Short Term Solutions – Long Term Problems

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  • US still risks default and downgrade
  • Euro zone buys time
  • Few drivers of growth surprises- major economies still struggle
  • Equities are likely to see selling pressure
  • A positive- expect a fall in inflation even if commodity prices stay
  • Emerging Markets bonds to do well

Pass me the sticking plaster. Both the Euro zone and the United States are in the throes of providing short-term solutions to long-term problems, just about holding things together. To be fair, both have managed to buy time, however the problems are still far from solved. In the case of Greece the Euro zone has provided €159 billion of support to allow Greece to remain solvent. As we go to press the US politicians are still prevaricating about a deal but surely they will have to produce something otherwise parts of US government start to shut down and a technical default would be called by the rating agencies. Across the US and the Euro zone all I see is more debt, just spread around a few more countries and a series of fixes whilst the politicians work out a plan for sustained debt reduction across the western world. All hope is not lost. In our search for positives we found one thing – lower inflation. Over the next six months even if commodity prices stay at these uncomfortable levels inflation will fall back sharply in many parts of the world. All we have to do is get through the next six months.

The Euro zone government’s provided the world with its new grand plan to hold the Euro zone together and by the skin of their teeth they have lived to fight another day. Greece has the support it needs to see through a few more quarters and newly empowered European Financial Stability Facility (EFSF) is mandated to support Portugal and Ireland should they encounter further problems. The solutions announced by Euro zone finance ministers provides some near term help to the financial markets but have left many skeptical as to whether it provides the long-term solution. The long-term solution for the survival of the Euro zone in its current form is for the other Euro zone countries to assume the debt of Greece Portugal and Ireland.

Such political convergence is probably a step too far for Union at the moment. In essence the debts of Greece have been extended- revised- improved with a strong whiff of default. The Greek economy is being provided with €15 billion of new structural investment to be disbursed over the next two years. Bear in mind that the Greeks previously squandered their convergence monies back in the 1990’s as they approached entry into the Euro zone. For Greece not to provide further problems for the markets, requires a monumental adjustment in the economy and an (unrealistic to our mind) assumption about the sale of Greek assets. The required reduction of government spending is a massive eight percentage points of GDP over the next three years.

The US politicians have also taken their prevarication all the way to the wire as they negotiate an agreement over raising the debt ceiling. It will not be lost on investors that the US politicians raised a considerable risk of the US going into technical default. The biggest debtor in the world should not be treating investors in this manner. Indeed the rating agencies may still decide to downgrade US debt to AA from AAA given the mess of negotiation of recent months.

Our fundamental concern for the global economy and the financial markets remains the lack of growth. Economists from all parts continue to cut their GDP growth forecasts, whether it is for China, Europe or the United States. In Europe the latest round of industrial confidence surveys were well below expectations. The European surveys of industrial confidence were particularly weak and probably reflected, at least in part, some of the political problems in the lead up to the recent deal over periphery country debt. The Euro zone PMI for July was reported at 50.4 from 52.0 in June, suggesting that the manufacturing sector is barely growing. Without growth a country may not be able to pay down your debt, if you can’t pay down your debt they you may ultimately have to default. Paying down debts also detracts from growth. In the case of the United States debt reduction by the federal government is expected to drag US GDP growth down by 1% point per annum by through the next two years. The old world of Europe and the United States still face a mountain of debt and insufficient growth.

With many governments burdened with high debts it will fall on the private sector to generate growth. However it is difficult to see what will drive the private sector to grow. Private sector industry needs customers that are willing to spend increasing amounts of money on goods and services. However both industrial and consumer confidence is low. Industry has strong profits and good cash flow but is unwilling to spend. Consumers still face a squeeze on their incomes from high inflation and are still concerned about their indebtedness.

Gold climbed to $1600 as the politicians were putting their final finishes to their plans for the US and Europe. We believe $1600 could be something of a barrier to further significant gains in the gold price given that the issues in the US and Euro zone may be ‘solved’ for the moment.

Again we reiterate that investors should retain their core holding of gold and not to be tempted out. For those investors that have taken on a trading position there is an argument for taking some profits.
We may find that the equity rally runs out of steam again in the absence of better near term news from the global economy. The US equity markets has been trapped in a trading range of 1250 to 1350 since February and we sense little appetite for a break out to the upside from current levels around 1340. US corporate profits results have generally beaten expectations.

On average profits have come in 4% ahead of expectations. However investors are more concerned that profits are being achieved without capital investment and employment growth and hence are unsustainable.

There are positives, at least on the medium term horizon. Sometimes it is better to lift your head and ignore the near term noise and look further into the future. Indeed sometimes it is easier to predict what will happen in the longer term than to guess at day-to-day movements.

One factor that is worth watching is inflation. A dip in inflation could be just the antidote to the recent debt problems. A significant driver of the current bout of global inflation comes from the substantial year-on-year increase in commodity prices. For example Brent oil has risen 43% and the corn price by 65% over the past year. By March/April 2012 assuming that commodity prices remain where they are today much of the first round effects commodity price induced inflation will have slipped back close to zero. We could have the prospect of a tumbling of inflation rates. Lower inflation will take the pressure off the emerging countries central banks to raise interest rates. Countries such as Turkey, Egypt, India that are heavy importers of energy in particular could be winners as and when inflation tumbles.

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