There are two issues just ahead on which you need to keep an eye.
First the still unresolved eurozone crisis. Over the next month the EU will be meeting to try and hammer out a permanent solution to the sovereign debt crisis. The problems of the “web of debt” will not be solved without noticeable pain and our sense is that this pain must be felt more equitably. European voters will surely require that the risks are not simply transferred from European banks to taxpayers, as happened in Ireland, or there will be much greater civil unrest and, eventually the election of politicians who will not be looking to prioritise a cosy European consensus. Fingers crossed that market turbulence derived from Europe this month will just be short term noise.
The second problem arises in June. Ben Bernanke, head of the US Federal Reserve, introduced quantitative easing from 2009 (QE1 and QE2) to resuscitate the US economy, and support from QE2 ends in June. It is not clear that their economy can stand on its own two feet without such artificial stimulus. The implication is that the US stock market (and a fragile economic recovery) will not hold up beyond June unless QE3 is announced – but support for the latter is far from assured.
Concerns over a slowing economy later in 2011 are already showing up in the UK. Government bonds in the UK (gilts) tend to improve when the outlook for the economy is dull, and inflation likely to fall away, and gilt prices rose strongly from earlier in February. This doesn’t tally with the panicky headlines about inflation, so what is going on?
One catalyst for this turnaround was the Middle East unrest, which saw an investor flight to safe assets such as gilts. But the flight to safety was also fuelled, excuse the pun, by the market’s recognition that oil price rises are in fact deflationary. If you have to pay more for petrol at the pumps you will have less money to spend on other things. So while external inflationary pressures can push up prices today, they weigh down on UK consumer spending tomorrow at a time when unemployment has hit almost 2.5million. Consequently a near term cut in consumer spending (deflationary) is more likely than an increase in wage demands (inflationary).
This is to the benefit of gilts, and this is why gilts are sending out a very different message from the media. And of course this is being played out prior to the full impact of the government’s austerity cuts, also deflationary.
These deflationary tendencies highlight the risk of the UK economy slowing, and this is not helpful for the stock market in the months just ahead. There has been a fantastic market recovery since the lows of March 2009 (3500 on the FTSE 100 index compared to 5900 as we write) and a breather is overdue. Such a “breather”, or correction, can come in all sorts of shapes and sizes, but on the FTSE 100 it is straightforward to observe that support is down at 4800.This could be a bit uncomfortable in the short term, though it will create opportunities for those of you keeping some powder dry.