Market Review 21 September 2010

Last week was a positive one. Equity markets broadened and mid to small cap stocks did well. Asian markets recovered. In particular, the euro gained significant ground against the US dollar rising by 2.93% over the course of the week. That recovery was helped by a significant improvement in the outlook for Spanish government bonds. The S&P 500 index, in US dollar terms, was up 1.45% making for a return of 7.27% in the month-to-date. Meanwhile, the MSCI Far East ex-Japan index was up 2.88% – a return of 7.32% in the month-to-date, also expressed in US dollar terms.

There was noticeable currency weakness in the yen following Mr Kan’s victory in the LDP leadership elections and intervention by the Bank of Japan in the currency markets. The yen fell by 2.28% against the US dollar during the week. As a result, although the Japanese market recovered in yen terms by 1.72%, measured by the Topix index, the US dollar value of the index fell by 0.28%.

Last week, the Bank of Japan is estimated to have sold ¥1.7 trillion to ¥1.8 trillion over the course of a 24 hour trading day starting on Wednesday morning Tokyo time. The bank struck when the yen had reached 82.86 to the US dollar. The Japanese yen subsequently fell to an intra day low of 85.54 to the US dollar. The intervention was unilateral. The Bank of Japan was unsupported by any other central bank. The Bank of Japan also indicated that it intended this action to be left unsterilized.

Currency intervention, therefore, is being used as a form of quantitative monetary easing. The Bank of Japan has considerable further resources should it wish to go further in the direction it chose last week. Prior to the intervention, there had been a rising crescendo of complaints and threats from the Japanese business community seeking to highlight the difficulty of competing in world trade against the background of a rising yen.

To our minds there are a number of important implications of these moves. Firstly, the Bank of Japan has probably now initiated a process of QE2, which others will follow. In the circumstances, it is unwise to include the yen as a ‘risk aversion’ trade any longer. For most of the summer, traders have typically bought the US dollar, the yen and the Swiss Franc when there were any signs of world economic problems or weakness. Finally, this move by the Bank of Japan has substantial implications for Asian politics and Asian/US relations.

The decision to intervene was probably driven as much by Japan’s relationship with China as with the US. What motivates the Japanese companies clamouring for action against the rising yen is not so much the pressure from American competition as the fear of being undercut by exporters in China, Korea, Taiwan and Singapore – all being countries which manage their currencies aggressively. With Chinese economic policy now serving as a model for other Asian countries, Japan was faced with a stark choice: back US criticisms of Chinese currency “manipulation” or emulate China’s approach. It is a sign of the times that Japan chose the latter option at the cost of irritating America.

Having just returned from the Far East, I can confirm that in various industries, Japan is no longer competitive. Most of those industries are traditional ones like ship building, where the Koreans are now clearly more competitive, or a range of consumer goods like flat screen televisions. Japan will increasingly have to rely on more sophisticated technology and the job for investors is to find the ‘pure’ plays.

Meanwhile, the situation in Europe is clearly improving. Gross domestic product in the region will likely increase 1.7% this year instead of the 0.9% projected at the depth of the banking crisis in May, at least according to the European Commission. At an auction of €4 billion of Spanish 10-year and 30-year debt last week, yields fell. Demand for the bonds was 2.32 times the amount sold in respect of the 10 year bonds and the bid-to-cover ratio for the securities maturing in 2041 was 2.1.

Spanish credit spreads versus their German equivalents have narrowed sharply this month. This has not yet happened in respect of Greece, Ireland and Portugal. Indeed, some would point to modest continuing widening. Tomorrow, Ireland will seek to raise money in the market and it will be interesting to see what they eventually have to pay. However, various specialist bond advisors are now suggesting that “there are definitely” some “opportunities in these countries for investors with a long-term approach”, at least according to Pictet.

Bloomberg apparently has asked the 32 banks that act as so-called primary dealers at German government bond auctions for their predictions of yield spreads between the 10-year securities of Greece, Portugal, Ireland and Spain versus benchmark bunds a year hence. Thus far, responses have come from 15 of the banks. HSBC, Goldman Sachs and Société Générale are all advising their clients to buy Greek government securities. However, the removal of Spain from the immediate danger list is clearly important. The EU/ECB/IMF package last May could have been something of a stretch if Spain was to tap it too deeply. However, without Spain, the picture is much easier. The strength of the euro is an index of the overall improvement.

It is intriguing that notwithstanding the thought that yields on Irish 10-year debt rose to their highest relative to bunds last week since at least 1991, and that the similar Portuguese-German spread approached the most on record, fixed income sophisticates are willing to buy these bonds in their continuing pursuit of yield.

The situation in the United States is probably more nuanced. The rate of growth has clearly subsided. ISI’s Companies Surveys are now at a six month low and expectations are rising that all the Bush tax cuts will be extended by year-end. The US Senate passed the US$30 billion Small Business Loan Fund last week and that is likely to start immediately. US junk bond yields, though, made another new low last week of 7.86%, which compares with a peak of 22.49%. Interestingly, US companies have announced US$56 billion in share buy-backs since June.

Employment continues to be the key determinant of political pressure. Some commentators remained hesitant about the prospects of recovery in employment. However, last week’s employment related data were encouraging. ISI’s survey of permanent employment by companies increased significantly to 48.9% – a new high for the cycle, and its survey of temporary employment companies similarly rose to 67.4%, which is strong by any standards. Lay-off announcements made another new low. A combination of gentle underlying improvement, continuing political nerves and the likelihood of further monetary easing should be a powerful stimulant to the US stock market.

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.