Economic stimulus or deficit reduction?

The US earnings reporting season has generally been a positive affair suggesting corporate America is finding its way towards better earnings growth territory. But the feel good factor has been interspersed with economic data that is at best ambiguous about the economy and at worst, raising fears of a double-dip recession. The latter looks increasingly unlikely, but the rate of growth in the US economy is hardly inspiring greater confidence amongst its consumers.

“The reaction to the outcome of the tests was quite muted, partly because of the weak nature of the tests themselves, but also because many of the banks in question had already raised capital anyway”

The US government, like nearly every government around the world, has engaged in massive fiscal stimulus programs that have resulted in huge deficits. The conundrum now for each country is to decide how quickly to try and reduce these deficits without crimping the economic recovery.

The US Treasury has certainly been on the side of promoting economic growth before worrying too much about fixing its $1.4 trillion deficit. But the UK and its European neighbours have tended to focus more on reducing their deficits, particularly through reducing government spending, ahead of GDP growth. It is almost a chicken and egg situation.

The US continues to be absorbed in the battle with China over the level of China’s currency. This forms a big part of the US’s trade deficit problem with China and resolution of the value of the yuan would go a long way to helping the US grow its way out of trouble. Even the IMF has said the yuan is "substantially undervalued".

But the Chinese government is playing by its own rules, understandably. The yuan has climbed 0.69% against the dollar since Beijing announced it was decoupling it from a peg to the US dollar on June 19. Will this be enough to appease the US? We suspect not.

No stress in Europe

Back in Europe, the major event (or non-event as it turned out) was the results of the bank stress tests on 91 European banks. This was a copy-cat exercise to the one done in the US last year, which resulted in several banks raising new capital and restoring a huge amount of confidence in the financial markets. In fact, it would be fair to say it was a significant factor in the turning point of the GFC.

So the European’s decided that repeating the tests on its banking system might produce a similar effect, except, they set the bar too low. Even though 7 banks failed the tests (5 of them unsurprisingly in Spain), another 17 barely passed. Critics have pointed out that the Tier 1 capital ratio test was set at just 6%. If that crucial test had been set at the more acceptable 8% level, then the banks would have needed to raise an extra 27 billion euros instead of the paltry 3.5 billion euros recommended. In addition, if losses on sovereign loans were included, then 23 banks would have failed, not 7.

The reaction to the outcome of the tests was quite muted, partly because of the weak nature of the tests themselves, but also because many of the banks in question had already raised capital anyway. This was another difference to the US situation. Since the beginning of the crisis, 34 European banks had already raised 300 billion euros in new equity. Most of Europe’s top banks have Tier 1 capital ratios well in excess of the international standards required by the Basel Committee.

Basel III on its way

The Basel Committee has scaled back many of its proposals to beef up bank capital and liquidity rules. The third instalment of the rules for the global banking system has been chipped away by nervous governments and of course, the banks themselves.

But President of the European Central Bank, Jean-Claude Trichet, said the reforms would still be rigorous enough to promote long term stability in the financial system.

The lobby group for more than 400 of the world’s biggest banks, The Institute of International Finance, said that the Basel III reforms could lop 3% off economic growth over the next 5 years in the USA, euro zone and Japan and cost almost 10 million jobs.

The G20 is set to endorse the finalised version of Basel III when it meets in November this year, with implementation from the end of 2012.

The technical picture for the FTSE is starting to improve as the 5,000 level looks to have provided good support once more. The 200 day moving average is the only remaining resistance, a break of which would give us a target of c.5700/5,800 which is derived from the completion of the recent bullish flag continuation pattern. This upside target is very close to the 2010 high, should the 5700 target be reached a test of the 2010 high would be extremely likely.

The 5,332 level should now provide near term support, this level is equal to both the June high and the 200 day moving average. The recent low of c.5,090 and the key psychological 5,000 level are likely to provide support if the 5,332 level is breached.

The Dow managed to convincingly break out from the downtrend line in place since the June 10 high. In addition, has closed above the 200 day moving average (red line) at 10,409, which is very bullish. The converging RSI and MACD are supportive of the upward move, which leaves the immediate resistance at the June 21 high of 10,594. Should a break above this level result, we would expect the next upside target to reach the May 13 high of 10,920.

Downside support lies at the 200 day moving average (red line), followed by the psychological 10,000 level.
 

Gold continues to trade below both the US$1200 level and the 50 period moving average (green line), which suggests weakness in the near term. This is supported by the RSI divergence. Should a continued decline result, we would expect the May 5 low of US$1,156 to offer initial support, followed by major support at the 200 day moving average (red line) at US$1,148.

Though gold is likely to experience short term weakness, there is no change to our longer-term bullish view.