Back and forth

Back and forth
04/07/12 @ 07:07 GMT by Michael Derks, Chief Strategist

Those fresh policy initiatives which emerged from last Friday’s EU Summit continue to be debated ad nauseam amongst European policy officials. After both Finland and the Netherlands threatened to vote against the proposal to allow the rescue funds to purchase troubled sovereigns in the secondary market, EU President Van Rompuy countered by claiming that individual states cannot block the plan unless more than 15% of the eurogroup vote it down. Apparently Angela Merkel and Mario Monti are due to meet in Rome later today to discuss the finer points coming out of the EU Summit. Separately, French politicians were left agape following the fiscal findings of the National Audit Court, while Italian PM Monti sought to exhort his fiscal credentials by claiming that he expected spending cuts for 2012 to be much greater than EUR 4.2bln. Meanwhile, the single currency remains perched at the 1.26 level. Traders are still short the euro, and so in the absence of any further adverse Europe headlines there is still plenty of potential for more short-covering as trading books reduce risk through the traditionally slow summer months.

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Commentary

BoE decision should be unanimous. Yesterday’s economic news was a real clincher in terms of ensuring that the MPC will increase its asset-purchase program by at least GBP 50bln when it meets tomorrow. The construction PMI fell below 50 last month to the lowest reading since late 2009; no doubt the damp weather weighed on this outcome, but at the same time it is consistent with most recent indicators suggesting that the economy is still really struggling. Separately, the demand for finance by households and businesses remains very weak, with M4 money supply falling by 4.1% in the year ended May. Overnight, shop price inflation fell to just 1.1% last month, according to the BRC, the lowest since late 2009. These figures had virtually no impact on sterling, although volumes are extremely thin and traders remain generally reluctant to take on risk as we head into the traditional summer trading hiatus.

Mixed messages from China. Noticeable recently have been determined attempts by Chinese policy officials to talk up the economy. One oft-repeated mantra emerging from Beijing is that the economy started to turn the corner last month in response to some of the stimulatory measures adopted previously. Thus far, the evidence to back up this claim is decidedly mixed. A gauge of non-manufacturing produced by the National Bureau of Statistics and the China Federation of Logistics and Purchasing registered a 3mth high in June, although the various PMI surveys for the manufacturing sector released over recent days suggest activity remains quite subdued. Moreover, lending by China’s four major banks fell sharply last month, by almost 25%! Notwithstanding the official rhetoric, our sense is that China will continue to press ahead with additional measures to ease both financial conditions and the stance of monetary policy in the months ahead. At a local level, policy officials have been prepared to relax property controls, with Beijing content to look away in most instances. These measures have included home subsidies and discounted mortgages for first-home buyers in some major cities. While officially still determined to prevent house prices from rising, the central government is also keen to prevent property prices from falling too quickly in some areas. With an increasing number of the larger developers experiencing financial difficulties, new construction is still declining in many areas. As we have been arguing recently, there is still plenty of potential for China to ease monetary policy in the next few months, including lower interest rates and some further reductions in bank reserve requirements.

Risk avoidance still extreme. Given the myriad financial issues plaguing Europe over the past couple of years, it is no surprise that investors have been particularly reluctant to take on risk. With America now clearly being dragged down by Europe’s problems, and China and other parts of Asia also adversely affected, this caution has been justified to some extent. During May, when most investors and traders feared the worst, the MSCI World Free index of global equities dropped by 8.5% and the Aussie dollar fell by almost 7%. Interestingly, although both equities and risk currencies such as the Aussie have since retraced around 70% of the ground they lost in May, investor trepidation remains extreme. One survey conducted by the American Association of Individual Investors shows that 44% of respondents believe US equities will decline over the second half of this year. This is a very elevated reading, and moreover it has been well above average for the past two months. Not surprisingly, this survey has a very good track record as a contrarian indicator. For example, back in early March 2009, the pessimism reading for this survey was at a historical high of more than 70%. Should European leaders show more willing, as they did last Friday at the EU Summit in Brussels, then investors right around the world might progressively shed their defensive instincts. Risk assets and currencies such as the Aussie and the euro would be expected to benefit.