Financial Markets Focusing Greece and Spain - Shaw Capital Management Newsletter

The situation in Greece and in Spain has obviously caused great concern in London. But the Bank is also aware of the risks as a time when the economy is still in a very fragile state, and of the need to compensate for the fiscal retrenchment by maintaining a supportive monetary policy, and low short-term interest rates. There are therefore reasons for concern about the prospects for sterling. If the latest measures do succeed in reducing the fiscal deficit to manageable levels without aborting the economic recovery, and if the problems affecting the euro continue, or become even more serious, then sterling may well maintain current levels or even appreciate further.

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But the situation is very uncertain, and the odds do seem to favour a further period of weakness until the effects of the latest government measures can be more accurately assessed.

The yen has weakened slightly over the past month as the improvement in market sentiment has increased

the “risk appetite” of investors for the equity markets, and for commodity-related currencies.

The economic background in Japan has continued to improve, helped by the export performance; but there are still doubts about whether this improvement can be sustained, and these doubts have been increased by the latest announcement by the new prime minister that the main priority of his government will be a reduction in the huge fiscal deficit, rather than the promotion of fresh measures to accelerate the growth rate.

There is also a further uncertainty created by the decision by the Chinese authorities to adopt a “more flexible” policy on the renminbi that presumably means that it will be allowed to appreciate slightly faster. It is not clear what the consequences of this move will be; but overall it seems likely that conditions elsewhere, especially those affecting the euro, and some disappointment with “risky” investments in global markets, will continue to provide some stability to the Japanese currency.

Shaw Capital Management August Newsletter: Financial Markets Focusing Europe

The big fall in the euro in recent months is clearly having a significant impact on the performance of the

euro-zone economy.

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Factory output expanded at a record pace in April, helped by investment spending associated with the export effort, and overseas demand for European capital equipment, and the trend appears to be continuing. The major beneficiary has been Germany, but other northern member countries are also involved.

However the situation is much less encouraging in Greece, Spain, and Portugal, because they are less competitive in export markets, and are being forced to introduce austerity measures to reduce their fiscal deficits.

Domestic demand across the entire euro-zone remains weak, and so, despite the export performance of some member countries, it seems unlikely that the overall growth rate for the zone this year will reach 2%. The European Central Bank remains reasonably optimistic about prospects; but fortunately it has not moved towards an “exit strategy” that might involve reversing the measures that were introduced to counter the recession.

Short-term interest rates have been left unchanged and close to zero, the programme to provide unlimited three-month loans to the banking system is continuing, and the bank is also still intervening in the markets to buy the bonds of weaker member countries that had been sold heavily because of fears about debt defaults. The bank is therefore continuing to provide support for the system; but it is not really doing enough to offset the concerns about the debt crisis.

Greece remains in the eye of the storm; but there have been increasing concerns about the situation in Spain; and the situation has been made worse by the latest warning from the Fitch Ratings agency that it may take further massive asset purchases by the European Central Bank to prevent the sovereign debt crisis in the area escalating out of control.

Shaw Capital Management August 2010: Financial Markets Focusing Europe - There are fears that Spain will need to follow Greece in requesting help from other member countries and the IMF to enable it to avoid a default, and that Portugal, and perhaps even Italy, may also need to be rescued.

The pressures on the euro will therefore be intense; and whilst there may well be further support from the Swiss National Bank and others, the future of the single currency system clearly remains very uncertain. The latest modest rally in the euro must therefore be treated with great care.

Sterling has recovered from the weakness that developed in May, and is ending the month higher. The economic background in the UK has not provided any real support, and the Bank of England is clearly intending to maintain short-term interest rates at very low levels; but there has been some movement of funds out of the euro into sterling, and the new coalition government in the UK has introduced measures to reduce the massive fiscal deficit that have been well received in the markets and led to an improvement in sentiment.

There is clearly a risk that these latest measures in the Budget will depress the level of activity still further, and fail to solve the fiscal problems; but for the moment it seems that the new government is being given the benefit of the doubt.

The evidence on the performance of the economy ahead of the Budget announcement was still pointing to a very slow recovery in activity.

The manufacturing sector is reasonably buoyant, with exports expanding rapidly; and retail sales also increased more quickly than expected.

