An update from Perpetual - Economic data has been resilient, but sentiment has weakened

After notable declines in August, global share prices have continued to fall across most regions in September. However, this decline has not reflected developments in the US, where earnings came in better than expected during the recent reporting season and where US economic data confirmed a subdued, but positive economic expansion. In the wake of these trends, the market has wound back its expectation of an imminent double-dip US recession.

Investors are more focused on Europe than the US

Despite the seemingly more favourable US outlook, the Europe situation has been driving global sentiment with market trends subjected to heightened speculation and wild swings in sentiment. At present, European authorities have not been able to restore confidence in the regional situation and they cannot agree on whether the primary problem is bank balance sheet stability, market liquidity or the growing probability of a regional recession.

Can Greece meet its deficit reduction targets?

The main problem remains Greece, which has sunk deeper into economic recession in the June quarter and the speculation that it will not be able to meet the agreed deficit reduction targets under the terms of the May 2011 bailout deal. If this were the case, Greece may not receive the next tranche of financial assistance from its European partners. The Greek government announced an emergency property tax designed to raise an extra 1.7 billion Euros to close its 2011 budget gap and ensure the sustainability of public finances. If this is enacted by the Greek Parliament, the disbursement of the next aid tranche is likely by late September, which might improve market sentiment. However, short-term political risks remain heightened (due to the large amount of reforms that need to be implemented) and budget consolidation and tightening credit conditions will continue to hamper Greece's growth prospects in the medium term. Financial system concerns are amplified following ratings downgrades.

Yesterday, international ratings agency Moody's downgraded the long-term debt rating of French banks Societe Generale (to Aa3 from Aa2) and Credit Agricole (to Aa2 from Aa1), citing funding and liquidity problems. This had a more significant impact on Asian markets yesterday than in Europe last night. Moody's stated its belief that 'SocGen has a level of capital… that can absorb potential losses it is likely to incur over time on its Greek government bonds and to remain capitalized at a level consistent with its Bank Financial Strength Rating even if the creditworthiness of Irish and Portuguese government bonds were to deteriorate further'. Although Moody's maintained the rating for another French bank BNP Paribas at Aa2, it kept the rating under review. This has seen France's sharemarket record the largest decline post-August 2011.

China will help, but won't rescue, Europe

In contrast, August data show that China's economic activity has remained robust, with exports being more resilient than expected, the momentum of industrial production rebounding somewhat and property construction picking up speed. Meanwhile, Chinese Premier Wen Jiabao, who facing calls to widen support for indebted European countries, stated that developed nations should cut deficits and create jobs rather than relying on China to refloat their respective government finances and economies. This concerned investors who thought a Chinese-led bailout of Europe would be an easy solution to the current malaise.

Balance sheet strength and earnings growth remain the key for each stock's relative performance

As such, investors seem to be more focused on the macro picture at present, than company specific earnings outlooks, and this is usually the time when market volatility increases. The domestic August reporting season saw results that were not too far below pre-season forecasts. However, the reporting season was more notable for the commentary around the future outlook for growth in the wake of a soft non-mining domestic economy. The outlook here remains highly uncertain given the volatile global picture and the domestic situation that continues to be negatively impacted by our above-average interest rates and the resilient Australian dollar. In relation to earnings in FY12, the strength of each stock's balance sheet and the consistency and quality of its earnings will remain paramount to its absolute and relative performance and many stocks will require large margin expansion to sustain current prices, which will be a difficult task in the prevailing climate. In such as environment, market volatility is likely to continue.