This year started on a strong note with significant increases in Australian and Global share markets (relatively speaking). However, investors could be forgiven for getting that ‘déjà vu all over again’ feeling.
Share markets had solid runs into April 2010 and April 2011 only to be dragged lower by flare-ups in the Eurozone debt crisis, worries about a double-dip recession in the US and concerns about a hard landing in China. And here we are again with worries about Spain, softer employment data in the US and ongoing concerns about a hard landing in China making it feel like the start of an eerie replay of the last two years. From the April 2010 high, global and Australian shares fell around 15% and from the April 2011 high they fell around 20%.
The double-dip worries of 2010 and 2011
In 2010, shares rose solidly into April with Australian shares rising above the 5,000 level. However, shares fell sharply in the June quarter on the back of worries about the ending of the first round of US quantitative easing (QE1), the intensification of the European debt crisis, a fall in business conditions in the US and China, and worries about the impact of central bank tightening (in China, several emerging countries and Australia).
Similarly in 2011, shares started the year well with US shares making it above pre-Lehman levels and Australian shares getting back to 5,000. However, once again shares and other risk-related assets were hit, starting in the June quarter and this time continuing into October. This time the correction was even more severe.
So what’s the risk of a re-run this year?
Four key threats remain in Europe and are likely to ensure a bumpy ride in global financial markets.
Firstly, Greece is still likely to struggle to meet its deficit reduction targets as the economy continues to contract, and even though it is becoming less of a threat it’s still a source of volatility.
Secondly, the French presidential election starting later this month could see a Socialist victory with President Sarkozy trailing in the polls for the May run-off. This could weaken France’s commitment to the fiscal compact agreed with Germany and the adoption of even less growth-friendly policies.
Thirdly, tighter conditions in Germany with a 20 year low in unemployment and interest rates well below inflation could yet again prevent the ECB from acting quickly enough if trouble blows up in the peripherals again. Finally, conditions could deteriorate further in Portugal, Spain and Italy. At the moment this is the bigger threat.
Some offsetting positives
However, there are several positives compared to a year ago when the Eurozone crisis last flared up in a big way.
Firstly, Spain is solvent at reasonable levels for borrowing rates (unlike Greece). Secondly, the provision of cheap three-year funding to European banks under the ECB’s three-year Long-Term Refinancing Operation program has substantially reduced the risk of banks not being able to fund themselves. Thirdly, China has certainly slowed but with inflation trending lower and property prices coming down many economists believe there is plenty of scope for the authorities to ease and ensure a soft landing.
The US economy is arguably in better shape than was the case a year ago with labour market indicators looking stronger, the housing sector looking like it’s bottoming and the manufacturing sector hasn’t been hit by the supply chain disruptions that followed the Japanese earthquake. Australian shares have been running around 4300 on the ASX 200 compared to near 5000 in April last year and commodity prices are far lower than they were a year ago, e.g. base metal prices are around 20% lower. Finally, global monetary conditions are easier with central banks easing whereas a year ago central banks in the emerging world, the ECB and Australia were tightening.
So where does all this leave investors?
After strong gains through the March quarter, it was inevitable share markets would hit a rough patch. Further volatility and weakness is possible over the next few months given normal seasonal weakness between May and September.
Indeed, shares are cheaper today, the normal safe haven of sovereign bonds are less attractive, global monetary conditions are easier and the risk of a Eurozone banking meltdown has faded. For these reasons many economists still see share markets as being higher by year-end, so would see any weakness in coming months as providing attractive entry points.
It’s early days yet and so we will keep an eye on Italian, Spanish and French bond yields, the US ISM index, Chinese money supply growth, the A$ and oil prices.