Feature: Yes, The Wall Of Worry Has Grown, But...

The AMP's chief economist and strategist, Dr Shane Oliver updates his Wall of Worry report from may, which was pushed a little higher yesterday with the US Federal Reserve cutting its 2011 and 2012 growth forecast for the US and lifting its estimates for inflation and unemployment.

Back in May we became concerned the worry list facing investors - including European debt, China and softer global data generally - was getting more serious and shares were vulnerable to more weakness in the months ahead.

This has indeed been the case.

From their April highs to recent lows, global share markets have had a correction of 7%, but Australian shares fell over 10% on added concerns about rising interest rates and the strong $A.

However, we also thought the current rough patch would prove temporary and, as we saw last year after a similar rough patch, confidence in the global recovery and hence shares would recover into year end. Is this still justified?

The worry list remains worrying

Over the last month or so the worry list for investors has included a renewed intensification of European debt problems, fears about European Central Bank tightening,

Japan's return to recession, high oil prices, monetary tightening in China and other emerging countries, slowing growth indicators in the US, the ending of QE2 this month and US debt ceiling negotiations.

With so many balls in the air its little wonder share markets weakened.

At its core, there are effectively three key concerns for markets right now: Greece, the US slowdown and China.

Why all the concern about Greece again?

Greece's public debt woes first hit the headlines in late 2009.

It received assistance in May last year from the European Union, European Central Bank and IMF.

However, it has run into trouble again in recent months as austerity measures weakened the economy, in turn necessitating more spending cutbacks, which are now meeting intense Greek opposition.

At the same time, Germany in particular has been insisting private investors in Greek debt share in part of the pain by extending the term of loans, which in turn has pushed Greek bond yields to exorbitant levels (e.g. the 10 year bond yield touched almost 18% last week) making it impossible for Greece to rollover private debt as assumed under the original bailout.

Several points are worth noting:

The direct threat to the global economy from a Greek slump is non-existent as it's less than 0.5% of global GDP.

Rather, the worry is that it if it defaults it might set off a global credit crisis much as Lehman's failure did in 2008.

French and German banks are the most exposed to Greece with an $US53bn and $US34bn exposure respectively.

This is probably manageable but the real concern is French banks' $US590bn exposure and German banks' $US499bn exposure to Ireland, Portugal, Spain and Italy.

An uncontrolled Greek default could lead to a sharp rise in funding costs for these other problem debt countries, making it harder for them to reduce their debts and at the same time lead to a run on exposed banks.

And banks may stop lending to each other as occurred in the GFC.

All of which could lead to another credit freeze and disruptions to global economic activity as occurred after Lehman's failure.

The situation has been worsened by opposition to bailouts in Germany, conflicting communication from European officials and political compromise in Europe that tends to come only after a market panic.

However, with Germany dropping its requirement that private bond holders be forced to rollover their loans and the Greek Government winning a confidence vote Greece appears to be on track to gain another bailout package.

Nevertheless, there are still more potential upsets along the way including a Greek vote on the austerity measures next week and issues around what sort of voluntary private debt rollover will be required.

What is clear is Europe wants to avoid unleashing a Lehman style event with German Chancellor Merkel stating "We all lived through Lehman Brothers...I don't want another such threat to emanate from Europe."

However, while Greece now looks on track for another bailout package, at some point a Greek default looks inevitable.

Despite four years of austerity, its public debt to GDP ratio is projected by the IMF to be 152.5% in 2014, which will be higher than the 127% it was at when it ran into trouble in the first place in 2009.

Europe is likely to continue trying to do all it can to delay default until Spain and Italy are in better shape and a default can be better managed in terms of its impact on the European banking system.

This suggests that whether it's Greece, Ireland, Portugal, Spain or Italy - European sovereign debt problems will be a periodic source of volatility in financial markets for some time to come.

In the short term though, relief looks to be on the way as the can is kicked down the road yet again for Greece.

The US slowdown

While the latest iteration in the Greek debacle has been unnerving markets in the last week or so, a broader issue has been a softening in global economic indicators.

This is most clearly evident in the US. GDP growth slowed to an annualised pace of around 2% in the March quarter, the current quarter isn't looking a lot better, the ISM manufacturing conditions indicator has fallen sharply with a further fall in prospect this month based on regional manufacturing surveys and the last few months have seen a slowdown in the US labour market.

However, much of the soft patch can be explained by temporary factors:

Japanese production disruptions following the March earthquake have adversely affected global supply chains, particularly in the auto and IT sectors in numerous countries.

The 20% or so surge in world oil prices earlier this year is likely to have knocked 0.5% or so off global growth.

Bad weather has likely accentuated the weakness in the US with snow storms earlier this year followed by floods and tornados more recently.

In terms of the first two there are good signs:

Japanese production is returning to normal, as seen in a rebound in Japanese manufacturing conditions in June.

Reflecting a return to normal supply levels, US auto production is scheduled to rise 19% next quarter to make up lost production.

This could add 1 percentage point at an annualised pace to US GDP growth.

The oil price has now fallen back below $US100 a barrel, pushing down gasoline and petrol prices.

While US indicators for June are likely to remain soft, this would suggest stronger growth in the second half.

Another round of quantitative easing in the US (QE3) is only likely if this rebound fails to materialise.

China

China is in the sour spot of its economic cycle.

Growth and property price momentum is slowing, but still high inflation is maintaining pressure for monetary tightening and posing the risk of a hard landing.

And property prices are slowing.

However, there are several reasons why we see a Chinese hard landing as unlikely.

First, thanks to slowing economic and money supply growth, and a topping in food prices, inflation is likely to slow over the next six months allowing the authorities to take their foot off the monetary brake.

Second, while excess housing is apparent in some cities and in some categories, overall China has not been building enough houses so fears of a property crash are way overdone.

Third, China will likely support its banks should the investment loans associated with the 2008-09 stimulus go wrong.

Finally, given the risk of social unrest Chinese authorities will do all they can to avoid a hard landing.

And in a semi-command economy with very low public debt and huge foreign exchange reserves, they have plenty of fire power to do just that.

So far while growth indicators have cooled there is no sign of a hard landing.

Outlook for shares

After sharp falls since April highs, shares are now good value again with global and Australian shares falling below forward price to earnings multiples that applied at the end of the correction mid last year.

Continuing corporate takeover activity (including a bid for Fosters in Australia) appears to recognise this.

However, just because shares are cheap is no guarantee shares will rise in the next few months.

The September quarter is normally the weakest quarter of the year and ongoing worries about Greece, Europe, the US and China could push shares lower still in the next few months.

Nevertheless, it suggests that there is good scope for shares to rebound into year end if we are right and the global economic recovery ultimately continues, and Greece is given another bailout.

This is particularly so with global monetary conditions likely to remain very easy.

Concluding comments

With uncertainty about the global recovery likely to linger for a while we could still go through more volatility and weakness in shares in the months ahead.

However, we remain of the view a Greek blow up will be averted for now and the global economic recovery will continue, with stronger economic conditions through the second half of this year.

As such, with shares now very cheap again and monetary conditions likely to remain easy, shares are likely to recover into year end.

More broadly, the continuing volatility in financial markets highlights the changed world we live in.

The GFC has left the world with a hangover in the form of excessive debt levels and extreme monetary policy settings in advanced countries, excessively easy monetary conditions in emerging countries and very skittish investors prone to jump at the slightest hint of any potential problem.

This will likely ensure volatility will remain high for some time to come, highlighting the increased importance of asset allocation for investors compared to stock and manager selection.