More pain for various economies means more pain for stockmarket investors, according to the chief economist and strategist at AMP Capital Investors, Dr Shane Oliver.
The last few weeks have seen investors transfixed, first on Europe as it belatedly introduced another package of measures to deal with its sovereign debt problem, and then the US, which in the nick of time agreed to increase its debt ceiling and thereby avoid a partial shutdown and default.
Markets, which enjoyed brief relief rallies in response to both – very brief in the case of the US! – have continued to weaken.
Global shares are now down 10% from their high earlier this year, Australian shares are down nearly 13% – and Asian shares are down 7%.
The real issue has been the deteriorating global growth outlook, with the political bun fights in Europe and the US just making it worse.
The US and European debt debacle
The good news of course is well known.
Europe has expanded its support for problem debt countries and America, by raising its debt ceiling, has avoided a partial government shutdown which would have almost certainly plunged the US back into recession.
However, the European debt problems have not gone away.
The bailout fund (the EFSF) is not big enough, it’s unlikely Spain and Italy will be able to make their share of contributions to it, investors now worry they will be forced to share in the pain of bailing out other countries as they have with Greece, comments from political leaders have raised concerns about their commitment to the agreement and intensifying fiscal austerity will make the debt problems worse.
Reflecting this, Italian bond yields have broken to new highs and Spanish bond yields are back to their mid July highs.
Italy and Spain account for around 30% of Euro-zone GDP and a third of its debt, so a spiral of ever tougher fiscal austerity forced by rising bond yields in these two countries (as has occurred in Greece, Ireland and Portugal) would be a major concern.
Meanwhile, the intense political debate in the US has drawn world wide attention to the scale of its debt problem, brought forward the timing of fiscal austerity and left the door wide open for a sovereign debt downgrade from ratings agency Standard & Poor’s.
Back in April, when S&P put the US’ AAA sovereign rating on negative outlook, it appeared to be giving it until 2013 to lower its deficit.
In mid-July, it indicated the politics were such that if the US didn’t move now the odds of doing so later were low, indicating $US4 trillion in savings over ten years would be expected.
In fact, only $US2.4 trillion in savings at most have been agreed to.
So if S&P is true to its word, a downgrade is likely in the next few months.
The other ratings agencies, Moody’s and Fitch, have retained America’s AAA sovereign rating but have warned it could still be downgraded.
A ratings downgrade would probably have less impact on US borrowing costs than feared.
The experience of other countries downgraded from AAA to AA suggests just a 0.2% rise in long term bond yields; forced selling of US bonds is likely to be limited as most investors can still hold AA rated debt as it’s still investment grade.
The uncertainty involved in the economic outlook would likely see continued safe haven buying of bonds; and if US bond yields do back up too much it’s likely the Fed will start buying them again (via QE3).
Certainly, talk of a downgrade is not presently worrying bond investors as US 10 year bond yields have fallen to just 2.6% from 3.7% in February.
The biggest impact of a US ratings downgrade may actually be felt over time in the US dollar, which will remain under downwards pressure to entice investors to invest in lower rated US debt. Potential beneficiaries are the currencies of other AAA rated countries, notably Scandinavian countries, Switzerland, and commodity currencies such as the Canadian, Australian and New Zealand dollars.
Core Euro-zone countries such as Germany and France are also AAA rated but the euro is unlikely to benefit given the debt problems facing the Mediterranean countries and the increasing obligations for core Euro-zone countries resulting from this.
While a ratings downgrade may not be a disaster for the US, the debt ceiling debate and talk of a downgrade has focused attention on America’s public debt problems and brought forward momentum for fiscal austerity at a time when the US economy is fragile.
This in turn has adversely affected business and consumer confidence.
The real problem – the slowing global economy
This brings us to the real problem – the recent slowing in the global economy.
We have been of the view the soft patch in global, notably US, growth during the first six months of this year was largely due to adverse weather, Japanese supply chain disruptions and the surge in oil prices, and that growth would pick up in the current half.
However, the recent deterioration in key economic indicators suggests more may be involved than temporary factors.
While business conditions indicators (or PMIs) in Japan have recovered, the US and Europe have continued to deteriorate and PMIs in India, China and Brazil have also slowed.
While some sort of bounce is still likely in the US in the current half year as auto production returns to normal, it is looking softer than we previously assumed
