EDRG: Market Flash – The FOMC took two major decisions at its recent meeting

Debates among members of the Bank of England’s monetary policy committee suggest that similar measures could be taken shortly.
The latest PMI data in Europe indicate that corporate sentiment has declined further. The provisional euro zone index for September fell from 50.7 to 49.2, the level seen in the summer of 2009. Both company and consumer confidence has been battered by the financial crisis, the lack of concrete solutions to Greece’s problems and fears that Spain and Italy will be contaminated even if their situation cannot be compared to that of Greece. Ratification of the EFSF by the 17 euro zone parliaments continues. Five countries including France have already voted in favour and the process should end around the middle of October. The fund will then be up and running, taking over from the ESFM which has already had several issues.

EUROPE
The market mood soured over the week. S&P downgraded Italy from A+ to A with a negative outlook, a move that was more or less expected as it is the A-rated country with the highest debt, but then poor PMI figures for the euro zone and Germany in September underpinned concerns that growth was slowing sharply. At the same time, markets are still waiting for (i) the EFSF to be given more clout, (ii) details on the Greek rescue plan and (iii) measures to calm fears that euro zone banks are fragile. The IMF hardly assuaged concerns with estimates of EUR 150bn in latent losses on the sovereign bonds of Greece, Portugal, Ireland, Spain, Italy and Belgium with another EUR 75bn in losses on their banks.

The IMF says these losses will fall if fiscal policy helps restore balanced budgets. However, it continues to plead for Europe’s banks to be recapitalised but fails to specify the amount. The IMF is focusing on banks which rely on short term financing and which are heavily exposed to sovereign risk. Heads of France’s banks have tried hard to reassure the
markets but so far without success. Baudoin Prot, for example, told the French economic daily Les Echos that BNP would meet Basel III requirements in 2013 without an increase of capital. He also confirmed that the bank was working towards shrinking its balance sheet.

European markets, at any rate, fell to year lows with indices back to July 2007 levels. Financials bore the brunt of the selloff.

News that a UBS trader had lost EUR 2.3bn from fraudulent positions on equity index trading did nothing to lift morale.
The trader had invented ETF positions to mask his risk exposure.
More encouraging news came from Inditex where Q2 results easily topped sales and operating profit expectations, rising by 9% and 14% respectively.
And deals continue to be made: SABMiller (brewing) has sweetened its bid on Foster’s in Australia to AUD 9.9bn (EUR 7.4bn) up from AUD 9.5bn. In a sector awash with rumours, Safran might team up with GE to acquire Italy’s AVIO (EUR 1.5bn in sales and debt of EUR 1.5bn also) for a price tag of around EUR 3-4bn. The main hurdle is political but both groups would be very complementary.

France has released the results of the first 4G auction. Orange and Iliad have each bought 20MHz while Bouygues Telecom and SFR have bought 15MHz. The size of Iliad’s commitment makes chairman Xavier Niel’s ambition to double in size quite credible. It will mean an aggressive strategy to win new clients.

US
A relapse sent the US market down to August lows by the end of the period. The much-awaited FOMC meeting was the
week’s highlight. Ben Bernanke unveiled his Operation Twist plan to get long term Treasury bond yields lower. By selling USD 400m in short term debt (less than 3 years) and using the proceeds to buy 6-30 year debt, the Fed will extend average maturities in its open market account (SOMA) more than expected by the market. Even so, investors were not surprised by the amounts in question as they had stopped expected to see another QE phase. The only unexpected element was the Fed’s decision to use proceeds to buy MBS.
There was some good company news: United Technologies is to pay USD 18bn to acquire Goodrich (aircraft) and both
Oracle and Adobe released better than expected results in a sign that the economic downturn has not yet occurred. But bank stocks were once again the focal point of market turbulence. Moody’s downgrade of Wells Fargo and BoA-ML showed that US banks too were victims of the global trend.

