IS THIS the beginning of a new market plunge? Probably not - but ask me again in 48 hours.

Slow global growth will test markets
July 1, 2010

IS THIS the beginning of a new market plunge? Probably not - but ask me again in 48 hours: there's a couple of hurdles to clear in Europe first. They are, in batting order, tonight's ejection of Greek bonds from bond indices that are the template for sovereign bond funds, and tomorrow night's withdrawal of €442 billion ($A630 billion) of central bank lending from the European banking system.

Both these events were predictable. The central bank money was supplied to more than 1100 European banks a year ago as a buffer against the financial crisis. It was always temporary, and now it's being withdrawn, with back-up measures in place in case it all goes pear-shaped. And people invest in government bonds because they want their money to be safe, and an investment in Greek bonds no longer fits the bill.

Both situations have the potential to cause disruption, and a clear read on the forces behind the global market selloff will only emerge when they are resolved.

The trigger for the ejection of Greek bonds from the indices was the mid-June decision of credit-rating agency Moody's to join Standard & Poor's in ranking Greek government debt as junk. With two of the three main ratings agencies classifying the bonds as garbage, the bonds moved outside the investment mandates of the bond indices and associated funds.

Greece can count itself unlucky: the odds on a Greek bond default actually lengthened soon after S&P moved, when Greece secured a €110 billion lifeline from the European Union and the International Monetary Fund.

Moody's believes, however, that a junk rating is justified given the risks the Greek government faces as it attempts to cut spending, raise taxes and rein in its debt to justify the funding lifeline, and the implications of the downgrade are playing out this week as bond investors quit their holdings.

Greek bond spreads are spiking upwards as this occurs - but it should be a momentary flutter: the European Central Bank is the only buyer, and when it has finished mopping up, the market for Greek debt will be moribund for years as Greece get its balance sheet in order.

The scheduled repayment of more than half a trillion dollars of one-year funding to the ECB by more than 1000 banks raises two concerns.

The first is that repayments will expose liquidity and solvency issues in weaker banks, including Spanish banks, which have high exposure to commercial and residential property. The ECB will extend short-term funding to banks that struggle to cough up the dough they owe, but the repayment deadline is, in a sense, a stress test of the European banking system.

Those who believe the full extent of the collateral damage Europe's banks took in the crisis has not been revealed are watching closely, and hedging their positions by selling before the deadline.

The second concern is that banks will look to shareholders for new equity to help fill the hole the repayment of the ECB money creates. This is manageable, if the the first test reveals that Europe's banking sector is healthy.

If the two hurdles are cleared, attention will return to the longer-term issue investors are confronting: whether the global economic recovery is faltering.

Economic data for the rest of this year needs to be treated with care because it is increasingly being compared with a recovering economy a year ago, rather than the abnormally low levels of activity that accompanied the final phase of the global crisis.

In Australia, jobs growth, house price rises and retail spending have slowed in the face of the Reserve Bank's decision to boost the cash rate from 3 per cent to 4.5 per cent between October and May.

In the US, the housing market continues to struggle, profit downgrades are flowing, consumer confidence is falling again and bank lending has been declining.

Concerns in the market this week following a downgrade in the US Conference Board's growth forecast for China are less serious: a slowdown from an unsustainable pace is being engineered, and Beijing still looks likely to stay in control of the process.

In Europe's markets, however, there is concern that stimulus is being withdrawn too aggressively. The dangers were aired by the Obama administration in the lead-up to last weekend's G20 meeting, but Europe is holding its course, and the developed-nation members of the G20 effectively endorsed Europe's tack by committing to halve their budget deficits by 2013.

Evans & Partners strategist Michael Hawkins notes that the global growth questions will not be completely answered for several months.

The good news is that slow global growth is now factored into sharemarket prices. The Australian component of the MSCI global index, for example, has a solid base now at 11.3 times expected earnings in the next 12 months, down from 16.8 times in September last year, and well below a long-term average of 14 to 15 times earnings. Wall Street's S&P 500 index looks just as inexpensive, at 11.7 times estimated earnings a year out.

But there's bad news, too: the relatively lengthy time frame for a resolution of the risks to global growth means that a sustained and rapid sharemarket rebound is also unlikely.

mmaiden@theage.com.au

Source: The Age