Is the current pessimism warranted?

The Japanese PM has sacked a number of ministers in an attempt to win opposition support for his consumption tax bill – he wants to double consumption tax to 10%, from 5.0% at present. Its a Japanese thing, which is inexplicable to most of us. Will it be enough – seems unlikely;

Chinese non manufacturing PMI fell to 55.2 in May, from 56.1 in April, the lowest reading since March 2011. Service industries account for 43% of the economy, according to Chinese official reports and their target is to increase that percentage to 47% by 2015. With the official manufacturing PMI barely in positive territory (the HSBC survey suggests contraction), the pressure on Chinese officials to introduce a stimulus programme is ever increasing. The PBoC will also reduce RRR’s and cut interest rates;

Deutsche bank suggests that the Chinese may relax its tight curbs on the property sector. Personally, I believe that the Chinese authorities have no choice but to loosen current restrictions, especially if they want to maintain economic growth above the hard landing scenario. JPM is the 1st of the major banks to cut its estimate for Chinese 2012 GDP growth below 8.0%. Indeed, they have reduced their forecast twice in a month, to 7.7% at present. Given the excessively bullish  (and wrong) views on China by the head of JPM’s Chinese unit Ms Jing Ulrich in the past, this is quite a big deal. Having said that the material downwardly revised GDP forecast remains optimistic, based on current policies, in my humble view. However, as you know, I believe that China will introduce a mini stimulus programme (between Yuan 1tr – Yuan 2tr), as suggested by Credit Suisse;

Interesting note by the head of emerging markets, Mr Sharma of Morgan Stanley. He argues that Chinese growth will decline to 6.0% (very likely in my view) and that debt to GDP (including SOE’s) is about 180%, which is more worrying than in the US, even though debt to GDP in the US is much greater – though per capita income in the US is much, much higher. Mr Sharma argues that consumers are not in a position to re balance the Chinese economy, until GDP declines to 6.0%, once again a view I would tend to agree with. He adds that another stimulus programme is just “pushing on a string”. Very likely, I agree, but I remain of the view that the Chinese authorities will want a higher growth rate this year, given the major personnel changes in their leadership – basically, an insurance policy and, as a result, will introduce a mini stimulus programme. His solution is for China to increase its population, which is “greying” fast. Interesting views and, in my humble view, far more realistic than the absurdly bullish views that most banks have pushed re China for years (Source FT);

President Putin seems to be becoming less popular. The FT reports on a poll carried out by an agency that works for the Kremlin, which published numbers last week which reveal that just 48% of Russians trusted Mr Putin, down from 55% in March when he won the Presidential elections with 63% of the vote. Cant see that improving in the near future;

The Cypriot President states that Cyprus may well need a bail out. Its strong links with Greece makes it highly vulnerable. In addition, its banking sector (insolvent) is many times its GDP;

Some good news on Spain. Unemployment declined moderately (by 0.63%) in May, the 2nd monthly decline – presumably tourism related given the season is starting. Having said that, the jobs are, in the main, temporary and will reverse as the season comes to an end. In addition, unemployment remains above 24%;

RBS has calculated that Spain would require around E405bn to E455bn for a bail out, including money to recapitalise its banks, finance budget deficits and roll over existing sovereign debt, up to the end of 2014. Personally, I believe that analysts inevitably understate the amounts required. However, lets assume these numbers are correct. The ESM has available funds of just E500bn, and with demands from other countries (Portugal will require another bail out in a couple of months or so) this is clearly impossible. Without the ESM being allowed to have a banking licence and therefore allowed to borrow to increase the size of its resources, I just cannot see how this will work;

The Portuguese government has raised its forecast for unemployment to 15.5% this year and to 16.0% next, from 14.5% and 14.1% respectively. A second bail out in a few months time is a certainty;

The ECB will announce its decision on interest rates this week. It is also expected to review its strategy to deal with the EZ crisis. The ECB would prefer to wait until the outcome of the Greek elections (and the 2nd round of French Parliamentary elections) is known, before deciding on interest rate cuts (which I believe will happen at some stage) and therefore an interest rate cut this week is, on balance, unlikely. In addition, the ECB does not want to ease the pressure on the EZ politicians to deliver appropriate policy responses – Mr Draghi made it clear last week that the ECB would not “fill the vacuum” created by the inability of EZ countries to act. Mr Draghi has called for, amongst other things, a banking union. However, the extreme volatility in markets at present could force the ECB to act much sooner than they would wish. In addition, EZ inflation forecasts are expected to be reduced to below the ECB’s 2.0% threshold, which will allow the ECB to cut interest rates. However, cuts in interest rates are unlikely to prove sufficient, leading, in due course, to a (likely?) QE programme;

