Financial markets focus Q3: Your questions answered
Discussions about the global financial markets have led to some often repeated terms, but what do they really mean?
- Much anticipated bailouts
Eurozone countries such as Greece, Portugal and Ireland have all had trouble borrowing in the normal free markets at reasonable rates of interest. They’ve had to turn to authorities such as the International Monetary Fund, the European Union and the European Central Bank (ECB) for assistance. These organisations provide cheaper loans to these countries in return for a commitment to get their debts under control, and this is referred to as a bailout. Spain, and possibly Italy, may have to go down the same path.
- Dreaded austerity measures
Countries which have excessive levels of public debt and budget deficits, due to high levels of borrowing, have had to adopt austerity measures. These measures include either raising taxes to boost government revenue or cutting spending, and we’ve seen some European countries choose a combination of the two. It’s a difficult balancing act, because it cuts into economic activity, which may make it even more difficult to balance budgets.
- Plans to recapitalise banks
As economic activity weakened through the Global Financial Crisis (GFC), individuals and businesses defaulted on their loans. This cut into the capital base of banks, creating a need for recapitalisation. Without adequate capital, questions arise as to a bank’s long-term viability as a lender. An example is the recapitalisation of US banks at the time of the GFC, where the US government lent money through the Troubled Asset Relief Programme – most of this money has now been repaid at a profit. Spanish banks are now having to be recapitalised as well.
Investors have welcomed the news that the ECB plans to buy European bonds. Why is this good for the markets?
It’s certainly good news for the markets and it has had a calming effect on nervous investors. European countries have let their public finances get out of control over many years leading to excessive levels of public debt, and there’s an element of market panic that is worsening the situation. In terms of this panic, there is a role for a lender of last resort to step in and provide assistance – for Europe, the ECB could play part of this role.
The ECB’s position is if countries in need of assistance agree to conditions with the European bailout funds (to reform their economies and get their budget deficits under control), then the ECB, in tandem with these bailout funds, will buy bonds in these countries, pushing bond yields down to more sustainable levels. At the moment, we are waiting for implementation to occur.
A few major Australian companies have released their mid-year results. Have the markets responded well?
For this reporting season, the results for 2011-12 are not as bad as investors initially feared. Over half the companies that reported their half-year earnings have seen their share price rise on the day of reporting. And the overall market has risen since the reports started to flow at the end of July.
Some of the cyclical stocks, or stocks that are very sensitive to economic conditions, have seen strong gains in their share prices. The resources sector is experiencing real weakness at the moment, whereas the banking and industrial sectors have recorded modest profit gains. We constantly hear talk of a resources investment boom, but we also need to allow that miners have seen a fall in commodity prices at a time when they are involved in massive investment projects, and in some cases are seeing cost blowouts. All of this has resulted in struggling share prices and reduced profits, compared to a year ago, for the miners.
Should the Reserve Bank of Australia (RBA) intervene to limit the Australian dollar?
Such an intervention would involve the RBA entering the foreign exchange market, and selling Australian dollars to push their value down and buying foreign currency. The RBA has resisted calls to intervene till recently, but has become more concerned that the continued strength in the Australian dollar has seen it diverge from underlying fundamentals.
The counterargument is that the Australian dollar is not far away from where the fundamentals suggest it should be. I’d estimate that it’s no more than 5-10% overvalued against what the terms of trade might suggest. It’s not extreme enough to justify an intervention. If the RBA is fearful that the strong Australian dollar is bearing down on the economy, a better approach would be to cut interest rates. It’s an ongoing debate and the RBA is obviously looking at it closely.
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What you need to know
The information in this article was provided by AMP Capital Investors Limited (ABN 59 001 777 591, AFSL No 232497) and is current as at Wednesday, 22 August 2012. While every care has been taken in the preparation of this document, AMP Capital Investors makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. No reader should act on the basis of this article without obtaining specific professional advice.
