20 mins. to read

Given all that has happened in markets this year, many would be forgiven for thinking we were further than half way through it. The six months that have elapsed have themselves been a tale of two halves. Optimism over the global economic recovery saw many stock markets push on towards multi-year highs by the end of the first quarter.

However, the tide swiftly turned in the second quarter with investor optimism and hope being replaced by pessimism and despair. The chief sources of angst again lay at the doorstep of Europe with waning confidence in the ability of leaders to address the bloc’s debt crisis. Election uncertainties in key European nations such as Greece and France added to the mix, as did a banking crisis in Spain. As a result markets gave up much, and in some cases all, of the gains seen in the first three months of the year. 

As we turn into a new quarter the tide seems to be turning once again, with EU leaders it seems now acting decisively and in unison. Economic data elsewhere in the globe however remains somewhat mixed, meaning that central bankers are likely to maintain an easing stance for some time. 

Meanwhile equities overall remain historically cheap. So what do the next 6 months hold for investors?

Certainly it seems opinions on this are changing almost daily, and we have sought to communicate our view on changing developments through our daily notes.

A key thing emerging from the past 6 months is that some perspective needs to be maintained amongst the daily noise, and with this in mind over the next two weeks we are revisiting our ‘Top Ten Themes’ from the start of the year. Not surprisingly we believed Europe, and the policies of central banks was to be a key area of focus for markets, and so it has proven. The oil price however also holds key implications for markets. In Australia meanwhile it also seems timely to revisit our call on the carbon and mining taxes.

1. Future of the Euro

At the start of the year we posed the question whether 2012 be the year that a country leaves the eurozone? And as the past six months have gone on, the unthinkable suddenly became very thinkable. A Greek referendum set the cat amongst the pigeons, the prospect gained momentum as the ‘first’ Greek election saw anti-bailout parties gain a seat in the table.

However when push came to shove it seemed the Greek public ‘really’ did want to remain part of the Euro, and recognised the potentially disastrous consequences (for themselves) of returning to the Drachma. The second election saw the balance of power restored to pro-bailout parties.

However the problems facing the single currency were not going to be laid to rest by Greece facing up to its fiscal responsibilities. Particularly, as Spain and Italy were now firmly in bailout territory themselves.

The point was hammered home by legendary trader George Soros who recently talked of there being ‘three months to save the Euro’. He then went as far as to present a plan for Europe to move forward and avert a deepening crisis that could bring on “a lost decade” as he puts it.

Mr Soros called for a European Fiscal Authority, a Debt Reduction Fund and European Treasury Bills as mechanisms for Europe to move out of the crisis. 

He also astutely observes the problem at the core of the crisis:-

“The main source of trouble is that the member states surrendered their right to print money to the ECB without fully realizing what that entails – and neither did the European authorities.”

And we concur that practical steps towards constructing a fiscal and banking union which are needed to address the concerns of the financial markets over the near term. And this necessarily will require the absolute buy in and political will of the bloc’s dominant player – Germany.

Germany needs to act decisively to preserve not just the periphery and problematic nations, but the very core of which it dominates.

The biggest loser to the breakup of the EU would unquestionably be Germany. As Mr Soros points out Germans have ‘suffered practically no losses so far. Transfers have all been in the form of loans, and it is only when the loans are not repaid that real losses will be incurred.”

The euro has continued to lose ground against all the major currencies including the US dollar and this is providing a significant boost to the German economy with manufacturing companies and exporters doing near record levels of business. The strong German economy is deceiving the German population into thinking that the Eurozone debt crisis has bypassed them.

Certainly the question of the Euro has marked an important cross-roads for the markets.

This came to a head on the last two business days of the quarter with the EU Summit. Going into it markets were extremely nervous and sceptical that a breakthrough could be made on the Eurozone debt crisis. With views very much polarised at extreme ends of the spectrum, the investor relief at the compromises reached at the Summit and Germany’s reversal on key policies caught many by surprise.

The first major move coming from the Summit was agreement on a 120 billion-euro plan to stimulate growth. That was certainly a positive, but the stickier point to come was what decisions would be made on the bailouts of peripheral economies. And the decision to ease loan terms for Spanish and Italian banks was a decisive clear signal here. Also highly significant was the decision to set up a single banking supervisor,  

As a result it seems the Euro has been left to live another day, or at least another three months…..

