Commentary: The 7% Solution
Wednesday, 30th November brought a multiple liquidity shot in the arm for markets. As well as co-ordinated action by six central banks to cut the cost of US dollar funding by 50bps, the Peoples’ Bank of China reduced its Reserve Requirement Ratio for domestic banks by 50bps to 20%, and Brazil’s central bank cut the benchmark Selic rate by 50bps to 11%.
The headline effect of this liquidity jolt was a positive week for global equity markets, with the MSCI ACWI in sterling climbing 7.4%, as Australia, Brazil, Korea, as well as France, Germany, Ireland, and Italy, all posted double digit weekly gains in sterling terms. Commodities surged. Oil (Brent crude) was up 3%; gold was up over 3%; and copper gained just shy of 10%. Bond yields, particularly in the stressed parts of Europe, fell over the week. For instance while the ten year US Treasury eased 7bps, the French OAT dropped 46bps and the Italian ten year yield was off 58bps.
The central bank action on the US dollar swap rate immediately cut the cost of dollar borrowing for European banks from a three year high, amidst rumours that funding strains had reached breaking point for some major players, but they also created bilateral agreements to allow borrowing in other currencies and extended the swap lines to February 2013. This move appears to be short term fire fighting while policy makers in Europe continue to work on a longer term solution for the Eurozone.
By contrast the actions in China and Brazil are more to do with the tipping point from policy concerns about overheating in these now powerful economies, to concerns about slowing growth. Brazil cut borrowing costs for the third policy meeting in a row, and the PBoC cut the RRR for the first time since December 2008. Chinese data has been poor for a few weeks, and November’s official PMI at 49.0% and the flash HSBC/Markit PMI at 47.7% indicate the impact of slowing external demand on Chinese manufacturing.
Normally the start of a rate cutting cycle would be unequivocally good for equity markets, and that was the Pavlovian response last week, but there are important caveats that muddy the waters. Firstly in China, as a Fitch report highlights, the release of additional lending capacity created by the RRR cut may be mitigated by the lingering overhang of poor loans and the need to sure up bank balance sheets. Secondly, although the raft of central bank meetings this week, particularly the ECB on December 8th, may see further policy loosening, there is clearly going to be a fiscal drag in much of Europe as austerity measures are enacted.
Mario Monti announced the new budget package yesterday (Sunday) and is presenting it to parliament today. It includes a forecast of a 0.5% GDP decline for next year and no growth for the year after, which both appear optimistic. Austerity measures are already being enacted elsewhere, and more will surely follow. Particularly as the “solution” which will be discussed at this weekend’s Euro summit is a fresh Treaty and much tighter fiscal union with penalties for individual nation members which miss deficit targets.
Germany, in the form of chancellor Merkel and the Bundesbank, appear intractable in their requirement that fiscal arrangements must be agreed before relief measures can be discussed and implemented. This week’s summit may well be a seminal moment that history marks as the birth of a tighter, tougher and more resilient European currency union, ten years after Euro notes were first happily and naively issued. However the shorter term cost of the past year’s shilly shallying and the next year’s implementation could be a nasty global recession which rate cuts fail to ward off.
The US equity markets had a punchy week in dollar terms, slightly more muted in sterling, but according to ISI the US has now had nine straight weeks of stronger economic data, and they now forecast fourth quarter US GDP at 3%. Last week’s employment data showed the unemployment rate dropping from 10.15 to 8.6%, and the manufacturing PMI came in at 52.7%, comfortably in positive territory.
Absent a spectacular December, equity markets are set for a poor year in 2011. The MSCI ACWI is down 8.5% (sterling, total return), and emerging markets, much touted twelve months ago, are down 16.5%. There has been a lack of breadth in markets, as evidenced by the equally weighted global index underperforming the cap weighted one.
As a final thought, this week sees the funeral of Jim Cox. Jim was a legendary fund manager and a memorable man. His ability and example shaped the professional and investment philosophies of a generation of fund managers who grew up together at Schroders in the 1980s and 1990s. We all owe him a debt of gratitude.
Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton