Factors affecting volatile equity markets

Feb 10 2010 by Andrew Miller, The Journal

EQUITY markets had an unsettled time in January with the major markets posting their largest monthly fall since February 2009.

January’s sell-off continued into February as investors focused their attention on the potential debt problems faced by a number of the euro-area countries, while choosing to ignore the positive data from the economy and the corporate sector.

So is this just a temporary setback or the start of something more sinister?

In order to answer that question we must first look at the reasons behind the sell-off. Several factors have upset the markets. These include Greece’s fiscal position, the threat of greater regulation of banks by the Obama administration, and the tightening in Chinese monetary policy.

Market worries over the last two of these factors seem overdone. Tighter Chinese monetary policy is the result of the better than anticipated recovery in the Chinese economy. Greater financial sector regulation was expected, and the recent proposals, if implemented, are expected to have a manageable impact on earnings, being enacted over a number of years rather than immediately.

This leaves the current focus on the fiscal positions and outlook for the sovereign debt of the peripheral European economies. Greece has been under the spotlight since the beginning of the year, but attention has now turned to the other countries where the market foresees problems – Portugal, Ireland, and Spain.

Concerns over these countries’ deficits cannot be shrugged off. They will probably suffer a period of sub-trend economic growth as government spending is slashed to cut back fiscal deficits.

But it seems premature to conclude that current problems will worsen significantly – possibly to the extent of one or all of these countries leaving the euro.

And, if the worst happened, the small size of the Portuguese, Irish and Greek economies would make it easier for larger countries to come to their rescue if needed.

Spain is a much larger economy, accounting for around 11% of euro-area GDP. However, its current problems must be put into context. Spain sensibly ran fiscal surpluses from 2005 to 2007, which left its gross debt, as a percentage of GDP, at very low levels going into this crisis. This should have left it with ample capacity to run fiscal deficits in the short term.

Given that Spanish unemployment is approaching 20%, the necessary adjustments will not be painless.

But the credibility of the authorities is high, and given relatively good current debt-to-GDP ratios we do not believe that the current fiscal situation will deteriorate sharply and lead to as bad an outcome as some fear.

So we do not believe that this is the start of a large correction, but do think that the situation is serious enough to monitor on a regular basis.

Investors remain very nervous, but we think that this nervousness will abate as it becomes clear that a renewed economic downturn and banking crises is not at hand. Volatility may remain high for a while, but this is not the time to be reducing equity positions.

Andrew Miller is head of Barclays Wealth office in Newcastle