The Good, the Bad and the Ugly

No, not the Alpha Team, although some of you may have spotted a familiar looking Mexican moustache! However, spaghetti westerns got us thinking about ‘The Good, the Bad and the Ugly’. In this case, perhaps the USA, Greece and China? Yes the US Fed has to tread a careful path with interest rate policy but there is little doubt that the economy is improving. However, the Greek situation has gone from ‘bad to worse’ and as far as German taxpayers are concerned the Greeks are likely to be ‘Unforgiven’ and given the choice, they would no doubt ‘Hang ‘em High’.

How ugly is China? The stock market sell–off has hit millions of middle class Chinese investors’ household wealth at a time when the country is looking to re-balance itself away from manufacturing exports to consumer consumption. Furthermore, there could be knock-on effect around the rest of the world. To put this in context, Chinese tourists spent more than those any other country last year, an estimated $165bn, while 12% of the world’s luxury goods, with most shopping done overseas, were made by Chinese consumers.

It was only some weeks ago that there was talk of China gaining a greater weighting in benchmark global market indices. However, will this happen now? The current situation is going to leave a deep, adverse impression on international investors for a long time. Despite being the world’s second largest economy, China could still be perceived as an emerging market.

The uncertainty from Greece and China has created volatility, particularly in the commodities market and a flight to safe havens. With China slowing, the Greek impact on Europe and the prospect of US interest rates rising, many Emerging Markets could also fall into the ugly category. Given recent events, the US Dollar may be seen as a safe haven and some investors and countries may wish they had a ‘Fist Full of Dollars’.

What have we been watching?

Besides too many Clint Eastwood films, we have been watching lots of things falling and rising in value as Greece and China continue to dominate the financial news headlines. Trading volumes remained painfully thin however, with many fund managers either sitting on their hands or visiting Wimbledon, watching the Ashes or staying at home due to transport strike action.

This overshadowed some significant announcements in the UK Budget such as restrictions on tax relief on buy-to–let mortgages from 2017 which pushed shares in house builders lower as well as some of the new challenger bank mortgage providers which were also hit by a new bank tax levy. The introduction of a ‘minimum living wage’ will also impact a wide range of UK businesses from retailers and leisure companies to domiciliary care and low end (cleaning) support service businesses.

In China, the Shanghai Composite index remained extremely volatile. Investors who borrowed money to buy shares have been turned into forced sellers to cover tighter margin requirements from lenders and with the many stocks suspended have had to sell whatever they can including commodities.

Talking of ashes, or rather burnt fingers, about 80% of Chinese shares are held by individuals. This means that what happens in the Chinese equity market is likely to have an impact on both Chinese consumer confidence as well as their perception of the previously infallible state apparatus. A raft of measures have been introduced aimed at halting the three week market slide. This includes a ban on shareholders with stakes of 5% or more from selling and temporary suspension in trading of some shares but at one point, this covered one-third of the market!

Equity volatility and concerns about its impact on an already slowing Chinese economy also led to significant weakness in key commodities such as iron ore and copper, with the latter dropping to a five month low. This in turn impacted the UK quoted mining companies. The Australian Dollar fell to a six year low. As we have said countless times before, the world is a smaller place these days and we are all connected.

While Greece is not of the scale of China, it only accounts for 2% of the Eurozone’s output, its debt mountain is much more significant. Central government debt is estimated to be €313bn. Of this, it owes over €21bn to the IMF which itself has a financing capacity of €377bn. So who else is exposed to Greek debt? Well, Germany has the greatest exposure at over €68bn, France €44bn, Italy €38bn and Spain €25bn. Within and in addition to these estimates it is thought that the ECB owns €150bn of Greek bonds as collateral on loans to Greek banks.

The Greeks submitted fresh plans which looked very much like what creditors had asked for before the referendum and ‘No’ vote to austerity! In the meantime, the Greek banks, even with capital controls in place are leaking €100m a day and what was a liquidity problem is now a solvency crisis. The bail out decision is vitally important but needs a cash injection into the Greek banks otherwise the Greek economy will collapse which would make most of the tax assumptions and economic projections pretty meaningless.

Eurozone leaders pulled an all-nighter and reach agreement on a bail –out deal for Greece just as the UK equity market opened today. Creditors do not appear to trust Greece following the recent referendum and subsequent fresh Greek plans. The reported terms imposed in order for Greece to remain in the Eurozone are therefore extremely stringent and it will be difficult for PM Tsipras to gain support for them as some Greek officials are already saying they are designed to humiliate Greece. The Greek crisis has involved deadlines and the latest talks have again set a fresh date with the reforms needed to be ratified by the Greek parliament by Wednesday 15th July. All eyes on then on the Greek parliamentary vote Wednesday.

In the UK, industrial production data for May revealed a mixed message with further expansion driven by a recovery in oil sector activity but manufacturing output contracting due to the Eurozone uncertainty and strength of Sterling relative to the Euro.

The UK Budget revealed a more gradual path of fiscal tightening and a more moderate pace of spending cuts. This would lessen the need for monetary policy to remain in place for quite as long, although given events in Europe the BoE is unlikely to change its supportive stance. We thought the most positive thing to come out of the UK Budget for UK equities was the proposed reduction in Corporation Tax from 20% to 19% in 2017, falling to 18% in 2020. The other news for investors was the news that from next year, dividend tax credits are to be replaced by a tax free allowance of £5,000 with tax of 7.5% above this level for basic rate taxpayers.

In the USA, the trade deficit widened in May as the strong US Dollar continues to make life difficult for US exporters.

Japanese machinery orders increased to a seven year high in May suggesting that the recovery in company profits is feeding into higher investment.

The oil price dropped on the back of developments in China and Iranian nuclear talks. The IEA forecast a slowdown in oil demand in 2016 while supply would continue to build, with Iranian production to also possibly come back on stream. Brent settled lower at around $57.

Finally, we must thank one of our clients for pointing out the latest Eurozone plan to protect holidaymakers travelling to Greece this summer. From now on all Euro’s will be printed on Greece proof paper!

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The Good, the Bad and the Ugly

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