World: hit by a double whammy
The markets rapidly rotated to an aggressive 'risk off' position in August in response to a double whammy of concerns – the display of alarmingly dysfunctional political leadership on either side of the Atlantic, together with mounting concerns over the fragility of the US economy. Consequently, global equities contracted 13% in rapid order, Gold moved from $1628 to just shy of $1900 and US and UK bond yields approached all time lows.
While it is tempting to treat the sell off as an attractive entry point we need to acknowledge that the decline in the bond yields is posing major questions over the trajectory of growth, and therefore returns, expected from equities. The connectivity between nominal bond yields and nominal gross domestic product (GDP) growth suggests we have entered the stage of the cycle when operating leverage (the impact that a shift in revenue growth has on earnings) turns negative. Consequently a health warning needs to be attached to what appear to be apparently low market valuations – 2012 EPS forecasts look set to ratchet lower.
As in 2009 and 2010, policy initiatives and macro factors, not valuations, will be the catalysts for a recovery in equities. Much attention is therefore focused on whether Federal Reserve chairman Ben Bernanke can rally the market and sentiment. Unfortunately, he is more constrained in his policy options compared to last year. Therefore a 2010 redux is unlikely. The other policy response that would have a major market impact would be a signal of co-ordinated action in the eurozone (particularly a German acceptance of a move towards fiscal union and the establishment of eurozone bonds). This feels like hope rather than expectation. Until we get clarification on the status of the US economy and the eurozone debt crisis, markets are likely to remain volatile.
UK: QE2 on the radar screen
The UK economy is losing momentum. Consumption expenditure remains extremely fragile and is unlikely to rebound sharply. It has been impacted by sustained erosion in real disposable income and a deteriorating labour market. The housing market remains moribund. Net exports have failed to accelerate and with government expenditure contracting, corporate capital expenditure is the only visible source of growth stimulus. Growth projections of 1.7% (2011) and 2.5% (2012) are now looking optimistic. The chancellor has acknowledged that the recovery will be "longer and harder" than expected. It also poses questions over the sustainability of the austerity programme. UK gilt yields have hit their lowest level since the 19th century.
The August Monetary Policy Committee (MPC) minutes reflected mounting concern over the economy – no member voted for a rate hike. There was also consideration of whether there was a case for extending quantitative easing (QE) – a clear signal that further QE is on the radar screen and will be deployed if downside risks materialise.
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