And this has certainly shown up in the price of the single currency which understandably has been beaten up this year. Some were forecasting a test of the 1.20 level (vs the USD) but the recent political progress may now call into question that scenario. 

Given the high levels of debt abounding in peripheral nations it is too early to say that the notion of any country leaving the Euro is out of this question. And it will likely remain a source of angst. That said progress made recently seems to skew things toward the Euro holding together as the status quo, at least for the remainder of 2012.

Certainly the consequences of a country leaving remain significant and any decision will not be taken lightly. A country leaving would most likely see a run on its banks, a related credit contraction and downturn, and a period of higher borrowing costs with no European support. Weak credibility would see the new currency devalued while money printing to support debt would weaken it further and create more instability.

However it is not a one way street and remaining in the currency also brings some pain, particularly as the country forgoes any real control over monetary policy.

We believe that the prescription for “fiscally challenged” Eurozone countries will remain very much one of austerity first. However the changes in the balance of political power in certain countries, most notably France, mean that heed will also need to be paid to growth pacts.

The challenges facing Italy and Spain in particular mean that there will be likely be an on-going drag on the single currency versus peers. Particularly as the ECB will now be expected to support EU leaders and maintain a loosening stance. However decisive moves and increasing political co-ordination should avert any freefall of the single currency. An exit by a country from the Eurozone looks less likely now than a month ago, but certainly significant challenges still remain in keeping the club together.

2. European Sovereign debt

At the start of the year we stated that the key issue facing Europe is whether countries like Italy, Spain and Ireland can get on top of their borrowing. If they could then then Greece’s debt write-down could be taken as the exception rather than the norm. Failing that we would see further instability in Europe affecting the global financial sector and therefore global growth rates.

Clearly as the year has gone one, concerns over some of the peripheral countries’ ability to handle their debt load has indeed receded, with market expectations of a default by either Portugal or Ireland as examples, receding. However two of the largest players, Spain and Italy, have been of increasing concern, with implied default probabilities higher than they were at the start of the year. Cyprus has also officially became the fifth eurozone country to seek a bailout of up to 10 billion.

Market Implied Probability of default over next five years

And with significant debts this has no doubt increased market angst, as Italy and Spain are viewed by many as too large to bailout conventionally.  Indeed this was much of the backdrop of fears heading into the latest EU summit. 

Italy of course is a key part of the sovereign debt problem as it has a debt to GDP ratio second only to Greece. However, as we have pointed out, the country also has a high level of household wealth and a diversified economy. This means that the country is arguably in a better position to get its fiscal position back on track.  Spain’s predicament meanwhile is as a result of a collapsing property market. And an elevated level of debt and higher unemployment were always likely to mean that it needed to be the first ‘big nation’ to be addressed.

And so it proved, with country’s banking sector raising its hands for a bailout.

The reaction of EU leaders to requests from Spain (and Italy) for a bailout was key, and ultimately came as a relief. The decision to ease loan terms for Spanish and Italian banks was a clear signal of intent to extend support and not let peripheries (and Europe) sink into the abyss.

Germany dropped the critical requirement that governments receive preferred-creditor status on crisis loans to Spain’s banks. This is key and paves the way to recapitalise lenders directly with bailout funds.

Also highly significant was the decision to set up a single banking supervisor, which means that the institutions can go direct rather than apply for aid through their (in some cases already debt laden) governments. The support of Germany was integral to this – so it was a relief to see the German parliament approve the creation of a permanent bailout fund.

Unsurprisingly, the upward dynamics in stock markets have been mirrored in the bond markets with Spanish and Italian bond yields dropping sharply, and well below critical highs.

The overwhelming positive is that heads are firmly out of the sand on the issues being faced, and that consultation is occurring, and compromises being made. The key now is how effective the plan is, and what happens at the next stumbling block. We are not out of the woods, and that many challenges remain in the European rescue plan.

A clear and realistic plan to deal with the immediate sovereign debt and banking crisis and a roadmap to the longer-term objective of further integration will continue to be greeted favourably.

Credit ratings of selected sovereigns


Currently tensions in the euro bond market are also dissipating, with Italian 2 year bonds firming in price again as two year yields fell to a 7 week low of 3.26%. It was also telling that the cost of insuring against default on European corporate and sovereign debt has fallen to the lowest in two months.

