Can a resurgent USA rise above the euro crisis?

Can an improving United States offset the problems in Europe? Matt Sherwood writes.

Financial markets have started 2012 with considerable momentum, with a sustained period of ‘risk-on’ evident in global commodity markets, high-beta exchange rates, global oil prices and global share markets.

There has been a distinct pecking order on the rise: Europe has led the rise (with all markets up between 14 per cent and 24 per cent), followed by the United States (up 17 per cent) with Asian and Asia-related markets recording more modest rises (up anywhere between 7 per cent and 14 per cent).

The rebound in sentiment has reflected four factors:

1. Market valuations were very low. In late 2011, price-earnings ratios reached one of their lowest levels since the mid-1980s in many international markets, and this provided a potential springboard for prices if data was a bit better than expected.
2. US and Asian economic data has been consistently better than expected. While financial markets have been Europe-focused, the remainder of the global economy has been growing at a faster pace than in mid-2011. The US recovery has consolidated, and Asia is in line for a soft landing with falling inflation enabling policy support, if required.
3. The Greek default has, to date, been orderly – private investors appear willing to take a 70 per cent hair cut on their Greek debt holdings in exchange for broader and longer lasting reforms, including large Greek public service reductions, higher taxes and lower spending.
4. The European Central Bank (ECB) appears to have ring-fenced contagion risk from periphery economies in their government and bank funding markets, through its 0.5 trillion long-term refinancing organisation (LTRO), where the ECB lends funds to banks at 1 per cent for three years. This has seen interbank funding spreads decrease for the first time in a year.

A European quantitative easing (by stealth)

The key driver out of these four has been the LTRO program.

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After eight summits and numerous press announcements in late 2011, Europe seemed to stumble onto this solution, and may not have realised how successful it could be in stabilising sentiment.

The strange thing about this program is that the German leadership was ardently against a quantitative easing in the second half of 2011.

In a quantitative easing, the central bank prints money (either physically or electronically) and buys bonds off its government, and the government can use these funds to increase spending or fund investment, or both.

The LTRO is a quantitative easing, but instead of giving funds to governments, the European Central Bank has lent the money to the banks who have, in turn, bought government bonds.

So in essence, Europe’s LTRO plan is a quantitative easing program involving a third party.

Lending quality is the key

It is not yet clear whether European banks are using the funds wisely. The LTRO was aimed to strengthen bank balance sheets, but it could have the adverse effect if banks load up on risky assets such as the government debt of stressed periphery economies.

This would explain why the 10-year yields on Italian, Spanish and every other Euro member (with the exception of Cyprus) have declined in recent months and tended to outperform their US and Australian peers.

Borrowing funds and receiving a credit spread can be a good trade, as long as the bond issuer remains solvent. The ECB will offer another round of LTRO at the end of February 2012, and has just eased the collateral rules to encourage smaller banks to participate.

However, low interest rates with potential low-quality lending to Portugal, Spain and Italy (all of which were recently downgraded by Moody’s) is not a good combination – especially in stressful times, and there is no clear endgame for this policy.

The ECB will need to manage and monitor the situation very carefully, as while it is well intentioned, it could become problematic for markets if periphery bond yields rise. 

A return to trend US growth is hard with low savings

Recent US data on consumer credit, retail sales and employment growth have been eye-catching, and even the downtrend in housing has stabilised – which has fuelled expectations that the US recovery is self-sustaining and could return to trend in 2012.

There are two issues that will make a return to trend growth in the US harder than normal. Firstly, the US savings rate is low.

Although the US savings rate (at 4 per cent) is high relative to the past 15 years, it does not take into account mortgage interest payments, which contrasts with national accounting conventions around the world. US savings after interest payments are negative today (which has been the case for most of the past 15 years).

This means that the US consumer is in no position to borrow more – unless they want to be in a situation where debt is being used to repay debt. In this world, US economic growth will primarily be determined by employment and income growth. Refer to Figure 1.

