Market Review 25 October 2011

Commentary:  I’m Waiting For The Man

And so the markets await the outcome of this weekend’s European summit.  The outcome so far is … another summit on Wednesday.  The “grand plan”, the “big bazooka” or whatever it has been renamed by then, will be unveiled at the G20 summit at Cannes on November 3rd. It has always been clear that holders of Greek debt face a write-down.  In the July eurozone rescue proposal that write-down was agreed at 20%, at this weekend’s summit the mooted figure is reported as 50%-60%, as Greece’s situation has materially deteriorated in the intervening three months.

The situation is, in principle, the same as it was a year ago: the eurozone as a whole can cope, but some of its members cannot.  Bridging this gap is a political more than an economic problem, but the delays and reluctance have increased the size of the economic cost.  Various mechanisms have been mooted over the past two weeks as the pace of negotiations has picked up.  It is inevitable that politicians will fail to deliver a complete and comprehensive solution that addresses the underlying and long term structural issues that have allowed the eurozone crisis to arise.

However, past experience shows that investors have a relatively low threshold for relief rallies following post-summit announcements.  The proposed injection of extra capital into the European banking system may relieve concerns about the underlying health of balance sheets, but it is unlikely to be recycled into stimulatory lending to European corporate and consumers and will probably lower rates of return.  As long as the number is big enough and the mechanism straight forward, a plan for additional bank capital is likely to be greeted positively by markets.

The third week of October saw equity markets see-sawing day-to-day ahead of the European summit, with the MSCI All Countries Index (ACWI) down 0.5% in sterling over the week, led by the developed markets, in particular North America.  Over the week the Dow and the S&P were both up over 1% in US dollars whilst the NASDAQ was off.  The S&P rose or fell by 1% or more in four of the five trading sessions.  In the United States the third quarter corporate earnings season is in full swing, and so far results have been more positive than investors initially feared.

Banks reported during the week, and although Goldman Sachs reported a loss it, along with its peers, rose strongly over the week.  Apple’s missed earnings for the quarter and subsequent 6% price fall lay behind the NASDAQ’s poor week.  Economic data releases have been pretty reasonable.  In November Capitol Hill will return to the fray as the budgetary super committee swings into action.

Globally Energy was the strongest performing sector, with Materials and IT lagging.  Emerging markets lagged, with China and Hong Kong down over the week.  Bond yields tell the story within Europe, where the German 10 year yields 2.1%, with Spain trading at 5.4% and Italy at 5.9%.  The UK reported a stubbornly high inflation rate last week, but bond markets are clearly completely unconcerned about the risk of prospective inflation surprises. The UK 10 year gilt yields slightly more than Germany, at 2.3%.

The investor considering what returns might be made by the end of the year – or put another way, how to price the possibility of eurozone catastrophe versus the future path of corporate cash flows – is clearly and unsurprisingly confused.  For what it’s worth global equities now trade on 10.5x next year’s profits, which are forecast to grow 13%, and offer a historic dividend yield of 2.7%.

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