FYI | Mar 15 2012
By Andrew Nelson
Australian, US and even European share markets are up and running so far this year, with emerging markets posting even bigger gains. With the best January for global markets since 2006 now well behind us, the question is: what is the likely sustainability of this increasingly positive environment?
Risk appetite is returning to the markets, triggered by improving economic data coming out of the United States and an increasing level of optimism from Europe. News that European Central Bank is willing to provide virtually unlimited three-year funding to banks has, at least for now, removed the European debt crisis from the forefront of investor’s minds.
Russell Investment Management notes the ECB’s supply of nearly half a trillion euros in bank funding, with more to follow if needed, has at best ended and at worst forestalled, the risk of a Lehman Brothers type of bank collapse.
With European policy seemingly resolved to do whatever it takes to hold the euro area together, funding is now far more secure. This means banks are now better able to roll-over their holdings of sovereign bonds, which is pushing down bond yields for stressed issuers like Italy, Spain and Ireland. Europe’s problems are far from solved, but the probability of a deeper near-term crisis has is far less than had been feared.
Most certainly helping matters in an increasingly positive outlook for US economic conditions, with manufacturing reads posting steady, if not stellar gains, while housing construction numbers are also continuing to improve. Russell’s US chief economist, Mike Dueker, is expecting the US to post 2.5% GDP growth this year, with average non-farm payrolls gains of about 165,000 per month.
China, at least so far, isn’t turning into the horror story many were glumly predicting at the start of the year. Sure, the economy is slowing, but it is definitely not collapsing. The government’s plan to build 35m affordable new homes over the next 3 years is ramping up and the team from Russell thinks this will help offset much of the weakness in the private development housing sector. Thus, a hard landing for China (and the rest of us by extension) seems unlikely.
Another factor helping to push markets higher is that shares the world over are looking pretty cheap right now. This is providing ample room for upward re-rating, although the team notes that it’s still too early to get carried away with the optimism.
A thing to bear in mind, notes Russell’s, is that the profit cycle is maturing. This means margins are high, thus EPS growth is slowing. Looking forward, the team thinks that market gains will increasingly rely on higher P/E ratios, rather than higher earnings.
The recent run of US economic outperformance has generated an increasingly optimistic level of consensus opinion. While this is providing much of the current impetus, it also makes it more likely that data will eventually begin to disappoint.
While Europe isn’t looking like it may fall apart any minute, a Greek default is still a good possibility and austerity measures, which were great for improving confidence in Europe, are the opposite of what is needed to deliver actual growth.
This is a big problem; given growth is the only thing that can bring debt levels back under control. The team at Russell predicts that solvency issues are likely to be back on the screens again later in the year if countries like Spain and Italy remain locked into a seemingly never ending recession.
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