Overview

Nothing sharpens the mind more than a reality check. The extraordinary period of low volatility on investment markets since July 2012 has created a false dawn. Very low interest rates and unconventional monetary policies such as quantitative easing have created liquidity that has seen asset prices rise. House prices that plummeted in a number of developed countries in the aftermath of the GFC have either largely recovered or are at new highs. Sharemarkets too have enjoyed an inexorable rise as investors seek riskier assets in an attempt to generate a higher return than the pittance offered for cash. Little wonder that investor confidence has returned.

Yet it is not a time to be complacent. Despite what many people think, the GFC was not caused by defaults on subprime loans and associated derivatives. This was merely a symptom of the underlying problem. The root cause of the GFC was an excess accumulation of debt by households and businesses alike. Debt levels simply became unsustainable and as interest rates rose, defaults sky rocketed and losses cascaded through the financial system, with catastrophic consequences.

The bailout of banks too big to fail simply shifted the debt from the private sector to the government sector, many of which were already overburdened with debt due to a failure to initiate appropriate reforms (e.g. labour, tax and industry reforms aimed at improving competitiveness; removal of unfunded pension schemes that unduly burden public finances). Almost six years have passed since the depths of the GFC but the fundamental problem of too much debt remains ever present today.

Europe remains the prime case in point. Growth remains anaemic, propped up largely by Germany, with a number of economies in the region still contracting. Industrial production remains over 10% below its pre-recession peak and unemployment remains stubbornly high at a touch under 12% despite unprecedented monetary and fiscal policy initiatives.

While budget deficits have narrowed a little, the succession of deficits have only added to total government debt. Investors seem oblivious to this fact, with demand for higher returning government debt driving down bond yields in even the highest risk countries like Greece, Spain and Portugal, in some cases to pre-crisis levels.

Those who advocate that normality has returned use the example of government bonds to prove their point that risks have receded. Bond yields have only receded due to extraordinary monetary policy intervention where central banks have been buyers of government debt and private investors have followed suit, desperate for yield, despite the risks.

It is true that monetary policy measures have helped to provide liquidity and reduce interest rates, but they have not helped to reduce the debt burden. In effect all they have done is buy more time to try and fix the underlying problems.

Europe is already straining under austerity fatigue. While some reforms have been undertaken to improve government finances, much more needs to be done. Politicians that have tried to do the right thing have largely been ostracised by the populace. To appease the masses, the status quo has largely been maintained, which means that little has really been achieved to make government finances sustainable.

With governments and central banks running out of policy options, and household credit growth still contracting, Europe remains reliant on export led growth, particularly from Germany.

This reliance is looking increasingly fragile as Europe's second largest trading partner, China, is vulnerable to a potentially significant slowdown of its own, courtesy of the credit fuelled over-investment in residential housing and infrastructure.

Investor enthusiasm seems unduly predicated on interest rates staying low, allowing troubled borrowers to refinance their way out of trouble. But the reality is that growth in Europe remains tenuous at best and the risk of another recession cannot be discounted which would inevitably trigger more bad debts and put further pressure on both the troubled banking sector and the exposed sovereigns .

Ignore these risks at your peril.

United States

Economic Snapshot Last Reported Result Comments
Growth (GDP) -2.9% Mar'14 annualised The March quarter contraction was well below expectations. GDP fell due to a slowdown in inventory accumulation (probably from prior period overstocking), and extreme winter weather in many states that deterred shoppers and deferred some construction work. Net trade also provided a modest drag on growth.
Unemployment 6.30% May'14
7.50% May'13		 The unemployment rate has continued to improve. Over the last 12 months non-farm payroll growth has averaged 197,000 per month.
Industrial Production 4.3% y/y May'14
1.1% q/q		 Output rose 0.6% in May having declined 0.3% in April.
ISM Manufacturing PMI 55.4 May'14
54.9 Apr'14		 PMI has averaged 54.9 over the last 12 months. The manufacturing sector expanded in May for the twelfth consecutive month. Of the 18 manufacturing industries, 17 reported growth in May.
Retail Sales 4.3% y/y May'14
0.4%m/m		 Retail sales are up 2% on the March quarter, the strongest gain since March 2011.
Credit Growth 10.2% May'14 Annualised Consumer credit grew at the fastest pace since July 2011.
Outlook The contraction in growth in the March quarter is likely to have been transitory, adversely impacted by extreme winter weather. Macro data since then has been broadly consistent with an acceleration in growth. PMI data shows that new orders and employment are growing at the fastest rate since the recession. Admittedly, some of the growth is likely to be a rebound effect from the very poor March quarter. Importantly, household balance sheets are in much better shape, providing a stable base for growth.

Eurozone

Economic Snapshot Last Reported Result Comments
Growth (GDP) 0.9% y/y Mar'13
0.2% q/q		 Germany and the United Kingdom grew by 0.8% in the March quarter. France was flat while Italy recorded a nominal fall.
Unemployment 11.7% Apr'14
12.0% Apr'13		 The rate has barely moved since peaking at 12% last year.
Industrial Production 1.4% y/y Apr'14
0.8% m/m		 Industrial production growth remains anaemic and still well below pre-crisis levels.
Manufacturing PMI 53.5 May'14
53.4 Apr'14		 The advance PMI for June of 52.8 indicates that the rate of growth in output and new orders is beginning to slow.
Retail Sales 2.4% y/y Apr'14
0.4%m/m		 Trend remains positive.
Credit Growth -2.2% y/y Apr'14 Credit still contracting as household and business balance sheet repair continues
Outlook We expect growth to remain positive but very weak in outright terms over the next twelve months.

China

Economic Snapshot Last Reported Result Comments
Growth (GDP) 7.4% y/y Mar'14
1.4% q/q		 Lower than in recent years but still high in outright terms and stabilising.
Unemployment 4.1% Mar'14 Stable. Rate has moved once in two years.
Manufacturing PMI 50.8 Jun'14
49.4 May'14		 The PMI survey points to a modest expansion in activity.
Retail Sales 12.5% y/y May'14
1.1% m/m		 Trend has improved in recent months.
Fixed Asset Investment 17.2% y/y May'14 Rate of growth lower than previous periods but still high.
Outlook In recent months China has enacted more stimulus measures to prevent a slowdown. In the short term this should assist in maintaining growth at or near the 7.5% target. Nevertheless the enormous amount of debt that has been used to fuel over-investment in infrastructure and residential property since mid-2008 has the potential to translate into significant business, and possibly bank failures, that could comprise the financial system. The risk of a hard landing cannot be ignored unless the Government can orchestrate a credible policy response.

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