With Greece having passed its latest austerity package, thereby securing the latest round of financing from Europe and the IMF, there was optimism that a French-led plan to undertake voluntary restructuring of Greek debt, including participation by private investors, would be implemented.
This plan appears to have been shelved, on the basis that it would constitute a default as defined by the credit rating agencies. This has resulted in the timetable for developing and approving a second bailout package for Greece being pushed out further, at a time when the market was seeking a faster response. At the same time, both Portugal and Ireland have joined Greece in being downgraded to junk status.
Market opacity
Collectively, these rating action changes and opacity on a Greek solution have resulted in continued weak sentiment towards Europe in general, with the euro and peripheral European equity markets declining. Latterly, we have seen signs of contagion spreading to Italian and Spanish bond markets, a development which requires close monitoring given the larger size of these economies compared to those which have already been bailed out. In the absence of a cohesive and substantive policy response from the eurozone a continuation of these trends cannot be ruled out.
In emerging markets, we have continued to evidence that inflationary pressures remain elevated. In particular, Chinese inflation in June rose 6.4%, from 5.5% in May and higher than expectations of 6.2%, led by an unexpected pick up in food prices. The authorities had pre-empted this data point by raising interest rates by 0.25%.
It had been hoped that Chinese inflation had peaked in June, though expectations are now being pushed back suggesting that inflationary pressures may not weaken until the end of the third quarter, which raises the potential for additional and previously unexpected tightening.
Economic data in developed markets continues to warrant close attention. Encouragingly, forward-looking indicators of industrial activity (which had declined significantly in May) stabilised in June, signalling expansion going forward. Nonetheless, the one area of weakness remains the US employment market, with job creation remaining low and the number of unemployed ticking up to 9.2% of the labour force in June.
Cautious stance
Oil prices, which have remained high despite the release of strategic reserves by the International Energy Agency, will weigh on activity if they remain at elevated levels for a sustained period of time.
On the corporate front, the earnings season in the US will provide an insight into the sustainability of corporate margins, which remain at historic highs against a backdrop of rising input costs. Expectations are for earnings to have expanded by 14% in the second quarter year-on-year, compared to 17% in the first quarter. Matching, or exceeding these estimates, coupled with good guidance for the rest of 2011 would act as a positive catalyst for markets, particularly given that valuations are already low, balances sheets are healthy, and M&A activity remains robust.
In the absence of a resolution in Europe (which could still present systemic issues), continued inflationary pressures in emerging markets and uncertainty regarding the near-term outlook for the global economy we retain a cautious investment stance. We expect greater clarity on these issues in the coming weeks and months that will present opportunities to reposition into risk assets, but until then capital preservation remains of paramount importance.
