Special Report; The week that was...and expectations going forward

(SPECIAL REPORT; SUNDAY 20TH MAY - 01.14 - JAMES GERRISH)...Given the recent share market weakness, and uncertainty from a global perspective, I thought it worthwhile to cover off some of the major events that are weighing market sentiment.  

 

We've just come through a horrible week for investors with the ASX 200 down another 111pts on Fridays session. In fact, in the last 14 trading days, we've seen the mkt drop -422 points or -9.5% from an intra day high of 4448 on 1st May, to Fridays close of 4026.  

 

On the 4th of May, we highlighted the potential for some short term consolidation or a shallow pullback in the mkt given the recent gains and expectations for a weaker than expected employment situation in the States.  

 

We got that pullback but clearly, we significantly underestimated the severity of what has since played out.  

 

So if we cut to the chase, the main questions on investors minds at the moment is, should I step up to the plate and buy, hold what I've got or cut positions to reduce risk?? Very tough questions at the moment and everyone will be different, however i'll give you my thoughts and those of some of the commentators I read.  

 

Firstly, I think we need to be clear that mkts are being irrational - fear is in the drivers seat. Fundamentals are a distant second and in this environment, it comes down to investor psychology more than anything.  

 

The Goldman Sachs afternoon report on Friday (which is the best in the mkt) said...On a 1 year view the market is without any doubt a buy - the dividend yield support alone in some of the majors is unquestionably supportive, NAB on 8.4% ff yield (grossed up is a whopping 11.6%, ANZ 7.6% ff (or 1.5% grossed up), United Group 7% (9.7% grossed up) this is compared to 10 year Bond yields at 3.02%, 3 year Bonds at 2.40% & the RBA cash rate of 3.75%  

 

I tend to agree and its particularly relevant now that the RBA has clearly entered into an easing bias and we expect that rates will be cut more aggressively than anyone is predicting, starting with another cut in June - possibly for 50 basis points again.  

 

But as we said above, the mkt isn't being driven by fundamentals at the moment - it's fear that's taken hold so we don't actually know where the selling will end. 

 

 

Lets give some context to the current situation in Europe;  

 

 

Greece is the epicenter of concern at the moment and they're heading for another election, after failing to vote in a Government at their last attempt. Looking at the most recent polling, it seems like there is some degree of schizophrenia playing out with 78% of Greek citizens wanting to remain in the Euro, yet 70% don't want austerity. 

 

So they're back to the polls in 4 weeks, which is an eternity from a mkts perspective. It also seems like the anti austerity parties are gaining momentum and quite clearly, this increases the chances that Greece will default and exit the Euro.  

 

Somewhat worryingly, the Greeks themselves are starting to twig to fact that they might actually be on the outer and have started withdrawing funds from Greek banks to mitigate some of the carnage that would occur if they were to drop out of the Euro. 

 

For what it's worth, I don't actually believe Greece will leave the Euro. Firstly, the upcoming vote is a referendum around that very question. Vote for anti-austerity and as a consequence, you'll leave the Euro, revert back to a new currency which will collapse by 50-70% and you'll be unable to fund a budget deficit, and worse still, there will be a banking collapse which will make current austerity look like a bed of roses.  

 

Secondly, I don't think Germany will let it happen. I know the rhetoric from Germany has been quite harsh but that's what you'd expect them to do. The facts are that since the euro crisis began, rents in Berlin have risen by 70% in good districts and 23% in the dicey ones. This is a direct consequence of Germany's current prosperity which has seen it take a sharply divergent path from the rest of the Eurozone.  

 

The ECB has been forced to keep interest rates low given the problems elsewhere in the region, which makes borrowing for expansion cheap, and helps to depreciate the currency, making exports more competitive globally (sound familiar - hint - stars and stripes!)  

 

Ferdinand Fichtner, of the German Institute for Economic Research, said "Businesses can invest and expand further," he noted. "We will see more growth, more employment and higher wages, leading to better domestic sales as well."  

 

I think it's fair to say, that German's have little sympathy for their struggling neighbors, but equally so, they want to protect their own economic prosperity. Put simply, Greece leaving the Euro, would be a negative for the German economy that is chugging along quite well.  

 

Remember also, that Germany has lost its closest economic ally with the election of a Socialist Government in France, replacing conservative Nicolas Sarkozy.  

 

The new Government, led by Francois Hollande, has clearly said that Europe cannot cut its way to prosperity, which goes against the current line being pushed by the Germans.  

