We are again in the middle of a soft patch in US data with a growing expectation that weakness in Europe could follow. Slowing machinery exports from Japan also look like they could dampen the recovery there. Dollar funding concerns are back on the agenda as the Greek saga plays through another act, threatening contagion via the banking system.
In Trichet’s words, the link between debt problems and banks ‘is the most serious threat to financial stability.’
Bank commitment
Again the market is questioning central banks’ commitment as QE2 comes to an end and, on top of all this, there are heightened fears of a hard landing in China. While the weather in Europe has done its best to disguise the fact we are again approaching summer holidays in the northern hemisphere and the likelihood is that risk positions are reduced to make way for summer on the beach.
The net result has been weakness in risk assets, including a sell-off in commodity prices.
So what should we make of all of this? Is it prescient of an impending market meltdown or just another scare along the way?
As we move into holiday mode in the northern hemisphere with this profusion of risks weighing on the market, in the immediate term asset prices are likely to move sideways or downwards. But just as was the case last year markets are likely to rally come autumn.
Overly concerned
On balance we feel that concerns about an aggressive deceleration in global activity – the key overhang for risk appetite – are overdone. There is clearly something of an inventory adjustment in train and the market has still not fully adjusted to a world where developed world growth will be at best moderate and employment weak. But an end to the recovery in the US and elsewhere in the developed world still looks a lot less likely than continued low to moderate growth.
Moreover, just as was the case last summer there is an important backstop. Last week’s Federal Open Market Committee statement made clear that the Fed is committed to maintaining the size of its balance sheet and stands ready to step in with additional extraordinary measures if things really do start to go pear-shaped, including the purchase of more Treasury securities.
This commitment as well as ongoing extraordinary measures from the Bank of Japan reinforces our conclusion that global liquidity will remain flush – even without additional asset purchases from the Fed – and policy rates are likely to stay very low (and negative in real terms) for a long time to come.
Emerging strength
This combination should eventually, we believe, prove to be positive for key risk assets in the emerging world where, in contrast to the developed world, we generally remain upbeat about growth prospects.
Having corrected from highs earlier in the year, on many standard valuation metrics, emerging markets equities also now offer value – the Shanghai Composite, for example, has fallen by getting on for 10% from this year’s mid-April high on concern that higher interest rates will curb growth and depress corporate earnings.
In fact, the BRIC markets are all now trading cheap to their five-year average valuations (Brazil is trading on 9.5x 2011 earnings compared to a five-year average of 10.1x; China is on 10.7x vs. 13.5x; India 14.5x vs. 16.1x and Russia just 5.9x vs. 8.2x.)