JAPAN
The Topix rose by 2.1% in JPY and 2.7% in EUR, supported by gains earlier in the week when European debt worries had seemed a little less pressing. Much weaker-than-expected Japanese export figures for August exports and the IMF’s
downward revisions for Japan’s economic growth kept stocks mostly intact. Trading was thin particularly over the last two days when trading volume sank below JPY1 trillion a day and the daily average for the week fell 20% below that of August.

The JPY/USD was down 0.7% while the JPY/EUR lost 0.6%, lingering at record lows.Precision sectors jumped 7.8%, leading Topix 33 industry groups, after the weaker EUR triggered sharp sell-offs last week. HOYA shot up 9% and Canon rose 4%. Nikon officially launched its first mirror-less cameras and gained 8%. Many technology stocks also fared well. Nitto Denko surged 10% as its August sales saw no MoM fall. Toshiba, Murata, and Nidec jumped by more than 8% after investors brushed off the stronger yen and weaker demand for their key products.

Tokyo Electron was also among the best performers despite apparently disappointing orders in the September quarter for chip-making equipment. Meanwhile, Ricoh, Sony and Panasonic remained sluggish. Mitsubishi Heavy Industries managed to rise 5% after saying anonymous cyber-attacks had hit its fabs manufacturing nuclear plants and defence products such as submarine and missile systems.

On the negative side, TEPCO plummeted by 14% as newly appointed minister Mr Edano said restarts of Fukushima #2
nuclear plants were highly unlikely. Defensive stocks including JR firms and pharmaceuticals were mostly depressed.

ASIA
Asia like the rest of the world was hit by escalating risk aversion coming mainly from Europe. Our markets are currently trading on 1.5 times book value and a PE below 10 over the next 12 months. This already anticipates a sharp slowdown in global growth over this period. The risk of growth coming in below the 7.2% expected for the region in 2012 is already discounted in current market prices. But what has not been discounted is the possibility of banks failing in certain parts of the world. This uncertainty takes precedence over any considerations of short term valuations.

Asian countries have generally been very discreet about the troubled climate in Europe but we believe reports that China is ready to invest massively are premature. China will first focus on its domestic market and its close neighbours, preferring to wait for more cohesion in Europe before deciding, if at all, to participate in an economic stimulus plan. This is all the more the case as China’s own growth looks like coming off the boil judging from the PMI index for September calculated by HSBC which fell to 49.4 from 49.9 in August. China’s official figure for August was in fact 50.9 but the HSBC indicator still holds as an indication that the trend is deteriorating. The fact is that China’s industrial sector is starting to contract. And even if this figure should be treated with caution in absolute terms, China will most probably work on stimulating its own economy and could cut rates before flying to Europe’s rescue.

Inflation is the main hurdle facing rapid decisions. After falling back in August, it could return to peak levels in September but should then quickly retreat. That would allow a stimulus plan to be introduced. It’s the same picture in India, Korea and Indonesia where governments would have much more room to manoeuvre if inflation abated. Without going as far as talking about Asia decoupling from the rest of the world, it is still true that the zone has more ammunition and the finances to act. Tax revenues in China, for example, are 30% up on 2010 and the Thai government has just released the property part of its fiscal stimulus plan: 10% of the purchase price can be deduced up to USD 16,000, a measure that will chiefly benefit the rapidly growing middle classes. This is a strong contrast with Greece where the tax-free threshold keeps on falling.

The more the global situation worsens, the more probable a change in monetary policy in China, India and several other
Asian countries. The switch could come suddenly and forcefully if inflation finally started to cool. For those who believe in this scenario, Asia is extremely attractive at these levels.

