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Baby steps

While Europe continues to cause anxiety across global markets, some economies have fared better than others. We talk to Felix Stephen, Manager Strategy & Research at Advance, for his thoughts on current events.


In a widely unexpected move, the Reserve Bank kept the official cash rate unchanged at 4.25% following February’s Board meeting. The prospect of a further easing in policy in the next few months however, is still alive.


The US economy ended 2011 on a solid footing, largely due to inventory rebuilding, but the Federal Reserve remains concerned about the sustainability of the recovery.


Slightly better than expected data in Europe should be balanced against ratings downgrades from S&P and further issues surrounding Greece. The European Central Bank held steady following its January meeting, but stands ready to act “if needed” on interest rates.


The news that the UK economy contracted by -0.2% in Q4 2011 wasn’t entirely unexpected given the challenges from the European crisis, government austerity measures and tight credit conditions. Speculation is now rife that the economy may contract again in Q2 2012, which would place the country in a technical recession.


Japan’s economy is increasingly supported by domestic demand, while the external sector continues to wane. The Bank of Japan remains committed to its zero interest rate policy.

With more good news from the US, does this mean things are looking up?

The US economy ended 2011 on a solid footing, largely due to inventory rebuilding. Much better than expected January payrolls data has seen market expectations of further quantitative easing (QE) pared back, but given the continued presence of the European crisis, fiscal/political issues and a lacklustre (though improving) housing market, QE3 can’t be ruled out just yet.

Consumer spending was solid in Q4, accelerating by 2%, but was driven by pent-up demand for cars. The size of the US economy has now exceeded its prerecession levels, with GDP 0.7% higher than in December 2007, but the labour market is yet to make a full recovery. The level of employment remains 4.4% below its pre-GFC peak.

The Federal Reserve (Fed) isn’t optimistic about the economic outlook, and has downgraded its key economic projections. The Fed highlighted that it “…expects to maintain a highly accommodative stance for monetary policy” remaining open to QE3. Likely triggers include disappointing data on the economy, further evidence that inflationary pressures have waned and a worsening of the situation in Europe.

The good news is that data on the economy has been quite encouraging, especially in the labour market. Annual growth in non-farm payrolls is now 1.5%, its strongest pace since January 2007. This data comes on the back of encouraging business confidence numbers, and while consumer confidence measures have been mixed, they are on the whole encouraging, with consumers feeling more optimistic about current

economic conditions and their individual financial situation. The Fed will be looking for continued momentum in the labour market before it’s more confident that the jobs recovery is sustainable. Also, the crisis in Europe is still a potential problem for the US, so developments will continue to have a significant bearing on policy deliberations.

With contracting manufacturing and ratings downgrades, has any progress been made in Europe?

Slightly better than expected data in Europe in January should be balanced against a ratings downgrade from S&P and further issues surrounding Greece.

The upward surprises on the economic data front were mainly in relation to Germany, whose manufacturing sector expanded for the first time since September 2011. However, overall, manufacturing contracted in the Eurozone for a sixth straight month. Consumer confidence, whilst increasing for the first time in six months, remains very weak, and the fact that the unemployment rate held at a 14-year high of 10.4% in December, makes the weak outlook for the consumer sector even more compelling.

In a move that was somewhat anticipated, S&P announced it was cutting the credit rating of France, Austria, Malta, Slovenia and Slovakia by one notch. It also downgraded Italy, Portugal, Spain and Cyprus by two notches. Germany was the only major country to maintain its AAA status. This announcement was followed by a further statement that S&P would also cut the AAA rating for the European Financial Stability Facility (EFSF) by one notch. S&P noted its concern that policy initiatives taken by European policymakers may be insufficient to fully address stresses in the region. In particular, tightening credit conditions, rising risk premiums, and deleveraging by both households and governments is weakening growth prospects. The fact that policymakers were unable to make quick and decisive decisions to address these issues was also noted as a source of concern by S&P. Several countries, including France and Austria, have been placed on negative outlook for a possible further downgrade.

On the policy front, the European Central Bank (ECB) held steady following its January meeting. Although ECB President Draghi appeared to be more comfortable than in previous months, he reiterated that the Bank stands ready to act “if needed” on rates.

What impact has this activity had on sharemarkets?

Global equity markets began the year on a firm note with investors favouring riskier assets that provide relatively better returns over cash. Positive financial market sentiment was boosted by improved manufacturing and employment data worldwide, lifting investor optimism that the global economy is weathering the degenerative effects of the ongoing European debt crisis.

A weaker yet positive start to the US reporting season has also given investors confidence that corporate America remains in a strong position.

What is the outlook for sharemarkets?

The roller coaster risk on/risk off trading pattern of growth and defensive assets is likely to remain intact for a long time. However, we believe that the ‘bull market’ in growth assets is not over and that returns from growth assets are likely to be better than defensive assets up to around the second or third quarters of 2012. The increase in geopolitical risk thereafter, makes defensive assets more attractive than growth assets.

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