Welcome to Neil MacKinnon's Market Commentary blog. This page is updated regularly to cover events impacting the global financial and currency markets.

The most recent post appears at the top – scroll down for older entries.

Well, the polls are giving David Cameron the benefit of the doubt following the final TV debate last night though the bookies are still looking for a hung parliament. In the run-up to the election on 6 May, the markets will be keeping a close eye on the polls for signs of any ‘break-out’ from the stalemate that has characterised the election run-in so far. Keep an eye on the weekend press as there may be interesting news stories in this regard. Press comment this morning highlights alleged comments from Bank of England Governor, Mervyn King, who says that whoever wins the election will have to implement such severe austerity measures that they will be out of power for a generation. Well quite possibly, though I am always sceptical of such prognostications and Mrs Thatcher's term of office is probably testimony to the fact that fiscal retrenchment can strike a positive chord with voters. You could not say that about Greece though, where the FT this morning reports that Greece has signed up to fresh austerity measures in return for EU/IMF funding that could amount to €100-€120 billion over three years (click here). Greeks are already rioting in the streets of Athens and, along with strikes by trades unions, this look set to continue. However, raising the retirement age from 53 years (!) seems a small price to pay from our vantage point here in the UK.

The latest economic news reports a slight dip in UK consumer confidence which might just be due to recent market volatility and the impact of the Greek debt crisis. Anecdotal evidence suggests that things are starting to get better in the UK economy (at long last) with people starting to find jobs after being hit by the credit-crunch in 2008-2009. If this starts to show up in better retail sales data (and there is bound to be a release of pent-up demand after the depressing winter), then the financial markets might start to take a brighter view of UK economic prospects. All of this news might arrive too late for the incumbent government but gives the new administration a better platform from which to tackle the UK's budget deficit. It is not all gloom and doom in this regard and securing sustainable economic growth in the first instance allows a better chance of implementing the required fiscal adjustment. The worst scenario is following so-called ‘slash and burn’ budget policies (as In Ireland and Greece) which inadvertently backfire as nominal GDP (i.e., the economy) implodes as spending cuts and job cuts dent demand. Amazingly, this is ‘economics 101’ as taught in any standard economics text book, though some policymakers don't seem to have had any of these books on their reading lists.

Back to the markets; obviously a bumpy ride this week in equities though they seem to have recovered their poise after the Fed again remained committed to keeping interest rates low. This is the ultimate back-stop for the market. The Fed don't want to see any chance of the markets and the economy slumping again. They may even prefer to risk creating a new ‘bubble’ and deal with that as and when it comes. Today's US GDP numbers for Q1 may prove interesting and there is a good chance that they surprise on the upside. If this is the case, then there is every chance that this year sees global economic recovery gathering pace. So far, Asia, and in particular China, has led the way forward which is why commodity prices continue to trend higher.

Enjoy the Bank Holiday weekend!

.

The eurozone’s debt crisis continues to hold centre stage for the financial markets. Spain was downgraded late yesterday and it is worth noting that Spain has the largest combined budget and current account deficits (as a percentage of GDP) in the industrialised world. And you thought it was all about Greece. The FT this morning reports that German MPs claim that the upcoming EU/IMF package for Greece could amount to EUR100-120 billion (click here). It wasn’t that long ago that the EU/IMF were willing to pony up a total of €45 billion. It makes you think that if the same ‘generosity’ was applied to the rest of the eurozone, the total support package might be in excess of €1 trillion. Certainly, the Germans appear to have grudgingly accepted the need for some support to Greece. Without their support, monetary union might very well have started collapsing. But their support is likely to come with ‘strings’ if not ‘chains’ attached. Greece has had a history of being a champion serial defaulter going back to its independence in 1821. Now Greece is finding that it cannot access the markets. Double-digit interest rates have broken the proverbial camel’s back which is why the EU/IMF package is designed to by-pass the markets. The unsustainability of the situation reminds me somewhat of the UK’s experience during the ERM collapse. Then, the UK government had to keep raising interest rates to defend the exchange rate. Double-digit interest rates and an eventual double-digit unemployment rate was just economic madness and the markets knew it. So exit sterling (thankfully).