 

The German Chancellor Angela Merkel has made it clear recently saying "Growth through structural reform is sensible, important and necessary," she told Parliament. "Growth funded by debt will just lead us back to the beginning of the crisis. We can't do that, and we won't do that." 

 

But I still can't get past the fact that Germans are living a good life right now and would be reluctant to risk it.  

 

While the unemployment rate among Greek young people is believed to approach 50% - and is at a 15-year high in the rest of the eurozone - German unemployment is the lowest it's been since East and West Germany became one, 22 years ago. 

 

I think in the end, we'll see that Germany won't want to interrupt its economic momentum and will reluctantly renegotiate some of austerity packages to also consider support for growth, egged on by France and fears that a default in Greece, could be the start of something that will de-rail their own economic prosperity by spreading the larger Eurozone members.  

 

To complicate matters, and maybe more importantly, Greece is not the only concern at the moment. Spain seems to be garnering a lot of attention after it partially nationalised its 4th largest lender and has increased the capital buffers banks must hold against bad debts. The Spanish property mkt is crumbling and the economy is in recession. Youth unemployment (16-24 year olds who don't work or study) in Spain sits at 51%. That's up from 18% pre crisis and interestingly, it means the average age young Spaniards are leaving home has now risen to well into their thirties.  

 

Clearly, Spain has issues and it's estimated that Spanish banks will need a public sector bailout to the tune of $100 billion, which would add 10% to Spain's public debt to GDP, taking it to around 80% of GDP.  

 

As Shane Oliver (AMP) highlighted in an article this week, that level still sits below the European average of 87%, and normally wouldn't be a problem. Also interesting was an article by Adam Carr last week that discussed debt in terms of total debt, not just public sector debt v GDP. The net position of Spanish households is a lot better - without actually any debt at all. This is in direct contrast to Greece who had net debt leading into the crisis built largely on public debt to GDP over 106% - and it has since blown out to 165% debt to GDP.  

 

I guess the message I'm trying to get across here is that although Spain is a concern, economically, it's different to Greece. Its significantly bigger which we're all aware of, and potentially poses a bigger risk than Greece but its not at that point yet and importantly, has still been able to fund itself this year. 

 

To sum up in Europe; Greece is a major concern at the moment and will keep volatility high until the election, but history has shown us that European leaders are good at finding rabbits, and pulling them out at the right time. Spain is also a concern and will simmer in the background. It's also one of the major reasons why we believe Germany will be reticent to let Greece implode. 

 

 

The markets are also being driven by concerns surrounding China;  

 

 

Being in resource stocks, and particularly second tier names has been ugly over the last few weeks. Quite clearly, they are pricing in a hard landing in China where growth will come back below 7% and centralized authorities won't have the capacity to do anything. I don't think that's the case but there's enough money out they're saying otherwise, or at least, not enough money on the other side of the trade.  

 

Whatever the case, markets can stay irrational longer than many investors can stay solvent, so no matter what our view is, we've got to be conscious of the current market psychology. At the moment, resources, resource exposed sectors (mining services etc) and anything China focused has been pummeled, and is likely to remain so until it becomes obvious that the easing bias in China, which has already been started, will be enough to support growth.  

 

Thus, the main question for investors now is whether the story of emerging growth, particularly that of China is finished and demand for our raw materials will suffer accordingly. I certainly hope not and I'm sure Wayne Swan and the rest of the dysfunctional labor party echo similar sentiments (if they are to deliver on the $1.5 billion surplus that's been promised).  

 

So, what arguments can be made for/against the current situation in China?  

 

- We think growth will continue to be strong in China, albeit at a slower pace than we've seen in the last three years where growth has been at the top end of historical levels.  

 

- Goldman Sachs came out last week and revised down their forecast of China 2Q2012 GDP growth to 7.9% (from 8.5%), their 2012 annual forecast to 8.1% (from 8.6%), while keeping 2012 CPI inflation forecasts unchanged at 3.1%. They believe most of the slowdown in China's annual growth has already occurred supported by recent data covering Asia (ex-Japan) exports to China. 

 

- Money supply in China has been intentionally tight, courtesy of higher capital requirements for banks. This is starting to ease as inflation cools and central banks reduce requirements.  

 

Chinese M2 Money Supply




- Important to consider on the chart below, Chinese growth has not dropped below 6% for the last 20 years - It's a controlled economy with greater ability to massage trends than we enjoy in the western world.q They've consistently targeted 8% and often achieved higher rates, but that's changed now and 7.5% is the new norm. (as stated in their new 5 year plan)