In Further Stimulus We Trust

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By Rudi Filapek-Vandyck, Editor FNArena

This won't come as a surprise to anyone, but Europe is increasingly causing headaches and worries to economists and investment strategists the world around. Not necessarily because of Greece's political instability or because of rising yields on Italian government bonds, though that's a genuine worry too, but because of leading economic indicators pointing towards economic recession. As we all know, any struggle with too much debt can easily become something much more sinister if this struggle happens against a background of negative economic growth.

The latest round of global purchasing managers surveys the world around didn't exactly offer much to cheer about when viewed within this context. With indices and forward looking order books for service industries in Scandinavia, France, Italy and Spain diving firmly into contraction (below 50) in October it would appear the real bad news regarding Europe has yet to hit the news wires. No wonder some observers at the G20 meeting in Cannes last weekend reported it almost seemed like German chancellor Angela Merkel had given up on a quick and definitive solution to Europe's sovereign debt problems, instead resigning in the idea that, no matter what can be decided in the short term, the present uncertainties are going to remain with us for a while longer.

What will happen if France cannot maintain its AAA credit rating? Is Italy genuinely too big to rescue? How much longer can Greece cope with the imposed austerity measures?

Behind these ominous looking questions lies a general resignation it already is too late to prevent a recession in Europe. The main matter of debate is merely for how long, and how deep will the economic contraction be? Note that all available Euro area country-level activity PMIs have trended down of late, though not all to the same extent.

And then there is, of course, the $64 million question: how badly will a recession in Europe affect the rest of the world?

While the latter question is still very much up in the air, the October round of manufacturing and non-manufacturing surveys around the world have brought home a few truths about the current state of affairs in the final quarter of 2011:

– growth in all developed economies remains sub-trend and vulnerable to shocks of any kind
– despite improvement in the employment component, the US ISM fell to its lowest level since January 2010
– the new orders component in the US ISM survey tumbled, suggesting the outlook remains weak
– Euro area services activity PMI is now more than 10pts below the March cyclical high, though Germany's appears to have stabilised above 50
– Emerging countries including China, Brazil and Russia are showing mild improvements, but not India (where deterioration is looking ominous)
– if it wasn't for a big improvement in Japan, the global All-Industry PMI as compiled by JP Morgan might have contracted in October
– JP Morgan suggests the October All-Industry PMI corresponds with no more than 1.6% global GDP growth this quarter, which is below market expectations

In other words: if investors were worried about global contagion from Europe, it's probably too late for that. While none of the above suggests we are 100% certain going to relive the experience of late 2008, it should be clear by now there won't be much to cheer about in economic terms in the immediate future. Which is why part of the investment community has started to look forward to the next round of stimuli by governments and central bankers. Will the Federal Reserve go beyond its present Operation Twist? A growing number of experts in the US certainly seems to think so.

Note that Prime Minister Julia Gillard has promised the G20 she will launch another domestic fiscal stimulus program if indeed the European crisis impacts on global growth and that the International Monetary Fund (IMF) at the same time urged more stimulus from financially strong countries if indeed the situation in Europe worsens. Let's face it, this is now all but assured.

What about China?

Well, for starters, China is part of the select group of "financially strong countries", together with Brazil, Indonesia, Korea, Canada and Australia, but even apart from this, experts are increasingly expecting Beijing to re-open the stimulus gates soon. Last week, China watchers at ANZ Bank issued a report that carried the title "China: An Outright Policy Easing Is Imminent". ANZ is not just expecting a mild policy switch, the economists are predicting a 50bp cut to the reserve requirement ratio (RRR) for all banks, plus a possible 100bp cut in RRR for small banks on top of current measures to lower the tax and regulatory burdens on small and medium-sized enterprises.

Part of the motivation for such policy change comes from the Europe fall-out, but ANZ also sees plenty of triggers domestically. Chinese property markets are likely in for a serious slump while small and medium-sized enterprises are getting squeezed on all fronts from the government's tightening policy. Add continuously slowing growth and increasing weakness for Chinese exports and it is not difficult to see why ANZ Bank is predicting a swift change in China's monetary policy. All the while, China's inflation threat has subsided which effectively allows for a looser policy, similar to what happened in Australia this month (RBA rate cut on Melbourne Cup Day).

ANZ Bank also believes the official October manufacturing PMI survey for China is a precursor to further negative news, with both new orders and new export orders falling significantly, suggesting the downside risk in China’s manufacturing activities will increase "substantially" in the coming months.

Also, notes ANZ Bank, Chinese banks' preferred collateral is land and property so if property prices decline, banks are forced to increase their provisions, which effectively leads to a second round of credit contraction. Not to mention that in China local governments rely on land sale revenues to finance the debt of local government financial platforms, so any shortfall in land prices raises concerns on debt sustainability.

This is probably also why economists outside Australia increasingly see the rate cut delivered by the RBA last week as but the first of more to come, even as local economists are not so sure.

Judging by BA-Merrill Lynch's latest update on the prospects for the Australian share market, new stimuli for the global economy may well be necessary to move the local share market out of its present trading range. BA-ML market strategist Tim Rocks believes the way things are shaping up earnings growth for Australian companies appears poised to end up in negative territory this fiscal year. This not only confirms there will be continued cuts to forecasts and, as noted last week, the average EPS improvement for FY12 has already fallen to single digit prospective growth this year, it also indicates the local share market is merely fairly valued instead of great value, argues Rocks.

His analysis suggests true bargains are only to be found amongst those industrial stocks that nobody wants to own and that therefore trade at significant discounts, such as Fairfax ((FXJ)), APN News & Media ((APN)) and Woolworths ((WOW)).

Note also that Rocks is highly critical (as are others) as to whether further RBA cuts will benefit discretionary retailers as they have done in the past. Investors might want to take this into account before jumping on shares in David Jones ((DJS)), which have risen a lot since September and are now trading no less than 12% above consensus price target. Not that Myer ((MYR)) shares are necessarily much better value with the shares putting in a rally in October which has now taken them in the vicinity of FNArena's consensus price target.

One asset that is poised to benefit from a new round of stimulus is gold. No surprise thus, the price of gold is on the rise again, with technical market analysts at Barclays reporting to their clientele on Monday, they anticipate a break above technical resistance at US$1775/oz which would shift the market's focus to near US$1840/oz. Precious metals analysts at Deutsche Bank have already started talking US$2000/oz for the near future.

Analysts the world around are increasingly turning positive on prospects for Chinese equities. Recent history shows, or so the saying goes, that China leads global equities by up to three months…

(This story was written on Monday, 7th November, 2011. It was sent out in the form of an email to paying subscribers on that day).

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