The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

The first hint of higher interest rates in the States arrived after this week’s FOMC meeting.  Thomas Hoenig (President of the Kansas City Fed) emerged as the first interest rate hawk on the FOMC and voted against an unchanged monetary policy.  Hoenig “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Fed funds rate for an extended period was no longer warranted”.  In plain English Hoenig wants the Fed to signal to the markets that it is going to begin hiking interest rates at some stage in the not too distant future.

At the moment Hoenig is the only dissenter on the FOMC.  It will pay to keep a close eye on whether his view gathers support at future FOMC meetings.

The market’s reaction thus far to Wednesday’s announcement has been most evident in the US Dollar.  Its rally, which began after the 4 Dec 2009 Employment Report, has continued and the Dollar Index (DX) has now broken above its 200-dma.  The 50- and 200-week moving averages are the next resistance levels to be surmounted and they lie just above the current 79.59 level of the DX.  Hoenig hankering after US rate hikes will only serve to help the Dollar to extend its recent rally.  Commodities (as measured by the CRB index) have reacted badly, the US stockmarkets have remained under pressure (but they started falling two weeks ago) but the all-important US Treasury bond market has traded sideways despite Hoenig hinting at higher rates sooner rather than later.

However it is difficult to believe that the Fed is going to implement the first rate hike until the US economic recovery has gained significant traction which results in a very visible fall in the unemployment rate from its current 10%.  There is so much spare capacity in the States that the Fed can afford to let growth continue to build momentum without worrying about higher inflation resulting anytime soon.  Any premature rate hikes would be a serious policy error which would impact the economy & stockmarkets severely.

A more likely explanation for Hoenig’s action in voting against the others is that it allows the Fed to test the market’s reaction to a proposed change in the current policy stance of “low rates for yonks”.  If markets react badly over the next few weeks (particularly if the US bond market tanks) then we can expect all the other FOMC members to very publicly bang the drum that interest rates are not going up anytime soon.  The FOMC knows full well that it will eventually have to tell the markets that rates are not going to stay at “exceptionally low levels for an extended period” and this is a low risk way for it to prepare the markets for an eventual change in monetary policy.

I still think that the first US rate rise is out of view and over the horizon (and more likely to take place in 2011 than 2010) but will be paying close attention to future FOMC statements for clues as to when policy is likely to change.

With consumers set to be squeezed after the 2010 election, supermarket shares may not prove to be as defensive as they used to be.  Stockmarket folklore has it that supermarket shares are defensive because people always need to eat and this held true in the days when supermarkets only sold groceries.  But these days supermarkets sell far more than just groceries.  With Tesco taking one pound in every eight spent by British consumers, they will not be able to escape the effects of consumers battenning down.  It is true that food retailers are shifting their offering downmarket in an effort to follow their customers as they trade down in tough times.  However not every food retailer will be able to protect their sales volumes & profits in this way.

Sales of organic produce fell 14% in 2009, indicating that consumers are already trading down, with organic meat sales being hit hard (beef down 25% and chicken down 28%).  Consumers may buy organic & ethically produced food when they feel they can afford it but with the Food Standards Agency stating that there is no scientific evidence that organic food has health benefits, when the squeeze comes consumers will trade back down quickly.

The pain thus far has been felt most by those people who have lost their jobs during the recession.  As interest rates have been cut sharply, the vast majority who are employed have seen their monthly budgets improve as mortgage payments have fallen.  However any post-election tax increases are going to be felt by all 29 mln employed people in the UK (and their families) and this effect will be very broad-based indeed.  The supermarket shopper is going to look to cut back even further and now that the weaker retailers have already gone bust, the one-off boost to the survivors’ sales has already been seen and all are likely to suffer.

The counter-argument to this is that consumers will cut back on eating & drinking out and spend more on their weekly grocery shop instead. This will affect the pub & restaurant sector (which has already de-rated in anticipation and offers better value than supermarket shares).  It remains to be seen what consumers will choose to do when the squeeze is applied by a government seeking to get the budget deficit back under control, but investors should choose to invest where the risks have at least been somewhat discounted and upside is on offer.

However with Tesco, Sainsburys and Morrisons all trading on 13x estimated 2010 earnings, yielding 2.9%, 4.1% and 2.1% respectively, these shares are not a Buy.  If you feel compelled to hold a food retailer then SBRY yields the most and benefits from periodic bouts of takeover speculation.  Much better value is available elsewhere in the market and owners of TSCO, SBRY or MRW should sell out of them as they are too highly rated, still trading within 8% of last year’s highs, and do not offer sufficient upside to compensate for the risk that their sales start to suffer later this year as consumers begin to be squeezed.