Austerity will hit US income growth

Secondly, the level of household income is being subsidised by the US Government. Indeed, the level of US savings after mortgage payments – but before government handouts (including social security and other support payments) – is around its lowest levels in 35 years.

One has to wonder, how much longer the Obama administration can keep borrowing from the US Federal Reserve and global investors to fund US consumers.

Importantly, the Obama administration is likely to reach the US$16.4 trillion US Government debt ceiling in the 2013 financial year, and under the August 2011 agreement between Republicans and Democrats this will trigger austerity cuts.

Given the US Government is subsidising the consumer, this could impact US household income and spending.

This suggests sizable headwinds are in place to hinder a return to trend US growth, although a double-dip recession looks as equally unlikely in the absence of a severe negative shock.

US earnings growth remains buoyant

Historically, a US rebound is typically associated with annual US earnings growth peaking around 15 per cent – 25 per cent (see Figure 2).

Although the prevailing US economic recovery is the third weakest in US history (dating back to 1871), the earnings recovery was the strongest since World War II (with earnings growth peaking at 40 per cent).

This larger recovery reflects the size of the losses during the global financial crisis and the growing share of US earnings from Asia and other growth markets.

Earnings growth has since slowed, but is still around the peaks of previous recoveries. Refer to Figure 2.

February’s reporting season is key

With subdued local economic data, a strong Australian dollar and continued euro zone uncertainty, the market has already lowered its expectations for the 2012 financial year from 16 per cent in June 2011 to 4.3 per cent in February 2012, with the largest downgrades occurring in resources (reflecting lower commodity prices) – although financials have also been reduced lately, in light of developments at QBE.

As the 2012 financial year forecasts have been lowered, 2013 forecasts have been rising (partly reflecting base effects), but at 14 per cent they remain optimistic.

The main wildcard here is resource prices, and if they can continue to reverse recent price falls, then the market forecast could be achieved.

Elsewhere, the assumed expansion in non-resource sector earnings will be challenging if the domestic economy grows sub-trend, and tighter financial conditions are making this task harder.

When the ECB attempts to ease financial conditions in Europe, they tighten them in Australia through the impact on the currency, and the Reserve Bank has clearly stated that conditions would need to tighten further before domestic rates will be lowered.

The banks are cost-focused

Bank earnings growth is under pressure – primarily due to weak domestic credit growth. The best ways for banks to offset this change is to either increase lending margins (or at the bare minimum stop them contracting further) or to cut costs.

The banks have all announced slight increases in lending rates and broad-based staff reductions (to boost productivity).

Although it is tough for the workers, it will be very hard for the banks to maintain their cost base – which was progressively established when credit growth averaged 14 per cent per annum in the 40 years to 2007 – in the prevailing de-leveraging environment (where credit growth slowed to just 3.5 per cent in 2011).

Implications for investors

In an uncertain market environment, investors will wonder if there is any upside potential in global share markets.

While Europe has taken a step back from the brink and the US economy has improved, the prevailing environment is unlikely to reward large and careless exposure to risk.

By the same token though, with term deposit rates now declining and government bond yields remaining near all-time lows, the environment is equally unlikely to reward ‘no risk’.

Importantly, the building blocks for long-term wealth creation (attractive dividends yields and valuations) remain intact.

The three factors containing sentiment at present are global macro concerns, the high Australian dollar, and Australia’s high relative interest rates – and these factors appear unlikely to dissipate in the near-term.

With markets up for a few months, a further uptick would require macro risks to lessen – which is more likely to occur over the medium term.

In this environment, low quality companies or stocks facing sustained structural headwinds are likely to struggle.

Consequently, conservative investing (in terms of balance sheets and earnings growth) with a steadfast focus on valuations should serve investors well, as it gives downside protection with upside potential.

Note: This article was featured in Perpetual’s monthly market commentary – Perspective. 

Matt Sherwood is head of investment market research at Perpetual.