Market Review 2 August 2011

In the film Scream, a character sets out the “rules” for surviving a horror film. The third rule is “never say: ‘I’ll be right back’ …‘cos then you won’t.”

Stocks were down over the week, reversing the eurozone relief rally of the previous week, as investors tried to process the implications of a US credit rating cut, or worse a debt default. Ironically US Treasuries were the clear beneficiaries as investors sold higher risk assets instead. The MSCI World Index fell 3.8% in sterling, but bonds were up: the US 10 year yield fell from just under 3% to 2.8%, whilst the 10 year gilt yield declined to 2.9%.

The stock markets that fell the least were in Asia and the UK, and Emerging Markets declined by just 1.9% in sterling. The United States and Canada fell in most of the major markets, with the Dow and S&P both off around 4% over the week. The peripheral European markets of Greece, Spain and Italy retreated significantly after their optimistic end to the previous week.

At the end of July the MSCI All Countries World Index (“ACWI”) had a negative total return in sterling of 1.5% in 2011 so far, reflecting very poor returns in Japan (-5.9% YTD) and Emerging Markets (-4% YTD). Currency has been significant. In local currency ACWI is flat this year, and in US dollars it is up 3.3%. Gold continued to reach new highs, and is now up nearly 15% in 2011.

The past week served up a rich if indigestible diet for investors, catering to all tastes. On the sovereign front investors could follow the unfolding horror story of discussions, proposals and counter proposals on Capitol Hill as the debt ceiling default deadline loomed. In the absence of a deal stock markets fell heavily on Friday to end the week in a “risk off” mood, before news emerged on Sunday of a compromise deal which would likely pass in both Houses.

This is reported as raising the debt ceiling by $2.1 trillion, leaving enough headroom for it to survive the 2012 election, and will be balanced with an agreement for $2.4 trillion in deficit reduction measures, $0.9 trillion over the next ten years and the balance of $1.5 trillion to be found by a bipartisan “super committee.” Given the absence of any mention of mixing cuts with additional tax revenue, this looks like a defeat for the White House and the Democrats.

Perhaps the Tea Party tendency, whilst no doubt disappointed themselves at the outcome, have driven the pivot point of compromise much further into Republican territory than it otherwise would have been. Markets opened up initially on Monday in anticipation of relief from the summer’s second sovereign crisis.

However, the only distractions on offer in Europe were disappointing ones. After the market’s pleasing announcement by the Council of Ministers in the week before, it emerged that the EFSF may have to raise extra funding so that it can take over Italy and Spain’s commitment to extend bilateral loans to Greece. Several national parliaments must back new rules for the EFSF before it can lend to Greece.

Clearly the eurozone’s own horror movie did not necessarily end a week last Wednesday. Last week Moody’s announced that they have put Spain on review for a possible downgrade, and on Friday Spanish Prime Minister Zapatero called an early election, for November. The Spanish bond yield rose over the week to 6.1%.

As much of a concern for investors are the signs of sluggish economic growth. The UK reported a weak GDP number on Tuesday, and the US number on Friday, at 1.3% up on Q1 was shy of expectations at 1.8%. Today sees a US manufacturing number, and this Friday sees the announcement of July’s US payroll data.

Whilst US corporate earnings announcements have been solid, Q2 earnings announcements in Europe have been disappointing, particularly from the northern European manufacturing companies which had been the engine of strong European stock market performance in the early part of the year.

Bloomberg note that over 50% of the Euro Stoxx 600 companies reporting so far have missed broker forecasts. Of particular note last week were the Swiss banks and BASF, where stock prices were hit heavily in the wake of disappointing numbers.

Global equities now stand on 11.3 times forecast earnings, with a dividend yield of 2.5%. Emerging Market equities stand on 10.3 times with a 2.6% yield. The UK equity market has again reversed the natural order of the past fifty years, and stands on a dividend yield, of 3.2%, which is higher than the yield on ten year gilts, which is 2.9%.

Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton