Wednesday, July 13, 2011

Still plenty to worry about...

There is still plenty to worry about out there at the moment. Collectively these issues support our actions over recent months to "derisk" our portfolios.

Recent developments in Italy demonstrate in the starkest fashion that current problems in Greece are not so much about Greece itself, but about the risks of contagion to other debt-strapped countries.

There has been some good news, however. The just concluded meeting of Eurozone ministers has produced a proposal to increase the flexibility and scope of the European Financial Stability Facility (EFSF). This would include lengthening the maturity of loans and a lowering of interest rates. Importantly, it could lead to the EFSF buying government bonds in the secondary market which would help stem the rise in bond yields. It could enable Greece to retire its debt at a discount.

These measures would at least start addressing the sustainability of debt, rather than imposing increasingly restrictive liquidity measures that are just serving to push countries such as Greece into deeper recession. The finance ministers have given themselves until late August to work out the second bailout plan, but we like where this is heading (finally).

That news was tempered, however, with Moody’s Investor Services decision to downgrade Ireland’s credit rating to Ba1 (the highest speculative grade rating), with a negative outlook. This follows a similar move on Portugal last week. Indeed the same reasons were stated: that private sector participation which is likely in future bailouts will raise the costs of borrowing for peripheral countries.

The rating is less in dispute than the timing of the moves. Ireland, better than any of the “crisis” countries, seems to be turning the corner towards recovery. In particular it now has a current account surplus showing it is starting to pay its way in the world.

The next piece of news will be the results of bank stress tests due on Friday.

Meanwhile, in the United States, the political posturing around raising the debt ceiling continues. We expect a deal will be reached, but it will go close to the wire. Markets will become increasingly angst-ridden as the deadline approaches in about two weeks time.

The minutes from the June Federal Open Market Committee (FOMC) meeting held no surprises. The Fed continues to expect the US economy to recover in the second half of the year, as we do. The prospects of a further round of quantitative easing was openly debated, with some members stating that if “growth remained too slow to make satisfactory progress…it would be appropriate to provide additional monetary policy accommodation”.

While the Fed appears ready to take further action, we don’t believe conditions at this point warrant QE3. The fed has a dual mandate of full employment and price stability, but we believe it was the risks of deflation that won the cost/benefit argument for QE2. Right now the costs of QE3 would outweigh the benefits.