But unemployment rose again to 2.47 million, and the latest survey from the CBI indicated that the value and volume of business in the services sector fell, and that further weakness was expected in the second half of the year.

However the situation has obviously been changed significantly by the latest Budget measures, and the latest estimates from the newly-formed Office for Budget Responsibility are that growth will now only be 1.2% this year, rising to 2.3% next year, and improving slightly in succeeding years.

The Bank of England has welcomed the decision by the new government to introduce measures to address the problems created by the huge fiscal deficit. The governor, Mervyn King, argued recently that they would “eliminate some of the downside risks…and are desirable to remove the risk of an adverse market reaction.”

Shaw Capital Management August 2010: Financial Markets

Sentiment in the financial markets has improved over the past month. There has been further evidence that

the recovery in the global economy is continuing; the sovereign debt crisis in Europe has not yet produced a major casualty; there has been a modest rally in the euro; and the Chinese authorities have announced that they intend to adopt a “more flexible” policy towards the renminbi that is expected to allow it to appreciate at a slightly faster rate.

Shaw Capital Management August 2010: Financial Markets - These developments have suggested that the gloom was overdone. The effect in the currency markets had been to slightly weaken both the dollar and the yen, as the “risk appetite” amongst investors and traders has increased, and to strengthen the commodity-linked currencies and ease the pressures on the euro. Sterling has also improved over the month, helped by the measures announced by the new coalition government in the UK, both before and during the recent budget statement, to significantly reduce the huge fiscal deficit.

Shaw Capital Management  views on financial market - But overall movements in the major currencies have been fairly small, and there is still considerable optimism about prospects.

The latest evidence on the performance of the US economy has enhanced the prospects for the dollar, and this should also continue to provide some stability for the yen.

The sovereign debt problems in Greece, Spain, Portugal, and even in Italy, continue to worsen, and may well lead to defaults and put further pressure on the single currency system.

There must also be serious doubts about the latest improvement in sterling.

The new government in the UK is making credible efforts to reduce the size of the fiscal deficit; but it faces a daunting task, and will find it very difficult to maintain its tough stance.

There is therefore a serious risk of a crisis in the UK currency market, and so it is crucial that the international agencies prepare contingency measures to enable them to act quickly if the situation appears to be running out of control.

The latest available evidence on the performance of the US economy; show the recovery from recession remains on track.

Retail sales were 1.2% lower in May than in April, emphasising the cautious mood amongst consumers; non-farm payrolls increased by 431,000 in May, but 411,000 jobs were accounted for by temporary government hiring to complete the 2010 census, leaving the increase in “real” jobs well below expectations; new home starts fell sharply in May following the withdrawal of government measures to prop up the market, and existing home sales also fel.

And the M3 measure of broad money growth is also continuing to decline because of weak loan demand from reliable borrowers, and the reluctance of the banks to lend to anyone else. There are offsetting factors in the strength of the manufacturing sector; and consumer confidence figures remain reasonably strong.

The Commerce Department has recently revised its estimate of growth in the first quarter of the year down to a 3% annualised rate; but this rate may not have been maintained in the current quarter; and this has already led to a strong plea to Congress from the government to authorise additional spending programmes costing up to $50 billion “to keep the recovery on track”, it is not clear how Congress will respond.

The Fed chairman, Ben Bernanke’s recently testimony to Congress; that the pace of the recovery will not be strong enough to fix the jobs market or reduce the budget deficit without further help, also argued that, despite the size of that deficit, “to avoid sharp, disruptive shifts in spending programmes and tax

policies in the future, and to retain the confidence of the public and the markets, we should start planning now how we will meet these budgetary challenges”. This view about the economy is repeated in the statement after the latest meeting of the bank’s Open Market Committee, and so, although the bank believes

that the recovery is continuing, it is not surprising that it is quietly considering what steps it might have to take if the recovery unexpectedly falters.

There has been a modest recovery in the euro from a low-point in the early part of the past month, although it is still ending the period slightly lower.

The economic background in the euro-zone is continuing to improve, and there has been evidence of support for the euro, particularly from the Swiss National Bank, which reported an increase in its foreign currency reserves of more than $100 billion in May. But the benefits have been limited by the on-going sovereign debt problems amongst some member countries of the euro-zone, and especially by the serious deterioration in the situation in Spain, and so the improvement that has occurred remains very fragile.