Whether the Greek Prime Minister is singing in his bath as Chancellor Lamont did (post ERM exit) is unclear. I am not sure that ordinary Greeks have much to sing about. They will be on the receiving end of stiff fiscal adjustment which is already resulting in an escalation of social discontent. Other eurozone economies will be in the same boat, and it is interesting to note that Italy has found it difficult this week to attract investor demand at its bill and bond auctions. So regardless of any ‘positive’ market reaction to an EU/IMF package, the debt crisis is not over.

As far as the UK is concerned, we have little to gloat over as the economy faces tremendous debt difficulties. It is by no means a total disaster as our debt/GDP ratio has yet to break the 90% level which is regarded as the ‘tipping point’ for a retreat back into recession. There was some good news for the UK housing market this morning with house prices reported to have risen by 10% over the year. Certainly it looks as though prime property locations have been recovering over the past six months or so. The decline in the pound certainly increases the attractiveness for foreign investors for having UK property exposure. An improving housing market is an important ingredient for bolstering consumer confidence after a difficult period arising from the credit crunch. Indeed, lending and credit conditions have improved (from a low base) and I sense that the banks are much more willing to consider increases in lending. At the end of the day that is their business.

As far as the currency market is concerned, price action has been fairly muted despite the volatility in the equity markets and noise related to the Greek debt crisis. The stockmarkets might have made an interim high earlier in the week but last night’s Fed meeting continued to remain ‘dovish’ and that is the ultimate backstop in keeping investor sentiment bullish. American unemployment is still high at 9.7% and I think the Fed would prefer to see the unemployment rate below 9% before they start signalling any tightening of policy. Sterling looks as though it is in limbo until we see the election results, though the polls (depressingly) still point to a hung parliament outcome – roll on tonight’s prime ministerial debate.

.

The downgrade of Portugal and Greece’s credit rating set the cat amongst the pigeons yesterday. Stockmarkets slumped on the news and this highlights the wider risk of contagion as investors fret about a deterioration in the eurozone debt crisis. This morning, the market remains nervous. Greek 2-year bond yields shot up to 21%. The cost of funding Greece’s debt is now off the charts and means that the EU and IMF will have to cough up more cash just to short-circuit the market and provide for Greece’s funding needs for this year (with some estimates saying that €90 billion is required). A possible stumbling block remains: Germany. And Angela Merkel, who faces a regional election on 9 May (funny that a eurozone summit has been called for 10 May!), does not want to upset German voters who are heavily resistant to the idea of bailing-out Greece.

Indeed, Angela Merkel might take the view that Greece is effectively ‘bust’ and therefore baulk at the idea of writing out a cheque for €8.5 billion. The ball will be put in the IMF’s and ECB’s court and might involve the ECB invoking emergency powers to buy up Greek bonds. The problem with these type of measures is that it doesn’t really resolve the problem facing Greece and other economies in the eurozone. Double-digit interest rates and triple-digit debt levels are a recipe for debt restructuring which is implicitly a debt default. This will leave bond holders nursing heavy losses and a Greek debt restructuring could easily mutate into fears that other fiscally-challenged economies do the same. In the currency market, the euro is weakening on the back of all this and I guess further weakness is in  prospect.

I keep getting asked, what does this mean for the UK’s credit rating? I have to say it is a total mystery to me as to why the UK has a triple-A rating anyway. Having said that, the credit rating agencies lost a lot of credibility during the sub-prime lending crisis. But the markets do not need the credit ratings to tell them what is going on and the markets have already priced in a modest UK downgrade. Whoever is in power after 6 May faces a serious challenge in getting the UK’s budget deficit back on track. A hung parliament does not augur well for an early solution.

Apart from Greek worries keeping us all glued to our seats, the main event today is the regularly scheduled meeting of the Federal Reserve. Amidst all the market uncertainty, it would be no surprise to see the Fed keep policy on hold. The US economy is getting better though, and Friday’s GDP data for Q1 is likely to register evidence of stronger growth. At some stage, the Fed will signal that it is ‘normalising’ monetary policy through a variety of liquidity draining measures.

