Market Review 25 January 2011

Last week was thoroughly nasty. Wednesday, in the US, was a 90% down day. The breadth of the equity market shrank and those stocks and sectors which had performed well recently reacted sharply to the down side – notably natural resource stocks, technology related stocks and emerging markets. The MSCI AC Far East ex-Japan fell by 2.19% and the MSCI Emerging Markets i-share by 3.03%. The NASDAQ fell by 2.39%. By way of contrast, banks and European equities were firm. The euro strengthened by 1.74% against the US dollar. Our technical analysts advise us that the major trend for equities remains positive, with which we agree, but point out that up until last week, the US market had risen for 8 weeks in a row. It was probably too much to assume a 9th consecutive weekly rise.

As at 21st January, 81 US S&P 500 companies had reported their fourth quarter earnings – effectively 26% of the market capitalisation. The reported growth rate for those companies’ profits, excluding financials, is running at 29% up year-on-year. Results have been surprisingly good with the up-side surprise rate ratio currently standing at 74%. There have been one or two disappointing earnings announcements but these have been offset by some spectacular beats.

The most significant negative for markets has been the gentle upward shift in longer dated bond yields. In the UK, the 10 year government bond yield touched 3.7% and is now higher than the prospective dividend yield of 3.4%. The German 10-year government bond yield rose to 3.1%. Since the end of November, the 10-year German government bond price has fallen by around 7%. Our sense is that these higher bond yields reflect an improved outlook for growth rather than anything else.

For months, an enormous amount of investor attention has been focussed on the problems faced by Greece, Portugal, Ireland, Spain etc. However, what has been less obvious is that a significant economic boom is taking place in the north and centre of Europe (Scandinavia, Switzerland or Germany), a combined economic area the size of China. This was confirmed at the end of last week by the publication of German business confidence. The Ifo Institute said its business climate index, based on a survey of 7,000 executive, increased to 110.3 from 109.8 in December. That is the highest since records for a reunified Germany began in 1991. Economists had predicted the index would hold steady. French business sentiment has also strengthened.

There are also signs that this expansion has started to spread to the Benelux countries, eastern parts of France, Poland and the Czech Republic. In contrast to uncertainty in southern Europe, the last six months have seen a remarkable financial stabilisation in the other European periphery, namely central and eastern Europe. Indeed, this stabilisation has occurred without any significant devaluation or default. Although the economic recovery across central Europe remains uneven, the worst is clearly passed in most countries and, in places like Poland or Turkey, growth is now actually vibrant. Furthermore, the last 10 years has seen a major development of European corporations into pan European corporations, able and willing to allocate resources to those parts of Europe which make most sense.

We have to accept, of course, that the sovereign debt crisis in southern Europe has not disappeared. There are still major problems of default recognition in Spain. However, at least for the authorities, the scale of this problem is recognisable. During 2011, the possibilities are rising that a more substantial, policy driven solution to the southern European debt crisis will be found. Whilst this may not be a fully permanent solution, policy-makers are now heavily incentivised to stop the crisis from spreading. In the short-term, this is driven because European sovereigns face a particularly heavy debt re-financing schedule over the next two quarters. This has the potential to cause market stress. The second driver is the German wish that the ECB recovers practical control of monetary policy. Germany would probably like to see interest rates rise and this can only happen in the context of a more meaningful solution to the wider problem.

Last year, sovereign debt concerns saw financials, particularly banks, significantly underperform the rest of the European equity market. But many of these stocks are now attractively valued, potentially offering considerable upside. Axel Weber, Bundesbank President, put it as clearly as possible on 18th January. “Germany is benefitting considerably from the strong recovery of the global economy, especially in Asian emerging markets.” German factory orders rose five times more than economists forecast in November, driven by demand from outside the euro area.

Progress also is being made on reducing government deficits. In Spain, the deficit fell 46% in the first 11 months of 2010, though December is generally the biggest month for spending. The gap between the yield on Spanish and German 10-year bonds is currently 203 basis points. That compares with an average of 15 basis points in the first decade of monetary union. However, it is down from a euro-era high of 298 on 30 November, 2010.

The Spanish government cut public wages 5% in June and is freezing salaries and pensions this year. It scrapped a benefit for new mothers and a subsidy for the long-term unemployed. The wage cut also applied to regional governments, which hire about half of all public workers in Spain and control health spending, helping them, thereby, to reduce their overall shortfall to 1.24% of GDP in the first three quarters, compared with a full-year target of 2.4%. In the medium term, a pension overhaul, due this month, will raise the retirement age to 67 years from 65 and tighten rules on how benefits are calculated.

Elsewhere, India has performed poorly this year. However, corporate profits growth has been encouraging. Today, ICICI Bank, India’s second-biggest lender, indicated that its third quarter profits rose 31%, a record, as loans increased and provisions for bad debts declined. Net income climbed to 14.4 billion rupees ($315 million) in the three months ended 31 December from 11 billion rupees a year earlier. The State Bank of India indicated on 22 January that its third quarter profits had risen by 14% to 28.3 billion rupees. In the case of ICICI loans climbed 15% to 2.07 trillion rupees as of 31 December and provisions fell 54% from a year earlier.

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.