Wolfgang Munchau and Gavyn Davies have excellent articles in the FT. Essentially, Mr Munchau argues that the EZ will announce that they have agreed to a banking union at the heads of state meeting to be held on the 28 – 29th June. A banking union will, inevitably lead to the creation of Euro Bonds, given the sums necessary for any sensible EZ wide bank resolution and recapitalisation/deposit insurance funds, together with an EZ wide regulator/supervisor. The views of Germany is clearly the only one of any relevance. Mr Draghi pushed for a banking union last week and clearly a number of EZ leaders (Monti, in particular) have been proposing it. The EU is also supportive as it is in their interests, but their views are irrelevant – Germany (the CDU) is increasingly becoming highly sceptical of the bureaucracy in Brussels – indeed, very similar to the views expressed by a number in the UK – indeed, a delight to hear. Mrs Merkel has not dismissed the idea, indeed she is considering the proposals according to the media, but will she go for it. She certainly has not raised this issue with her people (more importantly her voters), who would be more than a little surprised, even sceptical and worse still hostile. If the German economy was declining, I would agree with Mr Munchau. Finally and probably more importantly, a number of German (and French) banks are serious under capitalised at the very least (a number of us would argue that they are insolvent) – would Mrs Merkel (or Hollande, for that matter) want such dirty laundry to be aired in public. The German public hate the thought of a bank bail out probably even more than the prospect of Euro Bonds, it could be argued. Whilst a banking union is inevitable at some stage, I believe that there is insufficient information to form a view, though I suspect we will know as we get closer to the EU heads of state meeting in late June. I don’t want to be a party pooper but, at present, I do not believe its on the table. This proposal, if enacted, will be a very big deal – it effectively will create fiscal and political union in the EZ, in addition to the existing monetary union. In addition, without a solvent banking system (which clearly is not the case at present), the EZ is, in effect, a dead duck. Having said all that, I believe that if a banking union is not agreed on the 28/29th June, I believe that it will have to be, quite probably later this year, as the current situation is unsustainable;

There is a serious possibility that the BoE will increase its QE programme (by £50bn?) either in a few days time (7th June) or in July. However, just targeting further purchases of gilts is not delivering the effect necessary, though the BoE has been reluctant to buy mortgage backed securities to date as they fear taking on increased credit risk;

Outlook

Asian markets closed materially lower (1.5% to 2.0% lower), reflecting the poor US employment numbers and the weakening situation in Europe. The Japanese Topix Index, declined to the lowest level since 1983 and has entered a bear market – it has fallen by more than 20% since 27th March. Having said that, any better news from Europe, combined with a mini stimulus programme in China should be helpful. Failing that, the Japanese economy should weaken further in the 2nd half of the year, as post tsunami spending fades.

Whilst the DAX is over 1.0% lower at present, most of the other major European markets are higher. The IBEX is near 2.5% higher (CAC is up 0.6%) , with the major Spanish banks BBVA and Santander significantly higher – over 4.0%. Very interesting. Personally, I would have hoped for the peripheral EZ markets (in particular) to remain weak, which will put far more pressure on EZ leaders to come up with the goodies by the end of the month. Mrs Merkel is, intrinsically an extremely cautious politician and if she believes she has more time, will certainly take it, in particular, as she has not done enough at home with either her colleagues and/or voters. Furthermore the EZ only moves when in a crisis.

German 10 year bund yields are marginally higher at 1.19%. Still believe its a (great?) shorting opportunity, though yields may decline as we get closer to the Greek elections and the EU heads of state meeting. Having said that in the medium/longer term, this exceptionally low yield is unsustainable, given that Germany will face much higher costs, as it has to contribute the most to the EZ bail out, which in my humble view, is inevitable.

A number of you sent me emails suggesting that my note yesterday included a number of “brave calls” – in non diplomatic language, suggesting that I’m wrong. Well, I agree that it is certainly not the consensus view (indeed, probably the total opposite), but that’s how I see it. Whilst, in the short term, German 10 year bund yield may decline further, I continue to believe that they are a serious short.

As far as buying the the financials (only the solvent ones, basically I look at UK and, in the EZ, Dutch and possibly even the French) are concerned, too early to invest is certainly a possibility, though I remain positive. As George Soros reports, the EZ has just 3 months to sort itself out. Whether its 3 months, I believe that its certainly this year. Indeed, if we get to late this year without a meaningful solution, we really will have a panic on our hands. I remain of the view that to gently nibble away (indeed even get a little more positive) is the better option at present and that to remain and indeed (even worse in my humble view) go short at these levels is a high, high risk strategy. Yes volatility will increase, but buying, especially on (hopefully significant) weakness remains my view.

US futures suggest a weaker open – by some -0.5%+, though is improving. However, I would not be surprised if this improves further – positive?

Finally, I believe that Europe offers more opportunity than the US at present. OK, that’s done it – my in box is going to be full, full, full.

Kiron Sarkar

4th June 2012

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