Clouds on the horizon

 Over the last year the markets have taken us through quite a rollercoaster ride.  While the immediate economic prognosis has been improving I would not necessarily expect the markets to celebrate that fact fully given that most of the good news is already reflected in the price. Indeed, the current economic recovery would seem to be a mixed blessing for the markets as it is usually followed by policy makers raising taxes and interest rates. The New Year certainly started with a bang, with both commodities and equities registering strong gains.  Although the economic news has indeed been positive, equity markets have recently relinquished their gains (and then some) due to three negative developments:

1. Tightening of the Chinese monetary policy
The Chinese economy bounced back strongly following its decisive stimulus program during which it eased monetary and fiscal policies in response to the global economic downturn. China was in fact so successful in averting an economic slowdown that the country’s annual growth rate surpassed its target of 8% and growth is now higher than it was when Lehman Brothers collapsed. But having recovered the soonest and sharpest, Chinese authorities have had no other choice than to start taking steps to cool down the supercharged economy before inflation becomes problematic.

2. Banking reform
Perhaps in response to his dwindling popularity, President Obama has recently announced plans to restructure the banking system.  The most controversial point consists of restoring the split between normal banking activities and riskier proprietary trading. Although this may be a prudent step to avoid future banking crises, these measures have been viewed as an unhelpful hindrance to bank lending, just as the economy is showing signs of life.

3. Greek tragedy
It seems that Greece’s public finances are on an unsustainable path with a budget deficit nearing 13% of gross domestic product and a public debt-to-GDP ratio expected to exceed 120% by end-2010.  Investors have already started to bail out of ‘peripheral’ European bonds even before the Central Bank has had a chance to tighten monetary policy. Greek bond yields have risen sharply and of course, higher funding costs simply make the country’s position even less tenable.  Greece’s situation has also raised a big red flag on neighbouring nations such as Ireland, Italy, Portugal and Spain.  These countries are all under pressure to reduce their budget deficits (through higher taxes and spending cuts) at a time when their economies are already suffering from busted property bubbles, high unemployment and the credit crunch. The more they raise taxes, the weaker their economies; and the weaker their economies, the lower the tax-take. It’s a vicious spiral from which it will be hard to escape, particularly given that they are no longer able to devalue or print their way out of trouble.

Looking down the list the last point is most troublesome. China is merely restoring a more neutral stance and isn’t clamping down on growth in draconian fashion. Our Emerging Markets research team views this as a necessary ‘’tap on the brakes now“ versus a potentially damaging skid later.  These actions should therefore be welcomed as a pre-emptive measure, which will ultimately mean that the growth cycle is all the more sustainable. It would be much more worrying if the Chinese economy were allowed to boom out of control and create yet…another bubble.  As for President Obama’s bank reforms, these will take some time to put in place and it is hard to see them being a major influence on the markets in the short-term. They will nevertheless impact negatively market sentiment if this administration keeps stressing how strongly they wish to fight Wall Street. Finally, what makes the Greek situation so troubling is the self-reinforcing nature of debt crises. We have all seen firsthand how big debts combined with rising funding costs are a toxic combination. And if Greece gets into trouble, how long before the same thing happens to Spain, Italy, Ireland or Portugal?

Better economic numbers and words of support from the EU have recently taken the sting out of the crisis. European bond markets and the Euro have stabilized and this has created a window of opportunity for markets to recover.  However, this is a story that will almost certainly return to haunt the markets. A sustained, robust economic recovery would represent one way out, but this does not seem a likely outcome. Meanwhile, an EU bailout package is probably not forthcoming until there is a real sense of crisis in the air. Things will almost certainly have to get worse before they get better.

Greek bond market
My key message is that even though equity markets are likely to generate positive returns in 2010, the easy money has been made in this cyclical recovery and that downside risks are building, with big government deficits likely to be the catalyst for the next crisis. It is my belief that the recent volatility in the Greek bond market is a foretaste of what is to come as other economies are put to the test.  This may well be a challenging year for equity markets and investors should remain cautious, reverting to a more defensive asset allocation while focusing on higher quality investments. Starting the year with an annual in depth portfolio review with your advisor to ensure your allocation is still in line with your objectives can help manage this risk and ensures you remain the course.