Neil Dwane, CIO Europe

RCM

To download this news item in pdf format, click here

RCM's Neil Dwane, CIO Europe, provides a macroeconomic view from Europe on the crisis hitting global markets.

A Political Failing

Presidential and Congressional elections in the U.S. are complicating a very difficult situation in the financial markets. The Troubled Asset Relief Program (TARP) is seen as helping Wall Street instead of the voters and homeowners on Main Street; on the other hand, solving this problem for the financial community is urgent in the U.S. and around the world.

RCM believes that TARP is at best a moderate solution for improving banks' solvency, but:

• It came too late for Washington Mutual and Wachovia.
• Very serious financing constraints persist in the financial markets.
• The situation is dreadful for European banks: Bradford & Bingley in the U.K., Fortis in the Netherlands and Hypo Real Estate in Germany all failed the solvency test.

Contagion Spreading Overseas

Yet politics can't interfere much longer because the contagion has now hit Europe. Their markets have been reacting to the leverage in financials and the news that this plan was having trouble:

• UBS has approximately 3.5 times the leverage of Switzerland's GDP.
• Deutsche Bank has nearly the same leverage in its balance sheet as the GDP of Germany.
• For reference, the combined debt of Fannie and Freddie was 50% of U.S. GDP.

The U.S. Consumer and the Paradox of Thrift

The U.S. consumer has remained remarkably resilient, but we are seeing two very interesting signals:

• Savings ratios are finally on the way up for the first time in five years.
• Because of the threat of unemployment, the pressure on wage rises is also mitigating.

Neither factor will be positive for the American economy in the next 3-6 months, and this is the paradox of thrift: if consumers spend less, then corporate revenues fall—and corporate revenues to date have been very robust.

Forecast for the U.S.

U.S. policy will remain troubled until the new administration is in place, and either Senator Obama or Senator McCain will have a serious headache coming to them in January.

• By mid-2009, the housing market may have fallen another 8%-10%, though we believe it will be approaching the last 12-18 months of its decline.
• A new administration is going to pursue an aggressive policy of fiscal stimulus.
• The Fed is likely to cut rates.
• The cost of this may be a weaker dollar in the medium term and rising inflation in the longer term. However, against the cost of a collapsing financial system, these costs are minor.

Corporate Earnings and Market Trends

• Earnings expectations remain too high for what we believe is a likely near-global and U.S. recession. Earnings historically have fallen in a recession year by over 10%, and the market has yet to factor that in.
• We should continue to see dividend cuts—Citigroup did it when refinancing the acquisition of Wachovia; other urgent refinancings are likely.
• We should continue to see international M&A that reflects the trends of globalization, such as InBev's acquisition of Anheuser-Busch.
• Many company dividends exceed the yield of 10-year Treasuries. Yet while this historically has been a classic time to buy equities, banking dividends are now being cut, which is why we may need to wait for another 5%-10% decline in the market before we say it's an unequivocal buy signal.

Equities Should Reassert Themselves

We see this as a good time to be thinking about buying equities because we believe the longer-term fundamentals of equities will reassert themselves:

• Two-thirds of the world's population is moving towards urbanization and industrialization—better healthcare, better technology.
• While the U.S. and the U.K. may now be over-borrowed and need a period of saving and rebuilding of their balance sheets, many emerging markets need to evolve their economies to keep their citizens happy. This should inevitably lead to greater demand for energy, infrastructure and technology.
• We believe that in the next 3-6 months, some of the secular, long-term, fundamental trends will continue to reassert themselves, and we will see a way out of what is currently a very difficult financial problem in America and Europe.

Read all Articles