Cost of default protection for non-financial corporates 


Certainly unemployment (which depresses domestic demand) remains a key headwind for much of the peripheries’ abilities to get themselves out of the mire. The jobless rate in Europe has ticked up to just over 11 percent with 17.561 million people out of work. Spain’s unemployment rate, the steepest in the EU, now stands at just under 25 percent.

There remain significant challenges in the quest to address the Eurozone debt puzzle. Although as the cases of Portugal and Ireland show, it is possible to turn things around in a relatively short space of time. The risk of further debt downgrades is likely to remain at the forefront through the rest of 2012.  However the increasingly co-ordinated response and support of stronger nations in the EU will go some way to ensuring that angst does not reach previous elevated levels.  

3. Global monetary policy

At the start of the year we noted that the outlook for global monetary policy remained biased towards additional easing, potentially through further QE, or at least rate cuts. We stated that the prospect of monetary tightening in the US and Europe is a long way over the horizon, with the result that the outlook for the world’s major paper currencies continues to be weak.

In such an environment, it is difficult to be confident in the ability of paper currencies to store wealth, and we expected precious metals (particularly gold) to remain well supported.

As the year has rolled on, the case for further monetary and fiscal stimulus has ebbed and flowed. For the most part interest rates have remained low, and in some cases (such as Australia) we have seen further cuts. However we have yet to see any action on the QE front which has disappointed some investors. This has flowed through to precious metals with the gold price being marginally below where it started the year, and currently around $1600.

However we have made the point that a lack of action in terms of QE or other stimulative measures should not be confused with a lack of willingness. Central banks for the most part have said and shown they are ‘willing’ to act, the question is one of timing.   

And when the move comes it can be significant in timing. A key example being the Central Bank of China which surprised the markets by making a 25 basis point cut in June, the first in four years. We had suggested that this move was likely due to a slowdown in growth and lower inflation, along with a desire to stimulate consumption. It certainly seems that this is the case in all three instances. 

Whilst the export driven side of the growth story is certainly not needing any help at the moment, the domestic side is less rosy. This confirms the view that recent easing shows that China is committed to, and has the capacity to ensure, a soft landing.

China’s situation meanwhile contrasts with that of the US which has been struggling to cope with tepid growth.  

Some were disappointed by the lack of any move so far this year on  the QE front by Bernanke and the Fed. However we believe this is symptomatic of the mixed messages coming through on the US economy.   

Whilst some manufacturing and jobs data has disappointed, much of the corporate and other economic data coming out of the US has been positive. Indeed the housing market is exhibiting signs of growth again, which in turn should have a favourable impact on job creation. Subsequent jobs data over the coming months could show this month’s data is merely a blip.

We believe this has been factored into Ben Bernanke’s thinking and when he talks of the Fed having ‘tools at their disposal should the economic recovery falter’ there can be no doubt over a willingness to act.

QE3 very much remains on the table as a policy option should Bernanke and co deem it necessary.

The wildcard also remains  of course the situation in Europe. A disorderly sovereign default in Europe could certainly be the trigger for further QE from the Fed.

Meanwhile in Europe the gauntlet has been thrown down to the ECB to follow the current line of political thinking, as they have done in the past. And we expectfostering growth will be prioritised over the risk of inflation. There also remains the question of whether the ECB will finally fire a QE bazooka of its own.

Here in Australia we have seen further easing by the Reserve Bank of Australia (RBA) with a 50 basis point cut in May and a 25 basis point rate cut in June. These have largely arisen from a weaker international picture (with a further deterioration in Europe and a more deliberate slowdown in China) and slightly weaker domestic conditions.

With the RBA now having delivered ‘material easing’ we continue to believe that the quantum and timing of further RBA cuts will be determined by events in Europe and China, and their likely impact on Australia’s economy. Certainly Australia retains a relative advantage in that there remains substantial scope for easing when compared to other peers. And indeed this may be favourable in order to increase the country’s international competitiveness.

4. Middle East tensions and the outlook for oil

At the start of the year oil of the sweet crude variety was trading around $100 and we warned of the risks to global economy of a price spike, particularly given increasing tensions towards Iran. With oil some $20 lower than it was 6 months ago this is clearly not the case currently, but nevertheless remains a risk, at some point.

The price of oil has very much moved in lockstep with equity markets over the past 6 months, spiking towards $120 in the first quarter as optimism on global growth gained, and then falling back down through $100 as angst over Europe escalated.

Ironically, tensions over Iran in particular have not dissipated, and arguably they are higher than at the start of the year.

