The limitations of European solutions are concerning investors

• Global investor sentiment improved significantly in the new year as closure of the European Greek solution, combined with a massive liquidity injection from the European Central Bank (ECB) and signs of improvement in the US economy, prompted an extended period of ‘risk on’ in markets.
• The market gains during this period were large and widespread (with the pace led by European markets – see Table 1), but were driven primarily by rising valuations (from very low levels), rather than any broad-based improvement in earnings expectations or reduction in capital costs. 
   
   

The market’s four month rally has faded

• However, more recently the continued disappointing European economic data combined with an end to the ECB’s liquidity injections (and the US Federal Reserve’s announcement that its often cited QEIII program had been suspended) saw the market’s four month rally peter-out fairly quickly.
• Over the past week the downtrend in global markets has intensified as a very soft US labour market report combined with rising Chinese inflation (which could limit the amount of policy support China can provide to its domestic economy) sparked concerns about the strength of the global recovery, and this has weighed heavily on risk assets.
• US shares have lost ground for five straight sessions and last night suffered their biggest decline this year (down 1.7%), as concerns about European government borrowing costs strengthened and weighed on investor sentiment before the start of the earnings season. Gold and US, German and UK Treasuries rallied as investors sought safety. Indeed UK 10-year government bond yields (currently 2.00%) are only 0.01% away from a 300-year low, whereas German 2-year government bond yields (0.09%) are less than Japan’s (0.11%) for the first time ever.

Europe’s troubles have spread into the bigger economies

• Despite all the talk of comprehensive solutions last year, solvency is once again an issue in southern Europe. The market’s primary European concern is not Greece, but Spain (particularly after it announced that it won’t be close to meeting this year’s austerity target of a 4.4% deficit which was more likely to be 5.8%). Last night the head of Spain's Central Bank stated that the nation's banks may need additional capital if the local economy’s performance is worse than expected. This sparked fresh fears that some banks might not survive a downturn exacerbated by the government’s austerity drive. Since its peak in early February 2012, the Spanish sharemarket has declined 16.5% with France and Italy also down heavily. 
• The latest forecast for Spanish public sector debt is for a jump from 69% last year to 80% in 2012, which is reasonable relative to its European peers and well below Italy’s near-120%. However, the acceleration of the debt rise is concerning investors as unemployment in Spain is 23% (and around 50% for those under 25 years of age) and the government is undertaking widespread austerity measures, which will prevent any economic recovery any time soon.
• Some analysts have indicated that a deeper (than forecast) Spanish recession in 2012 could also adversely impact market perceptions about the quality of its private sector debt, which at nearly 300% of Spain’s annual economic output has always been a bigger problem than public sector debt. In an environment characterised by declining house prices (which in recession could fall further), non-performing loans for the Spanish banks (currently 8% of total loans) are likely to place more pressure on regional bank balance sheets.
• These funding pressures will eventually flow through to Australian banks. Fortunately, Australian banks have increased the amount of deposits on their balance sheets and this will partially negate the impact.

The limitations of Europe’s liquidity operations have become apparent

• The magnitude of Spain’s debt position has highlighted the limitations of the European Central Bank’s longer term refinancing operations (where it lent regional banks around €1 trillion at 1% for 3 years) where under-capitalised European banks were used to prop up over-leveraged governments. The market’s attention is likely to swing to whether Spain can find a solution without a bail-out and, if not, whether the European bailout funds are large enough to cope with trouble in bigger economies such as Spain and Italy.
• From an investment perspective, these global developments highlight the importance of capital preservation and income generation. At Perpetual, we believe that investing in firms with a history of earnings generation and that have strong balance sheets and boards that reinvest capital wisely are the easiest and by far the best forms of risk management. In every downturn, the companies with the weakest balance sheets decline the farthest. Similarly, during these times investors increasingly look for companies that can generate sustained surplus cash-flow from their operations, whether the environment is supportive or not. Our fund managers continue to search for stocks that have good yields, potential income growth and which are attractively valued.
• These themes will be discussed in depth in the next edition of Perpetual Perspective, which will be dispatched soon.

Matt Sherwood
Head of Investment Markets Research
Perpetual Investments

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IMPORTANT NOTE: This document has been prepared by Perpetual Investment Management Limited ABN 18 000 866 535, an Australian Financial Services Licensee, Licence Number 234426, a subsidiary of Perpetual Limited. It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.