Weekly economic review by Gary Dugan
- US economic data shows ongoing weakness
- Good news- signs that inflation could be peaking
- High dividend paying companies offer some investment opportunity
- Eurozone ugly and unresolved
Investors continue to have to cope with a drip feed of negative news from around the world. The good news is that some of the bad news may start to abate. Inflation should start to fall back and Japanese growth should start to rebound. However some of the structural challenges remain a serious drag on sentiment. The Greek situation in particular remains unresolved with the credit rating agency Fitch downgrading the sovereign debt to junk status last week. Emirates NBD maintains cautious view on risk markets. Much of the global economic data is confirming the slow-down in growth. Global industrial production growth is in the midst of a slowdown from a quarter-on-quarter growth of 9% in February to a pace of just 2% in recent months. Last week there was some notably weak US economic data. Housing starts fell 10.6% month-on-month – the housing market shows few signs of a sustained recovery. Also the Empire survey of industrial confidence in the New York area fell twice as much as the market had expected. Emitares NBD remains somewhat concerned that the slower pace of economic growth is not reflected in the analysts’ corporate profit forecasts. The equity markets could face the headwind of modest downgrades to analysts’ profit forecasts through to the end of June.
Commodity prices have stabilized after recent weakness with some prices showing renewed strength. The fundamental imbalance between demand and supply and the vagaries of the weather continue to provide most of the surprises to the upside. Low inventories and surprisingly low rainfall in the mid west of the United States and in Europe have led to sharp spikes in the prices of wheat and corn. Both prices look like they could have further upside despite the recent large price rises. In the oil market the IEA (International Energy Agency) mentioned that they may move to release some strategic stocks in order to cap the rise in prices. JPMorgan research pointed out that the last time the IEA released stocks it led to a 20% fall in the oil price. Still strong demand for oil and the seeming limitations of OPEC to increase oil supply any weakness in oil is likely to lead to companies buying to rebuild inventories. For investors, any setback in oil prices is a buying opportunity.
The stabilization of commodity prices brings the possibility of better news for the financial markets from a dip in inflation. The rapid rise in inflation has forced many central banks to raise interest rates at a far faster pace than the markets previously envisaged. One of the drivers of the rise in global inflation has been the rise in commodity prices. If commodity price maintain at least some of their recent weakness the level of inflation may fall back, reducing the pressure for further monetary tightening. Indeed in coming weeks we may see some economists starting to reduce their forecasts for inflation for May and June. The opposing argument is that the inflation genie is already out of the bottle. Core inflation (something that the central banks worry more about) has risen more than many had expected. Last week the report for Eurozone core inflation, which excludes the most volatile items, accelerated more than expected to 1.6% year-on-year from 1.3% year-on-year in the previous month. Inflation is also becoming more ingrained in the system, it is not just cyclical. I spent some time in Asia last week and much of the news in the press was about the rise in prices for many goods and services. In Hong Kong for example, the authorities increased the minimum wage pushing the price of many goods and services higher. The minimum wage was raised because the basic products that low-income people have to buy have gone up in price. Rises in wage costs tend to unleash a further round of price increases until the whole thing becomes circular and damaging to the economy.
One strategy that Emirates NBD favours in equities at present is to focus on companies that are paying increasing dividends. In the financial crisis, in an unprecedented move, many companies cut dividends to preserve cash. However as the crisis has passed and the balance sheets of many companies have improved, many companies are willing to increase their dividends again. At a time when companies remain cautious about expanding their businesses- employment growth remains weak around the developed world, we expect more cash to be returned to shareholders through dividend increases and share buybacks. Those companies that return cash to shareholders should see good absolute performance.
The problems in the Eurozone continue to haunt the markets. The downgrade of the Greek sovereign debt rating to junk status by the credit rating agency Fitch sent Greek bond yields spiraling higher and bond prices lower. Greek government 10 year bonds now yield 16.2%. Also the problems for the Eurozone were compounded last weekend by the results of Spanish regional elections and street protests leading up to the elections. The incumbent Socialist government suffered its worst defeat in 30 years. In essence the voting population has registered its protest at the state of the economy but to be quite frank there are few alternative policies available to the current government. The financial markets want a reduction of government spending and a cut in government debt. The electorate wants economic growth and a marked fall in the rate of unemployment from the current rate of over 20%. The constraints on government are incompatible with a meaningful fall in unemployment. The Spanish situation remains a risk to global financial markets.