Market Review 13 July 2010

Last week saw a strong equity bounce back especially on Tuesday, Wednesday and Thursday. Markets took some comfort from remarks made by Trichet and Axel Weber, both of whom suggested that European governments were now moving rapidly towards resolving the problems of excess fiscal spending. The Greeks passed landmark legislation to reduce state spending on pensions. Although there was a demonstration of 12,000 people in Athens, there was no violence and opinion polls in Greece remain on the side of firm and decisive action.

Chinese trade data was more up beat. Meanwhile, the US second quarter earnings reporting season begins in earnest this week with Alcoa the usual first suspect tonight but with Intel reporting tomorrow, which will be more significant.

The rise in equity prices was accompanied by a contraction in European government debt spreads. A two way exchange of differing views about the outlook for peripheral European government bonds is emerging. Pimco remains nervous but other investors are enthusiastic to buy bonds issued by peripheral European countries. 

Meanwhile, Japanese investors continue to seek higher yields in Australian government bonds, European government bonds and in emerging market exotica. It is probably in Japan, with low nominal yields, that the hunger for higher yields irrespective of currency risk is greatest.

Yields on Portugal’s 10-year bonds have fallen 74 basis points compared with bunds from the record level in May. Italy’s yield premium has slipped 39 basis points since widening to 178 on 8 June, the most in 13 years. While Spain’s debt yield is little changed since May, international investors bought 66% of the €6 billion of 10 year bonds sold on 6 July. Investors in Asia bought 13.3% of the issue even after Moody’s said a week earlier that it may cut the country’s top AAA credit rating. Portugal sold €762 million of six month bills on 7 July, five days after the government had said it aims to meet EU limits for a budget deficit of 3% of gross domestic product in 2012, a year earlier than previously and down from 9.3% last year. The securities maturing in January 2011, were issued at an average rate of 1.947%, down from 2.955%.

Clearly, there is some improvement. The extreme risk aversion we saw in May has lifted.

Two-year Italian notes now yield 106 basis points more than bunds of similar maturity but this spread too is down from 139 on 25 May, when Berlusconi won cabinet approval for €25 billion of budget cuts designed to shrink the Italian fiscal deficit to 2.7% of GDP in 2012 from 5.3% last year. Greece is proposing to sell €1.25 billion of six-month bills tomorrow. The yield on the 4.6% bond due September 2040 fell to 9.37% last week from 10.25% on 28 June.

Greek pension legislation last week was critical. The new legislation will raise the retirement age to 65 for most Greek workers, cut pension benefits, relax rules on hiring and firing employees and lower basic salaries. The bill had been amended more than 50 times following objections from within and without government.

The Athens Bar Association argued that it was unconstitutional and promised to mount legal challenges. Nonetheless, the vote was 157-134 in favour, with three abstaining and six legislators absent. The socialist government’s 157 legislators all voted for the controversial bill despite earlier fears that some would break party ranks.

On the other side of the world, the Chinese economy continues to do well – at least externally. China’s monthly trade surplus is now back to the level it was at before the global financial crisis hit. It reached $20 billion in June, according to recent data, with the recent increase driven by continued steady growth in exports and stalling imports. The latter have declined 2.5% over the first six months of the year in seasonally-adjusted terms, while exports have risen a cumulative 10.1%. Taking the second quarter as a whole, the surplus was 18% higher than a year earlier and nearly three times its level in the first three months of 2010.

If the usual seasonal pattern is a guide, the surplus will continue to rise over the second half of the year. There is no sign in June’s data of a slowdown in global demand. Exports rose 43.9% year-on-year, which was stronger than consensus expectations. Shipments to the eurozone appeared to be as healthy as those to the rest of the world.

The import data is less clear cut. Imports rose 34.1% year-on-year, which was slightly below consensus. However, this data series is volatile month-to-month but the figures are broadly consistent with a gentle domestic economic slowdown and slower stockpiling over the last few months. Imports of unwrought and scrap copper were slightly lower in volume terms in the second quarter than a year before.

Some of the oft repeated risks remain. The IMF is the latest body to forecast slowing growth. Its updated World Economic Outlook, released in Hong Kong on Thursday, predicts world expansion will decline to 4.3% next year from 2010’s 4.6%, although that later figure has been revised up by 0.4% to reflect faster-than-anticipated growth earlier this year.

The IMF takes the view that downside risks have risen amid renewed financial turbulence. In a contrarian sense, this modestly down beat view is probably helpful. Recovery is taking place but gradually. Inflation is not a problem. The authorities remain cautious and interest rates in the West are unlikely to rise any time soon.

Meanwhile, analysts are definitely becoming more bullish about corporate earnings prospects. At the end of May, analysts in general were paring their estimates. Now just six weeks later, they have changed their minds. Areas like Europe, ex the UK, have flipped from expecting a slow down to anticipating further significant rises. There has been a similarly positive shift for emerging markets.

The IMF expects US growth to slip to 2.9% next year from 3.3% in 2010. While the IMF is forecasting a gain in eurozone growth in 2011, it sees modest improvement from a low level – 1.3% in 2011, compared with 1% this year. European bank stress tests have yet to emerge and could provide nasty surprises, although that is clearly not the intention. The intention is to boost confidence.

Regulators are examining the strength of 91 banks in an effort to determine if they can survive potential losses on their sovereign bond holdings. The market, naturally, is asking for details and for some indication that if a bank has difficulties where will it get the funds from to recapitalise itself. According to Nomura, banks could lose as much as $900 billion in a worst-case scenario where Greece, Ireland, Italy, Portugal and Spain all have to restructure their debt.

The banks being tested account for 65% of Europe’s banking industry. They include Deutsche Bank of Germany, BNP Paribas of France and ING Bank of the Netherlands, according to the Committee of European Banking Supervisors, which is organising the tests. The results are due to be published on 23 July. Our suspicion is that there will be sufficient detail and the results will be positive and inspire some greater degree of confidence.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.