The past two months have proved to be very challenging for markets, with equities setting new lows for the year in early October. At the same time US and UK sovereign bonds have rallied, as has the USD, evidencing heightened risk aversion. Ongoing concerns regarding the Euro-zone sovereign debt crisis and the global macro outlook have been the primary drivers of this correction.
Latterly, risk assets have rallied off these lows, principally on optimism that Europe is drawing together a grand plan which will address both funding issues for the peripheral economies and recapitalise banks as required. European policymakers have set themselves a tight deadline of early November to have finalised these measures. Details of this plan, coupled with macro data in both developed and emerging markets, are likely to test the sustainability of this rally.
The plan being drawn up by Europe will seek to address three issues – Greek solvency, Bank recapitalisation, and the provision of liquidity for the bond markets of Spain, Italy and other states as necessary. Clearly all three issues are complex in nature, and finding a credible solution will be a challenge, as will execution.
In regard to the European Financial Stability Fund (EFSF), current indications are that its powers will be extended to allow it to act as a Sovereign bond insurer. Assuming a certain level of guarantees, this solution could potentially extend the effective firepower of this facility to €1trn. These guarantees would apply to new debt issued by these countries, and is aimed at helping the five countries meet their combined €1.4trn of financing requirements required over the next two years. The provision of such guarantees may impinge on the foreign rating of guarantor countries (particularly France).
For Banks, Europe will carry out another stress test, to incorporate higher tier-1 capital requirements and mark downs on sovereign debt holdings. Estimates for the amount of additional capital European banks require range from €150bn – €400bn. How this recapitalisation is achieved – either through private investors, national governments, asset sales or the EFSF – remains unresolved, and as such systemic risks remain elevated. Finally, private sector involvement on a write-down of Greek debt is expected to be renegotiated from the average 20% haircut agreed in July to an increased level of around 50%.
Collectively, there is clearly a lot to be achieved in a very short period of time and there are still many hurdles and unanswered questions at this stage. The uncertainty has already weighed on economic activity in the region, which is showing clear signs of slowing. This economic weakness has spread beyond Europe, with both the US and UK reporting weaker economic data in the past two-three months.
Policymakers have begun to respond, with the Federal Reserve announcing operation “Twist”, which is designed to reduce rates at the long end of the yield curve, and the Bank of England announcing additional quantitative easing measures. The European Central Bank has unveiled measures to provide liquidity to the banking sector, in order to facilitate efficient functioning of interbank lending markets. But investor confidence in the ability of developed market central banks to further aid economic growth is weakening as they have limited additional measures available to them in the event that economic conditions deteriorate significantly.
Emerging markets have not escaped unscathed, with emerging market equities continuing to underperform developed market equities in September. Export data, particularly in Asia, is indicating a slowing in external demand. In China, the economy grew 9.1% in the third quarter, below expectations of 9.2%, and posting the third consecutive quarter of lower GDP growth.
Unlike developed markets, emerging market countries can undertake fiscal and monetary easing to stimulate their economies in the event that growth deteriorates significantly. Despite this, it is unlikely that emerging markets will escape unscathed in the event that global economic growth weakens significantly.
In summary, given the uncertainties regarding the European plan and the likelihood of continued weakness in economic data we are retaining a cautious investment stance in the very near-term. Against this backdrop we expect equity markets to continue to exhibit heightened volatility, remaining choppy into the year end.
Rory Smith is a director at Signia Wealth.
