Friday, 21 September 2012

Week in Review: The paradox of flows and balances

Gold has risen over 10% since the start of August
In a more discerning week for markets, most European equities drifted back from the euphoric heights they had reached earlier in September – unsurprisingly as readers of Mike’s recent post will note.  A cloud of uncertainty lingered over the region as investors watched eagerly to see whether Spain would succumb to reality and ask for a bailout of its flagging economy.  The arguments against were strengthened by a successful Spanish bond auction with borrowing costs reflecting post-OMT lower bond yields.

More encouragingly, however, the Financial Times reported that the package of measures which would be demanded of Spain when it does admit defeat is being pre-assembled behind the scenes.  While we eagerly await the announcement, it is rumoured to centre on measures to enhance competitiveness rather than axing spending and hiking taxes.  It is certainly too early to conclude that Europe may have lost its suicidal obsession with austerity, but as regular readers will know, the chances of having your cut and eating it are remote indeed.  Many measures to restore public finances are detrimental to competitiveness and vice versa. 

Putting these observations in the context of Spain, one source of uncompetitiveness is weak educational achievement and this unsurprisingly correlates with relatively low educational expenditure.  Cuts should not be the order of the day here.

Following on from weak payroll growth and zero wage inflation in the US, the recent rise in the oil price has seen US gasoline prices march towards $4.  This squeeze will be hurting US real incomes. Weak growth might be a good reason for stimulus and, as the Fed acknowledged, the looming fiscal cliff provides further reason for caution.  But when it is incomes which are feeling the squeeze, quantitative easing is arguably the wrong weapon to employ.  After all, incomes are flows and will be further depleted by higher inflation as a result of the falling dollar (down around 5% over recent weeks – with perpetual Fed money printing still to come). 

QE bolsters balances. The Dow Jones, less than 8% away from an all-time high, is up 4% in September alone with the Fed’s open-ended gesture providing much of the impetus.  Apart from equities the housing market benefits from QE as the current mortgage backed securities purchases are designed to lessen the cost of home ownership.  All very well one might think, but home affordability in the US remains close to all time highs and stands out as a beacon of value against almost any other part of the developed world.  A property revival is likely on the cards in the US, with or without the Fed’s support.

Finally because quantitative easing has been so bad for the dollar it has conversely been good for the anti-dollar.  Gold has risen over 10% since the start of August.  It is hard to see the yellow metal struggling now that QE3 has become open-ended.  But when dealing with assets of dubious practical value one must be mindful of the saying that bull markets end when there’s nobody left to buy (because sentiment is strongest).  Perhaps this gesture may actually propel the yellow metal into the final stages of a speculative bubble… 

Guy Foster
Head of Portfolio Strategy

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