I’m certainly going to be long the agricultural sector. The ECB, having cut interest rates below 1.0%, is likely to cut rates even further if, as I expect, inflation continues to decline. If that policy does not work (and I have my doubts that it will work), a QE programme in the EZ must be an option, in spite of strong German (Bundesbank) opposition. At the end of the day, however, rising inflation is the only way out of this mess, once again to the chagrin of the Germans. However, I see no other alternative.

I had closed my shorts in May and have been increasingly bullish into June – which has certainly paid off, though I must say that last weeks market performance, especially on Thursday and Friday has raised my levels of caution. The lack of a positive market move following the unexpected rate cut by the Chinese, surprised me I must say, in spite of my generally bearish views on China. UK and European stocks (on a currency hedged basis, in particular, in respect of European stocks), look cheap (together with a number of emerging markets), with the US less so. As a result, I am long the UK, Europe and, modestly, emerging markets, with very little in the US – indeed, may look to short US stocks. Generally, I will continue to remain long, but am reluctant to add to my large long position and may well trim back some of those position. Whilst the ECB should continue to cut rates in coming months, I remain of the view that longer term (10 year+) German and French bonds offer very little, if any, value and am short. The risk to my short 10 year German and French bond position could be a reversal, following a negative ruling by the German Constitutional Court for example, but at the moment, I will retain these positions. Clearly being short the Euro, against the US$ is a core position of mine – indeed, the longest held position that I have. Overall, volatility will continue. Lastly, the fiscal position of Japan continues to deteriorate alarmingly. Shorting the Yen has resulted in numerous premature trips by investors to the graveyard, though in a crisis, fundamental flaws are more easily exposed. In any event, I will certainly be following Japan far more carefully.

Finally, I would like to emphasize that, whilst I’m not a day trader, I am an active investor and not a long only, buy and hold player. I believe that a buy and hold strategy, particularly in these markets, are gone and will not return for some time yet.

Kiron Sarkar

8th July 2012