Double dose of good news lifts equities
Amidst the euphoria, time for a few words of caution
Global equity markets jumped sharply yesterday, boosted by two pieces of good news. The first was the announcement by Eurozone leaders of a package involving an enlarged €130bn bailout for Greece, an “expansion” of the European Financial Stability Facility (EFSF) and bank recapitalisations. But it was the second piece of news, of a stronger than expected (by the market anyway) US economic growth in the third quarter (2.5% at annualised rates), that ensured the rally continued on Wall Street. Whilst this is all encouraging stuff, and helpful to our view that equity markets were cheap and massively oversold at the end of September, a few words of caution are now called for.
Starting with the US, the acceleration in growth certainly, on the surface, looks impressive given the dismal performance in the previous two quarters (1.3% in Q2 and only 0.4% in Q1). What’s more, with companies cutting back on their rate of inventory accumulation (slicing a full percentage point off the headline growth figure), if anything, this understates the economy’s underlying strength. Thus, final domestic sales (the sum of consumer spending, fixed investment spending and government consumption) jumped by an annualised 3.4%, the strongest since the second quarter of 2010 and broadly in line with the economy’s long run trend. However, although within this consumer spending increased by an annualised 2.4%, a key factor behind the acceleration was a near 20% annualised increase in non-residential fixed investment spending, which added 1.6 percentage points to the headline growth figure. Whilst this too is something to be welcomed, the concern is, as regular readers of our research will recognise, that much of this could simply reflect companies bringing forward spending plans from early 2012 in order to take advantage of 100% first year capital allowances that are due to expire at the end of this year. If so, and as we have been arguing, we should also expect a decent outturn for the fourth quarter. But what it also means is that growth will be commensurately weaker, possibly close to zero, in early 2012.
The good news is that the stronger growth performance in Q3 of course also ties in with the boost provided to the quantity of money (defined primarily as bank deposits) by the Federal Reserve’s asset purchase programme (QE2), which helped drive up the three month annualised rate of growth in our M3 proxy measure of broad money to 9.0% earlier in the summer. Admittedly the narrower M2 measure has continued to accelerate, reaching 22.9% in September (more than three times the long run average), but with institutional money funds and time deposits above $100,000 (both of which are excluded from the M2 measure) slumping by 24.8% and 39.4% respectively, the annualised growth in our M3 proxy has slipped to a much more modest 4.6% in the latest three months. This is still comparatively buoyant compared with the last few years, but with QE having ended the worry is that it will now slip back again. That said, there have been signs of a revival in bank lending in recent months, led by commercial and industrial loans which have increased by an annualised 12.2% in the last three months. Unfortunately, this has been largely offset by continuing falls in real estate lending and consumer loans, limiting the growth in overall bank lending to 4.8%. Again this is better than the negative figures we have become used to over the last three years, but indications are that the rate of growth is now slowing. So whilst QE3 is probably off the table for the time being, it could come back into the reckoning again in early 2012 should commercial and industrial lending fail to maintain its recent momentum and monetary growth stagnates.
Turning to the events in the Eurozone, there has already been much analysis of the package, with most commentators agreeing that more detail is required, particularly with regard to how the remaining €250bn or so inside the EFSF will be leveraged up to €1 trillion. However, at this stage, our biggest concern relates to the additional €106bn that the banks are deemed to need to raise to boost their core Tier 1 capital ratios to 9% by June 2012. In particular, if the banks are required, over what is an extremely short time frame, to raise most or all of the additional capital themselves by definition this will have a significant deleterious effect on the region’s growth performance. This is because the very act of issuing new share capital will reduce bank deposits (used to purchase the new shares), which are the major component of the quantity of money. And since in our model of the world, there is a stable fundamental link between the quantity of money and nominal national income, weaker monetary growth will result in weaker economic activity. Alternatively, the banks could just as easily decide that the best way of complying with the target 9% ratio—defined as capital relative to assets—would be to reduce the denominator in the ratio (assets), which is dominated by loans to households and business. Indeed, this is precisely what we observed in the UK, the US and parts of the Eurozone in the immediate aftermath of the 2008 financial crisis. As banks were forced to demonstrate they were “safe” by operating with substantially higher capital-to-asset ratios they slashed their loan assets, precipitating a collapse in the quantity of broad money and exacerbating the downturn in economic activity. As perverse as it may seem, far from promoting growth, bank recapitalisation over the next eight months is likely to make the recessions in the region’s periphery significantly worse. For this reason alone, we will continue to avoid European equities.
Friday 28th October 2011
John Clarke - CIO