Equities should avoid more declines


WHAT started as an acknowledgement from Greece that it had been living way beyond its means has since turned into a universal re-appraisal of the risks of sovereign default in Europe. After Greece, the bond markets of Spain and Portugal were next to be re-examined. More recently French and Dutch yield spreads have widened against German bunds. Investors have shown themselves less inclined to finance the debt of countries that are not prepared to exercise budgetary prudence and governments have been forced to sit up and listen. The rhetoric of last weekend’s G20 meeting made it clear that expansionary fiscal policies were off the agenda and that fiscal consolidation has become the new watchword across the western world.

Fiscal consolidation in the UK has just been launched. The main British political parties were careful to avoid much detailed discussion about the huge budget deficit ahead of last month’s general election. Now safely in office, the new coalition has been quick to let voters know the extent of deep public sector spending cuts are inevitable and will be “felt for decades”.

The UK is not the only industrialised country that has budgetary woes. The US is in a similar position and market forecasts suggest the deficit could be 9 per cent of GDP this year. However, the US has stronger growth. A Bloomberg survey shows the consensus for US 2010 growth at 3.2 per cent compared with 1.1 per cent for the Eurozone in 2010 and 1.2 per cent for the UK. The US fiscal repair process will not be fully implemented until next year at the earliest, whereas Europe will feel the pain much earlier.

The optimism that fuelled rallies in stocks and other risk assets through the better part of last year came to an abrupt halt in April. Since then, the markets have had to digest the prospects of a prolonged period of slow growth in the industrialised world. The recovery in growth seen in most developed countries from mid-2009 was built around huge fiscal outlays. The time has come for governments to repair their balance sheets; as Bank of England governor Mervyn King noted, we are only half way through the financial crisis.

So the recent downturn in markets is based on logic. The obvious question to ask now is
whether this correction has further to go or whether it has gone far enough. Many of the
answers will be found in economic data. If the general pace of economic recovery
accelerates, the market would draw the conclusion that the correction was overdone.

Despite reassurances this week from Federal Reserve President Ben Bernanke that the US economic recovery remains intact, the market is likely to be sceptical about the ability of US growth to accelerate until labour data shows a significant improvement.

The impact of last Friday’s disappointing US payrolls number will be difficult to shake off since the market is incredibly sensitive to signs of a weakening economic backdrop. German industrial production growth in April, released this week, was better than expected at 0.9 per cent. This is further evidence that the German recovery is gathering pace. Also, Japanese machines orders for April were far stronger than expected. This data suggests that the global recovery is still in place.

However, the market got ahead of itself and expected stellar levels of growth this year. As those high expectations have been dashed, the markets have had to readjust to more moderate levels of growth, which has weighed on markets.

On a positive note it appears that that most countries will avoid a double-dip recession and stay on the recovery track this year. While the correction may not be over, most risk assets should avoid a further sharp collapse from current levels.