.

Good news this morning for Lloyds and BP who both reported profits for Q1. UK taxpayers can breathe a sigh of relief that the banks seem to have got their collective houses in order and that there might actually be a net gain once all this is sorted. Let’s hope that the banks have learnt their lesson, though it has to be said that banks historically are not good risk managers and have a poor track record of learning from their mistakes. With oil prices at $84 a barrel and some experts predicting an imminent move to $100, you would expect oil companies to make money. Certainly, the poor motorist is not getting much relief with petrol prices at an all-time high. Of course, commodities generally are on the up courtesy of China (Commodities Inc.) powering ahead despite worries of property bubbles and market worries about higher interest rates. A variety of commodities which are used in everyday life are all at – or close to – record highs. Cocoa is at a 33-year high, rubber is up 40% year-to-date and platinum and palladium are at highs as well. If you believe in the commodity ‘super-cycle’ then the longer-term outlook is for further increases in prices generally. Is this inflationary? It looks like it, though the ‘headline’ rates of consumer price inflation that are frequently reported in the financial media are comparatively low.

After the fall-out from Great Depression 2.0, it is not surprising that policymakers are more concerned about the threat of deflation rather than inflation. After all, deflation goes hand-in-hand with depression. Policymakers over the past 18 months or so have been pulling out all the stops to ensure deflation does not happen, especially in the US. However, they are having a hard job. Core CPI inflation in the US is 1.3% and some forecasters see it going to zero. This is despite the Fed ‘printing’ money and resorting to extraordinary and unprecedented monetary measures to put liquidity back into the economy. The problem is that banks aren’t lending and there isn’t much demand for credit anyway. Banks would rather use the ‘free’ money they are getting from the Fed and buy/speculate in equities. That’s why equity markets have been storming since March last year. This year, the S&P index is up nearly 9% so far with the FTSE100 up 6% (interestingly, the FTSE 100 is still below the level it was in early 1998!). The reason why headline rates of inflation are subdued (apart from statistical rigging by governments…) is that the labour market has no pricing power. Wage growth here in the UK is next to nothing and with unemployment at a 16-year high, not much is likely to happen soon.

Further out, history buffs will know that inflation is the time-honoured solution for governments to reduce their debt burden. And the main theme at the moment is the massive increase in budget deficits and debt for the major economies. Greece remains in the spotlight and I don’t see any way out from a debt restructuring which is an implicit default anyway and will leave investors nursing heavy losses. Portugal, Ireland and Spain are next in the firing line. I dare say the Germans might (unwillingly) back extra resources for Greece and it is quite possible that before this week is out that the EU and IMF come up with more cash (€50-€60 billion) which would take care of Greek funding needs for the next 12 months. Unfortunately, this does not resolve the solvency issue facing Greece, nor does it do much to prevent a drastic contraction in the Greek economy which can only result in further social discontent and maybe the fall of the Greek government.

Here in the UK, the latest opinion poll updates continue to suggest a hung parliament (many voters would probably like parliament to be hung…with a long rope). I am not convinced by the arguments made by some commentators that a hung parliament is somehow a good thing. I think it is just a recipe for political in-fighting and policy paralysis, with the prospect of yet another election before the year is out. This makes it all very difficult for the financial markets to make any serious investment decisions as you can almost guarantee unexpected volatility. In the currency markets, sterling seems to have steadied against the major currencies and, during April, GBPUSD has actually traded in a relatively narrow range of between 1.51 and 1.55. Even GBPJPY hasn’t done a great deal, trading in an approximate 139-146 range. This can all change of course which makes trading and investment very difficult at the moment. Roll on the May 6th!

.

Hello again. Kit Juckes is moving on to pastures new and we wish him well. I have known Kit for the best part of 20 years and I am sure we will all miss his contribution to ECU. I have been on the Investment Committee at ECU since 1997 and with Kit’s departure I will be taking over the responsibility of the daily blog.

