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Political uncertainty weighs on risk sentiment

05/15/2012 

 

Financial markets are currently dealing with political risk. In Europe, recent election results have highlighted the difficulty of implementing austerity measures after decades of government spending largesse. Political disunion is creating a leadership and strategy vacuum, in the face of formidable structural and systemic challenges. The ECB will likely step up its efforts in ring-fencing the critical sovereign markets of Italy and Spain. Yet, investors should expect volatility episodes until a sustainable European strategy is in place. In the U.S., fiscal uncertainty is also a headwind for the market but healthy corporate balance sheets and a well-capitalized banking system offer fundamental support. At the global level, we are more optimistic on the outlook for more aggressive monetary policy in emerging markets as inflation pressures ease. 

As we can see below, volatility in the European sovereign debt market is creating contagion risk in the broader credit market. Moreover, capital flows continue to pour in the stronger sovereign debt markets and non-domestic investors in particular continue to reduce their holdings in peripheral sovereign debt. Capital outflows put further pressure on peripheral GDP growth and are creating further negative feedback loops.

 

                                 

 

Divergent capital flows are also causing different impacts on property prices i.e. as Spanish property prices are deflating, excess money flows in Germany are raising its domestic  property prices. In Spain, domestic banks have had access to the ECB’s liquidity facilities but they now need to raise capital (EU 70-100bn) in order to provide against further property losses. At the end of the day, bank debt has to be restructured and private investors need to share in the losses instead of just loading the government balance sheet with further debt at a time where the country is running a high budget deficit (6.4% of GDP), in the face of high unemployment. Therefore, a realistic bank debt restructuring plan for Spain along with ECB support for its banking system would likely take some systemic risk off the table.    

 

 

Across the pond, we believe that stability in the U.S. housing market is likely to underpin consumer and small business confidence. Housing represents the biggest portion of household wealth for the middle and lower income brackets. Record affordability and a steady labor market are important pillars for the housing recovery. For the latter, the corporate sector will gradually increase hiring as productivity growth is becoming more challenging to achieve.

 

 

The U.S. consumer spending outlook is currently challenged and as we can see below a reduction in the savings rate and an increase in credit use may be indicating some household budget stress. On the fiscal side, policy uncertainty over the 2013 fiscal drag (3-4% of GDP) may weigh on corporate and household sentiment in the medium-term but visibility may improve as we approach the end of the election period. Therefore, looking towards the second half of 2012, the pace of labor force expansion and income growth will be critical for consumer spending and the overall U.S. economic growth rate.

 

 

 

On a more positive note, inflation expectations are likely to remain in check for the rest of the year.  This will aid the Federal Reserve to continue its accommodative monetary stance. In an ongoing low rate environment, our income tilted portfolios are likely to continue to benefit; especially at a time where a retiring baby boomer generation is seeking capital preservation and steady income distributions.

 

 

From a leading economic indicator perspective, we note that the ECRI index still points to a moderate growth environment. In Asia, we note that the Chinese yield curve is showing signs of recovery. The PBOC has recently lowered the reserve requirement ratio for its banking system and we expect further monetary action in an attempt to cushion the slowdown in Chinese growth. As inflation pressures ease, Emerging Markets will resume their secular growth path as their domestic middle-classes demand higher-valued goods and services. Thus, the next global cyclical leg will benefit in particular the U.S. technology and industrial sectors.

 

 

 

In conclusion, we are cognizant of the current global headwinds and we retain our nimbleness to increase our risk exposure in more cyclically exposed sectors at attractive risk-reward entry points. In the medium-term, we maintain our balanced portfolio posture with a significant tilt towards income generating securities and dividend paying equities.

    

 

 

 

 

 

 

  

 

Christos Charalambous CFA

Senior Strategist

christos.charalambous@edgewealth.com

 

 

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