FTSE 100 Bounces back strongly in July
The market has staged an impressive rally in the last month following an earlier decline of some 17%. Part of the reason was that equities were oversold in mid-June with heightened fears about the Eurozone sovereign debt crisis and an economic slowdown centred on the US where there was a raft of disappointing data, especially in the housing sector, which reawakened concerns about the possibility of a double dip recession.
Since then there has been an improvement in newsflow, most notably in the Eurozone where conditions have been calmer than at any time since the crisis erupted in April. This has helped the periphery states raise funds in the bond markets and further confidence was provided by the stress tests for 91 EU banks that were received well. Soon after, the new banking regulations were published (Basel III) and these were also received favourably. Although the economic newsflow in the US continues to point to a slowdown, there was better data in Europe, which has benefited from the weak euro and in the UK the Q2 GDP figure surprised on the upside. Finally, the Q2 results season has also been positive with most companies beating expectations. At the same time, the UK market has benefited from increased M&A activity with several bid approaches in the last month.
Ultimately, the performance of equities will be determined by the level of earnings and dividend growth. Despite the disappointment of BP, the impressive earnings reports have underpinned the current rally, but they reflect what has happened and not what is going to happen. In this respect, I expect the economy to show muted growth in 2011 as the austerity programme takes effect and the slowdown in the US and elsewhere makes it more difficult for companies to grow profits. Although we are currently going through a relatively calm period in the sovereign debt crisis, the issue of solvency is still a long way from being solved and it is likely we will have further periods of anxiety that will undermine confidence in risk assets.
In summary, I think most forecasts are too high for 2011 and with the continuing high levels of debt, especially at government level, the inevitable deleveraging will lead to a period of sub par growth. Although the equity markets have been buoyant, the bond markets' performance has been giving different signals. Yields have fallen sharply in the US and UK implying slower growth and the breakeven inflation rate has also fallen a lot, which has contributed to renewed concerns over deflation. While I think that deflation and/or a double dip recession is unlikely we are set for period of slow growth that will increasingly be reflected in decelerating earnings growth. Valuations are modest which means that the market will probably continue to be range bound with the risk that if the sovereign debt crisis erupts again there could be another sharp sell off.
Ted Scott
July 2010
Article last updated: Jul 29, 2010
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