The key issue for the markets to contend with in 2010 is the risk that the economy slips back into recession (the so-called “double-dip”).  As the banks have now been largely fixed, should the economy double-dip then it is likely the retailers will be foremost amongst the suffers.   

The retail sector had a strong rally last year as the stockmarket discounted a recovery.  If we use MKS as a proxy for the sector, they rallied from just above 200p in Dec 2008 to finish at the 400p mark, with the annual dividend cut to 15 pence along the way.  The risk now is that the consumer gets squeezed after the May election and consumer spending suffers as a result.  Even if consumer spending does manage to hold up, the sector has already priced in a recovery and there is not enough upside left to reward investors sufficiently to risk owning the shares.  If the sector continues to trade lower then at some point it will make sense to buy back in for the next recovery trade.

A second sector to be very careful of in 2010 is the pub & restaurant sector.  Wet-led tenanted operators such as ETP and PUB are going to continue to struggle whilst their food-led competitors MAB and MARS may fare relatively better.

It is likely that a newly elected government will both cut spending and signal tax rises once the economy is strong enough to bear them. The Government has a massive hole to fill in, net borrowing will end up somewhere around £175 bln in 2009/10 and £180 bln is forecast for 2010/11.  The fact that this is 12.5% of GDP does not tell the whole story as it also represents 39% of pre-credit crunch tax receipts.  The government’s income has fallen by 12% over the past two years but spending has yet to be cut by a single penny.  The emperor has no clothes – Gordon Brown will not countenance spending cuts and doesn’t have any money to “invest in services”, whilst the best David Cameron will be able to do is maintain spending on the NHS and cut spending significantly everywhere else. 

Take a minute to think about the mountain that needs to be climbed in the UK.  Central government total tax income is forecast to be £397 bln in 2009/10.  Adding on £175 bln net borrowing implies total government spending of £572 bln.  In the best year ever, total taxes raised were £451 bln (2007/8).  Its going to be a long, hard slog to get back onto an even keel and it will take years to fill in this particular hole via a combination of spending cuts, tax rises and hopefully renewed economic growth causing the tax base to grow as well.  The Bank of England will wait a very, very long time before risking any rate rises against this backdrop – it is more likely that QE will be resumed (from its current £200 bln) to support the economy/gilts market before any QE exit strategies are implemented.

At the moment the retail sector carries all the risk of being first in the firing line should consumer spending weaken and lead the wider economy into a double-dip recession.  Avoid retailers until the sector offers patient long-term investors a much better risk/reward.

UK politicians have started the new year with their eyes firmly focused on the upcoming General Election, which will most probably be held in May.  This week’s Hoon-Hewitt challenge on Gordon Brown’s leadership has only served to increase the uncertainty surrounding the result of the General Election.

Markets hate nothing more than uncertainty and although the Conservatives are tipped to win this year’s election there is the distinct possibility of the result being a hung parliament.  In such an eventuality the correct course of action for David Cameron would be to call another immediate snap election, seeking a clear mandate from the British public.  However, politicians enter politics in order to gain power so do not expect him to risk losing his grip on power (however slender) by risking another election.  The only upside of a hung parliament would be that the very competent Vince Cable would become a Cabinet minister.

What the Gilts market (in particular) needs from this election is a clear mandate for one party to go ahead and tackle the UK budget deficit in a decisive manner for the duration of the next parliament.  With 10-year Gilts now yielding 4% and Base Rates stuck at 0.5% until at least the other side of a post-election budget (and likely a lot longer if spending cuts & tax rises are sketched out in the post-election budget – as they should be), a sharp sell-off in the Gilts market ahead of the election is not likely so the pressure will be felt most in the currency markets.  Sterling depreciating will be beneficial to the stock market as a result of translating overseas earnings and a lower currency making UK assets cheaper to foreign buyers (retailers who source their product from overseas, as well as relying on UK consumers who will likely be squeezed by a post-election budget, would miss out on this particular party).

Uncertainties about an indecisive hung parliament are likely to surface first in the currency markets and we can expect Sterling to wobble seriously ahead of the General Election.  The Bank of England is unlikely to worry too much about a further slide in Sterling unless it becomes disorderly (as the UK economy, which is still officially in recession, will benefit from cheaper Sterling), so expect parity to be tested against the Euro, although it is doubtful Sterling will stay below parity for very long.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).