Market Review 27 April 2010

Markets had a strong end to the week.  Indeed, the New York market ended higher for an 8th consecutive week.  Inevitably, this has provided short-term technicians with a reason for caution.  Since 1970, the New York market has only advanced for eight weeks in succession eight times and only twice has it advanced for nine consecutive weeks.

Furthermore, since the March 2009 low, the S&P 500 has had its sharpest gains since at least 1960.  Steep rallies were evident from the market lows in 1962, 1974, 1982, 1990, 1999 and 2003 but these gains were typically in the 30%-40% range.  The rise from 1982 low had hitherto been the largest rise with a gain of 62%.

Despite these slightly awkward precedents, there have been none of the normal signs to suggest that a correction of any great significance is imminent.  More ‘selective buying’ has historically provided one of the most reliable indications of an approaching market top.  The New York market peaked on 3 September 1929 but the New York Stock Exchange advance/decline line was already in a well established down trend and clearly below its 1928 levels.  Currently there are no indications of selective buying.  Indeed, if anything the market has broadened and the earnings outlook has improved.

At least a third of S&P 500 companies have now reported earnings and revenue for the first quarter.  Operating earnings per share for the first quarter look as if they will climb to around $19 from $17.16 in the fourth quarter of last year and $10.11 in the first quarter of 2009.  This recovery in US corporate profits has been achieved despite two notable headwinds, which may slacken in the second quarter.

Firstly there has been about $0.55 in one-time recognition of expenses associated with the recently passed healthcare bill and, of course, a stronger US dollar, particularly against the euro, has probably reduced overall US reported earnings by about 50 cents in the first quarter.  Corporate profits in the US will likely surpass previous peak earnings in either the second or third quarter of this year and operating earnings per share for the S&P should climb above the previous peak in the second half of 2011.   In light of the earnings recovery, the S&P 500 remains a modestly undervalued market.

Within Europe, the Greek tragedy continues to unfold.  Last week saw the cost of credit default swaps for Greece rise sharply.  There were rises also in two and 10 year Greek government bond yields.  Greece has $9 billion worth of debt to refinance by 19th May.  The EU package such as it may or may not be requires some form of ratification by 15 member states.

The terms of the new deal, therefore, need to be settled swiftly to allow this ratification process to get underway.  The situation has not been helped by an upward revision in the size of Greek government debt, from 12.7% of GDP to 13.6% last week.  We have little doubt that a package will eventually materialise.

In effect, though, the market has indicated that it does not want to buy any more Greek government bonds and has moved the cost of market funding well beyond levels that might be acceptable to Greece.  There is now no alternative to the EU package.  Meanwhile, for bond investors, there has been a shift towards German and French government bonds.  Germany and France are reaping the benefits of low interest rates while many other members of the Euro zone have higher rates now than they did at the start of the global recession.  The European government bond market spent much of late 2008 and 2009 pricing in the risk associated with large budget deficits and various Euro zone countries.

Over the last six months, Greek 10 year yields have risen 471bp, Portuguese rates have risen 124bp, Spanish rates are up 16bp and UK rates are up 29bp.  By contrast, German interest rates for a similar maturity have fallen 32bp and French yields are lower by 28bp.  It is hardly surprising that this is putting strain on inter European feelings.

Meanwhile, Germany is setting the pace in Europe.  In April, the German IFO business climate index rose strongly to 101.6 from 98.2 in March, reaching a two year high.  IFO current assessment of business continues strongly upwards too to 99.3 from 94.5.  Delving deeper, the IFO manufacturing diffusion balance improved to 7.5 in April from -0.4 reported in March, trade and industry rose to 2.5 from -4.3, while wholesale trade improved to 5.0 from -3.7 earlier and retail trade rose to -3.7 from -12.3 in March.

Germany is clearly powering away.  The further improvement in the IFO index is in line with recent rises of corporate profits as global growth has continued to improve.  And in Germany, at least, concern about a forthcoming domestic credit crunch has declined in recent weeks which may have been a contributor to the further improvement of the IFO index in April.

A similar divergence is taking place between banks – large banks are doing better than smaller banks, prompting the question whether or not the credit cycle has turned.  There are some signs, at least in the US, that this may be the case.

Analysts have focused on the trend in provisions for loan losses as a clearer indicator of future bank profits than quarterly earnings.  All the big US banks have now reported for the first quarter.  Bank of America reported provisions of $9.8 billion, down $305 million from the fourth quarter – most consumer and commercial loan losses declined.  JPMorgan reduced provisions by $274 million overall and cut reserves in its card services unit by $1 billion.  Wells Fargo trimmed provisions by $583 million and Citigroup cut them as well.

Big bank results, of course, have been lifted by investment banking revenue, which in turn has been helped by fixed income trading.  Near zero interest rates have enabled banks to access cheap financing for trading positions.  Bond underwriting increased from the fourth quarter as US companies tapped debt markets to lock in low borrowing costs.  Citigroup increased revenue in its fixed income markets unit sharply over the previous quarter.

The bank also marked up the value of sub prime mortgage backed bonds by $800 million, a reversal of write-downs that has caused much of Citigroup’s losses over the past two years.  Of the four banks, Citigroup, perceived as the riskiest big bank, is the best performing bank stock this year, up 46.8%.  Wells Fargo has gained 24%, Bank of America 22.4% and JP Morgan only 7.9%.  Meanwhile, smaller banks in the US continue to scuttle into the hands of the FDIC, whose liabilities in this area are now at a 17 year high.

It is important that bank balance sheets should improve and credit conditions as well, because as the economic recovery gets underway, companies and individuals are likely to return to being net borrowers.  For the moment, the US Federal Reserve will maintain a loose policy stance.  The risk is that it tightens in the second half of this year.  If that happened, the US dollar could strengthen further, particularly against the Euro.  We do not expect to see European monetary policy being tightened any time soon.

So far corporate borrowing, at least for larger companies, has been satisfied in the corporate bond markets.  For the time being, we remain fully invested in equities but we are increasingly cautious about bonds both government and corporate.