And certainly this has the potential to drive prices higher in a short space of time. Relief over Europe and renewed fears over Iran saw the oil price rise 10% in one day in the past week. The ongoing deadlock in negotiations over Iran’s uranium enrichment program remains very much in a real issue.  EU sanctions against Iran come into full force this month, and no doubt will maintain tension on the oil price in the coming months.

However the risk of a military strike by the US (and its allies) any time soon. would seem incredibly remote. We continue to believe that any ‘plans’ would be put on hold, at least until the US election is out of the way later this year.

Should the economic recovery regain traction, the threat of oil prices reaching former highs certainly can not be ruled out.

And post the US election the ‘Iranian situation’ could well see a premium go back into the oil price.

5. Taxes – Carbon and Mining

At the start of the year we expressed the view that Australia’s decision to impose a price on carbon from July would have far-reaching consequences for the economy. In particular with electricity prices having already increased by 40% over the last three years, there would rise even more steeply over the next few years.

The Carbon Tax has now begun, but other than a lot of political posturing there has not been any tangible evidence of its impact.

After just one day, that is hardly surprising, but is serves to remind us that such imposts on the economy are usually creeping and often impossible to discretely measure.

Lower income households have been promised generous government handouts to offset any indirect effects of the tax, but we would expect the Reserve Bank’s inflation measure to eventually reveal the effects on prices over the next one to three years during the fixed price period.

The most visible impact of the tax will be from the transport industry who has steadfastly promised to immediately pass on all costs to its customers.

The rapidly rising price of electricity is another red zone where consumers will continue to see money draining out of the household budget, but much of the increases are attributable to regulatory increases allowed for infrastructure improvements. The carbon tax will merely exacerbate an already stressful situation for households increasingly focused on flicking switches on or off.

The Opposition has openly promised to undo the carbon tax legislation as its first action if elected, which creates sustained confusion and procrastination from affected industries hoping to delay any real expenditure brought on by the tax.

The Green Party’s ambition to create a totally renewable energy industry in Australia is unrealistic but exemplifies the pressure they are exerting on the embattled Labor government.


The market has struggled to accurately assess the financial impact on individual companies as the complexities of the effects of the tax are too difficult to quantify. Most large corporate have been actively reporting their environmental sustainability credentials for years, so there will be no quantum change in energy usage anyway.

The country’s growing energy requirements will struggle to adapt against the carbon tax impost, with renewable energy projects simply adding substantial cost for no discernible difference in emissions.

The high fixed cost price of the carbon tax is also at extreme odds with the tradable price of European carbon credits.

We believe that the government needs to find some more acceptable middle ground for its Clean Energy Future vision, in our view. Australia is blessed with an abundance of gas resources that could meaningfully reduce total carbon emissions, create substantial investment value and appease the environmentalists if they were willing to compromise.

Meanwhile the Minerals Resource Rent Tax also came into force from 1 July 2012. The original A$50 million profit threshold was watered down to A$75m to A$125m profit, and applies only to coal and iron ore projects.

The applicable tax rate was scaled back from the proposed 40% to 30% under the actual legislation.

We believe that the deductions under the legislation are very generous including accelerated depreciation, carried forward losses and allowed development costs write offs against revenue.       

Companies with deep inventories of potential iron and coal development projects will likely be less impacted as a result of the development cost allowances compared to companies with just operating coal and iron mines.   

There will be value leakage away from coal and iron mine earnings dependent on the amount companies can generate in offsets or deductions. The dollar value of that leakage is difficult to determine as no prior data exists to work from.

However we believe that falling mining revenue as coal and iron prices and volumes have softened and likely higher deductions coming through will put a hole in the revenue estimates the government was forecasting. The 2012/13 and 2013/14 years could be half what the government wanted.

Hence the outcry from the large miners has been subdued as the leakage to the government is very manageable but not avoidable.

We believe the door is as a consequence very much open to rake-in other commodity groups into the regime. It will only take the flick of a pen to legislate say copper under the MRRT. The Petroleum Resource Rent Tax takes care of the oil and gas industry.  

Australia will be less attractive for new investments in iron ore and coal mines in the near-term. However, the value proposition will, including the MRRT, always see a project get legs if the price is right. It is likely it will not take long for that mentality to reappear when assessing iron and coal projects in Australia.

The MRRT issue may not have caused as much fuss as the carbon tax has in 2012, but it remains a significant issue for the mining industry.

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