Market Update

Wednesday, June 27 2012

What Could Go Right?

Markets remain bearish waiting for the Greek elections and are reacting quickly to any piece of bad news. Markets dislike uncertainty and until clarity emerges in Europe it is difficult to imagine buyers emerging. However, the crisis is well understood by the market and has been thoroughly analysed. It is hard to imagine that the market has not priced in a significant amount of the bad news. For stocks to rally the news does not have to be that good, it just needs to be less bad. We run through what could go right given significant space is currently being devoted in newspapers to what could go wrong.

 

Markets are dislocated

To be clear, markets are dislocated at present. There has been a massive move towards so called “safe havens”. As noted in the chart below, Australian 5 year Government bonds now offer a yield of only 2% which is less than inflation. Investors globally are currently prepared to pay a very big premium for the AAA rated safety of an Australian Government bond. An example of the extent of this premium is explained by comparing investing over five years in the Government bond compared to investing in Westpac equity at present. Over five years the Government bond would pay you 10% whereas the Westpac shares would pay you around 63% in dividends (based on market expectations). Therefore, the Westpac share price could drop by 50% and you would still be better off!

 

Australian 5 Year Government Bonds

This relationship between bonds and equities is at an extreme level. The chart below highlights the difference with bond yields trading at a huge discount to equity yields reflecting the massive uncertainty in the world.

 

Equity Earnings Yield Versus Bond Yields

This relationship between bonds and equities is at an extreme level. The chart below highlights the difference with bond yields trading at a huge discount to equity yields reflecting the massive uncertainty in the world.

 

Equity Earnings Yield Versus Bond Yields

 

The cash rate is at 3.75% and likely going lower and in our experience we have never seen it lower relative to the dividend yields on offer in the market.

 

Defensive assets are becoming very crowded and while they are likely to remain attractive while there is talk of a Greece exit from the Euro, the returns on offer in return for that safety do not look compelling.

 

How long has this Crisis been going?

The chart below highlights the length of time this crisis has been going. We are into the fifth year which is a fair length of time compared to previous crisis. The Euro has complicated the recovery given the added political dimension of the problems in that market. Nevertheless the notable point from the charts below is that we are a far way through the crisis and the upside that can emerge as markets begin to sense the worst is behind.

 

What can go right?

The crisis in recent years has followed a similar pattern of crisis followed by policy response. Once again the markets are pressuring political leaders to undertake the necessary policy solutions to shore up confidence.

 

Europe

The European share market is down 50% and seems to be anticipating a recession. However there are a number of catalysts that could emerge which would create an environment which was “less bad” than at present. This includes:

Greeks vote for continued austerity and remain in the Euro. Recent polls suggest this is likely and would calm markets. However this would be temporary in our view and the market requires signs that they can ring fence the Greek problems. There are a number of steps that could be taken in this regard

  • Firstly a recapitalisation of Spanish banks with around 100m Euros required. Politically there remains some toing and froing into how this is achieved
  • A deposit holders insurance scheme across Europe to help avert a bank run
  • Further quantitative easing to drive down sovereign spreads
  • Agreement across fiscal union including an independent authority to assess budgets.

None of these solutions are easy politically in a region as diverse as Europe. Markets will likely continue to place pressure on political leaders until a series of policies are developed which helps to divert the crisis.

 

China

Chinese growth remains solid and their market has held up better in recent months. Nonetheless they did succeed in slowing economic growth over the past 18 months and inflation is under control. This provides them with some flexibility to stimulate the economy. The Chinese authorities have stated that they will not undertake another 2009 type stimulus package but nor should we have been expecting this. Rather further cuts to interest rates, a loosening of credit reserve requirements and further fiscal stimulus are likely and would boost sentiment towards resource stocks.

 

US

US economic growth has been the bright spot of the globe. While recent unemployment data has been disappointing, the economic growth in the US is largely being driven by internal investment and consumption which looks more sustainable than many economies. We do not see further quantitative easing as likely at this stage but should global sentiment drive softness in the US market then we could see further quantitative easing.

 

Australia

Australia has considerable fiscal and monetary flexibility compared to the rest of the world. We expect further interest rate cuts and expect the low A$ to provide support for the domestic economy.

 

Conclusion

We reiterate that it is hard to imagine that the market has not priced in a significant amount of the bad news and that for stocks to rally the news does not have to be that good, it just needs to be less bad. The markets remain nervous and are awaiting a policy response from the European Union.

 

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