U.S. market turns down on Euro fears

Although the FTSE 100 finished in marginally positive territory after the budget, the DOW Jones Industrials dropped 53 points to finish at 10, 836 as the Euro continued to fall heavily against the dollar.

The Euro was hurt by Fitch, the credit rating agency, which downgraded Portugal’s credit rating to AA- from AA, citing “significant budgetary underperformance in 2009” and “structural weaknesses” in its economy. German Chancellor, Angela Merkel, continues to resist pressure to offer economic aid to Greece as unsurprisngly a bail out would be politically unpopular. Germany is holding out against any deal until the Greek governnment has exhausted its options to borrow on the bond markets, or from the IMF (International Monetary Fund) and allow it to roll over its debt. The Eurozone continues to look a mess as there is no mechanism to devalue which would have been Greece's preferred option under the Drachma.

It was interesting to watch Jim Cramer's Mad Money TV show (CNBC) the night before last where he said the market was going much higher and the bears had been turned into cuddly koala bears.  Yet with all thus exuberance many risks exist for the global economy.  The first quarter earnings season in the U.S. is due to kick off in 3 weeks time and earnings will probably do well as firms continue to drive bottom line profits through cost cutting. However,  top line sales growth will be needed to continue the momentum in the second half of 2010. 

PIIGS debt may cause global economy to stumble in 2011

The debt default worries of the PIIGS European economies (Portugal, Ireland, Italy, Greece, Spain) look increasingly to be disregarded by the markets after the worries of last week. In order to safeguard the integrity of the Euro, there is significant political pressure for the more economically strong countries such as Germany to step in to the weaker economies such as Greece. However for politicians like Angela Merkel to sell any bail outs to their electorates is a difficult task. Greece and the other PIIGS countries are seen by French and German voters as having brought their problems on themselves through bloated state pension schemes, poor tax collection, excessive spending and an inability for politicians to tackle powerful unions.

For the Euro to collapse would be embarassing for European leaders and therefore it is unlikely to happen. But the scale of debt rollovers is so large that it may become a huge issue as international bond investors refuse to take on the risk especialy if PIIG polititicians won't take the difficult decisions and cut their budget deficits or raise taxes. Either route may mean that these politicians are voted out of office at the next national election. So these countries are stuck between a rock and a hard place! Without the flexibility to devalue their currencies, which countries like Greece used before the Euro, things are looking bleak for these heavily indebted economies. Suddenly the U.K.'s decision to keep the pound looks good for the British economy especially with the debt being racked up in the recession. Overall I fear that the glut of debt in Europe and the U.S. will come back to haunt the stock markets of the world in late 2010 and 2011, especially when stimulus spending comes to an end in the United States.

U.K. General Election result should drive direction of the Pound

This morning there was an interesting debate on CNBC after the future direction of the British Pound versus the Euro. The Euro has been under pressure over the last few weeks as Ireland, Portugal, Spain and particularly Greece struggle with huge budget deficits and sharply declining GDP’s.

If the Bank of England decides to maintain rates at 0.5% despite the worrying inflation numbers released for December, the pound could come under pressure as other economies raise interest rates faster as their growth recovers faster. This is already happening in Australia and although the U.S. Federal Reserve seems to be reluctant to raise interest rates in 2010, 2011 may be a different scenario particularly if U.S. treasury auctions to fund the huge budget deficit start to become difficult.

Both the Labour government and the Conservative opposition in the U.K. acknowledge the current budget deficit needs to be tackled but detail on is scant as the Election looms this summer. VAT moved back to 17.5% from 15% in January and several tax increases are due to hit in the next financial year starting April but the deficit remains a significant concern for the U.K. economy. The issue of government debt (Gilts) to fund this budget deficit has been supported by the Bank of England’s Quantitative Easing (QE) programme, but this will come to an end this year. In Q3 2009, the Bank of England bought some £97 billion in Gilts as part of QE.

The risk is that this Summer’s General Election will produce a Hung parliament where no party has an overall majority and this will slow down efforts to bring down the deficit. If this happens there will be a double whammy as Gilts continue to be issued and QE slows down to soak up the issue of this debt. The price of Treasury’s will fall as demand drops for these securities and the yield will rise. If the deficit is not dealt with quickly, there is a risk of Credit Rating Agency downgrade, reducing the U.K., triple A rating which again would push Treasury’s lower and the pound. A clear Conservative party win should reassure investors and drive Sterling and government debt prices higher. Therefore the future direction of the Pound seems linked not only to the future movements in Interest rates but are intrinsically linked to the Election. Uncertainty spooks investors, and a party without a clear electoral mandate through a majority in Parliament may be bad news for investors in Sterling.