CFO – 2ND QTR: HIGHER STAKES TO WATCH, DURING YOUR SUMMER VACATIONS

(14 July 2011) The end of QE II has lifted the fog over the financial markets.  We are now discovering the stakes have grown higher in 4 areas.  The third quarter will remain eventful, just as CFOs will take their vacation weeks.

USA

The economic growth engine in the USA is sputtering:  Unemployment and real estate remain a serious drag.   The debt ceiling issue has become the playground of harsh partisanship politics.  Increasingly the ghosts of the Japanese lost decade are coming back to haunt the Americans:  sluggish growth, high debt, and a slow transformation.  Not quite as bad as in Europe, but sufficiently serious to prompt the Fed to think about a QE III.   This was just the pattern witnessed in Japan.  It is hard to tell which of the US$ or the Euro is more vulnerable.

EUROPE

Austerity programs, pushed in the throats of peripheral countries like Greece, are not quite buying the time hoped for by politicians, and the French and German banks.  Financial markets are not convinced by a plan to create more supranational debt, while austerity dims the economic growth prospects of Southern Europe.  Contagion theories are back.  Speculators are eyeing Italy, and are testing everyone’s nerves.  Italy has come to control its budget deficit, but debt/GDP is standing at 120%, and growth averaged less than 1% for the last 10 years.   Not quite a standing duck, but the margin of error is rather slim for Italy.  The Euro has in the meantime stood its ground in the currency market.   We suspect the hand of China is protecting its economic interest. Slowly but surely, we are moving towards a resolution of the 3 factors:  Debt restructuring, loss distribution, structural reforms.  The longer it takes, the more painful deleveraging will be. 

CHINA

Perhaps the greatest level of rumours was found in China.  Growth for the 2^nd quarter was just reported at 9.5%, calming some stretched nerves.  Yet we seem to go from quarter to quarter about China growth, uneasy about a potential reversal.  The authorities are working hard to contain inflation, which notched up to 6.4% (and food inflation at 11.7%).   They even let the Yuan slightly appreciate against the US$.   There has been a string of reports about the true level of debt in China, and bad loans.  There are surely a few holes in the balance sheets, but we will have to wait and see to get the real picture.  There is room for a few surprises in China on that account.  But the real thing to watch is how China will manage a transition from a growth rate of near 10% per annum, to a more sustainable level of 6-8%.  When and how this takes place is a crucial piece for the rest of the world.

REST OF THE WORLD

As America and Europe remain fragile to external shocks, the rest of the world does count.  The Arab spring is inching forwards.  Egypt is not making much noise, but it is a large country and its political path remains uncertain.  In the 4 BRIC countries, inflation ranges from 6.4% in China to 9.6% in Russia.  There is some story to watch in those numbers.

World economic growth forecasts are still standing clearly above 4%, steady and safe for commodity countries like Canada and Australia.   But the 3^rd quarter might move those forecasts.  The game is tight.

André Du Sault.