Obviously, the focus in the UK markets remains on the opinion polls ahead of the election on May 6. The latest polls continue to tell the same story which looks like a hung parliament. I have read the views of some commentators who think that such an outcome might be a good thing. For example, they point out that actual cuts in spending have taken place during periods of coalition governments such as those in the 1930s or after the IMF bail-out for the UK in 1976. Others point out that hung parliaments elsewhere in Europe have tended to produce stability. I have to say that I am not entirely persuaded by this line of argument. In the 1930s, economic orthodoxy was very much in favour of spending cuts as a cure for the depression and Keynesian ideas had yet to impact on policymakers’ views especially in HM Treasury. More generally, I just think that it is dangerous to extrapolate from isolated experiences and conclude that hung parliaments necessarily produce a desirable political and economic outcome. In current circumstances, I think a hung parliament would more likely produce political infighting between the respective parties who would just position themselves in the most favourable light possible. I can’t see how a cross-party consensus could be achieved on cutting spending or more likely looking at the Liberal Democrats’ agenda of raising taxes even further.

The fact is, though, that tackling Britain’s budget problem is going to be a key challenge for the next few years. Britain’s budget deficit as a percentage of GDP (11.6%) is not too far away from the Greek deficit (13.6%) and the IMF have spotlighted Britain as requiring one of the largest fiscal adjustments in the G20 area. For choice, and the preferred policy recommendation, is to have a medium-term programme that is based on reductions in current spending rather than a plan which focuses on tax increases and cuts in investment spending. ‘Slash and burn’ policies, as being followed in Ireland and Greece for example, can quite easily backfire as budget cuts simply contract nominal growth in the economy creating a ‘death spiral’ of lower tax revenues and inadvertently a higher budget deficit. In Ireland, the economy has contracted by 20% from the peak in 2007 with investment slumping by 50%. Greece is already in a similar situation and the crisis rumbles on with talk that the €45 billion might not be enough or that the Germans want tougher austerity measures in Greece or that the German parliament just won’t approve aid. Greek bond yields headed higher this morning as the markets recognise that Greece’s debt is on an unsustainable path. This will all end in tears as some form of debt restructuring is inevitable with bond investors being on the sharp end of losses on their investments.

Elsewhere, the weekend communiqué from the G20 meeting is being regarded as positive for the markets. The G20 was quite upbeat about the prospects for the global economy and the controversial bank tax has been deferred for further discussion at the Toronto Summit in June. There was no explicit reference to China’s FX policy in the communiqué, though there were plenty of behind the scenes discussions which might end up with just a modest revaluation before too long. I suspect that, when it happens, the fact that the whole issue has been dragging on for so long will just end up with a yawn from the currency markets.

The main focus this week will be the Federal Reserve’s interest rate decision on Wednesday. The markets are expecting no change in policy and Fed-watchers who monitor the Fed’s policy statements are expecting no change in language. However, the US economy is recovering and I think that sooner rather than later the Fed will signal that an ‘extended period’ of low interest rates is no longer required. This should be seen as a ‘normalisation’ of policy rather than a signal that the Fed is about to raise interest rates. Interest rate risk is undoubtedly a key theme for this year but core CPI inflation in the US continues to edge down and I think the Fed will move cautiously. However, there is no doubt that the markets are sensitive to such changes in language.

The Bank of England faces a slightly different set of circumstances. Inflation is edging higher, the unemployment rate is at a 16-year high and economic growth is somewhat anaemic even allowing for the bad weather effects in Q1. What matters for voters is not the GDP numbers but rather ‘money in the bank’. On this score, income has yet to recover its pre-crisis highs so no wonder voters feel discouraged.

On the currency markets, the euro is struggling to make much headway and even the pound is doing better than the euro. There are still extensive short positions in both the euro and the pound, though, which makes it difficult for traders to be sure that it will be easy one-way traffic. The non-dollar carry trade is clearly popular though, and the Japanese yen stands out given some recent weakness. In the new Japanese fiscal year, there is some talk that Japanese financial institutions are upping their overseas bond exposure which can help maintain downward pressure on the yen.

.

.

Click here to read Kit Juckes's April entries

.