OTHER EMERGING MARKETS
India failed to duck the emerging market correction and the Rupee also fell, losing 3% this week and taking the decline vs. the USD since the beginning of the month to 7%. And yet non-residents have not deserted the Indian market. as year to date net flows are a positive USD 632m. Over the short term, it is hard to say if the currency will depreciate more but we can, however, suppose that the Reserve Bank of India will sell some of its dollar reserves were that to occur. There was no significant company news this week. The earnings season will start in two weeks and will give us some pointers amid generally low visibility. Until we can ascertain the quality of these results, we are not changing our investment strategy. The market fell 12.5% in USD with the currency taking the largest hit (-11.6%). Deteriorating conditions abroad – especially Europe’s sovereign debt crisis and fears of an economic slowdown in the US- drove the correction. Moreover, in the local market, the inflation rate for the first fifteen days of September surprised the market by coming in higher than expected. It rose to 7.37% YoY. Also, unemployment for August declined to a new record low. Companies remain optimistic about a soft landing. We don’t see a major structural problem in Brazilian economic fundamentals. We find market valuations appealing at current levels, but in the near term, the environment will remain challenging for risk-taking.

CONVERTIBLES
On average, convertibles are yielding between 4-6%. This week, companies like LDK Solar, AU Optronics and PGS bought in some of their convertibles. The BCP also launched an offer to exchange part of its Tier 1 and lower tier II debt. Companies are jumping on abnormally low prices to launch bond buy backs at attractive levels, thereby reinforcing their capital structure. We can expect to see more of the same on the convertible bond market until the markets stabilise. In results, Oracle released upbeat figures which had a positive impact on SAP. Hewlett Packard has sacked its CEO, Leo Apotheker, because of hits acquisition strategy and reshaping of the group. Above all, he had embarked on acquiring Autonomy in the UK for a very high price tag just before the markets collapsed.

COMMODITIES
Investors now feel that neither Europe nor the US can come up with an efficient solution for the economic and financial
crisis. This has led to unprecedented risk aversion and massive selling of commodities as a whole. For example, base metals quoted on the LME lost 10.5% this week. Brent crude lost close to 5% and even gold lost around 4% due to the rising USD and profit taking.

Libya’s oil exports should recover to 500,000b/d by next month or 1/3 of levels before the conflict broke out. This, and the potential price weakness engendered by anticipations of a double dip, could push other OPEC members to reduce their own production. This makes the sort of price collapse seen in 2008 unlikely. LNG prices are trading at record levels due to very strong demand in Japan, China and India. Bear in mind that only 12 nuclear power stations out of 54 are operating in Japan which means more thermal coal, gas and oil is being consumed. Germany is more or less in the same situation and its thermal coal imports have risen 6% to 17.9m tonnes year to date.

Deal-making in the sector is still intense. The Canadian gold mine Agnico Eagle is paying USD 275m , a premium of 65%, to acquire Grayd Resources. And an Indian conglomerate has paid USD 1.26bn for thermal coal projects in the hitherto infrastructure-free Galilee basin in Australia. Lastly, the US oil company Apache has acquired ExxonMobil’s North Sea asset for USD 1.75bn. This is further evidence of companies putting strong finances to work on beefing up pipeline projects.

ASSET ALLOCATION
After stabilising and in some cases recovering, equity markets were hit by another period of severe turbulence stemming essentially from worries over European banks. Average volatility over the last two months is 36, close to levels seen in the second quarter of 2010. Between September 15 and 22, the major indices performed as follows in local currency:

-Standard&Poor’s 500 -6.6%
-Euro Stoxx 50 -7.4%
-TOPIX -1%
-MSCI Emerging markets -6.1% (in EUR)

Bond yields fell sharply to reflect deep pessimism on the economic outlook. The US 10-year Treasury bond is now yielding less than 1.8% compared to approximately 1.7% for the equivalent Bund. Fuelled by the downgrade of Italy’s debt, yields there rose to 5.6%. The EUR lost further ground against the USD, falling from 1.38 to 1.35. The JPY hit a new record of 76.25 vs. the USD.

The RMB remained at 6.38, the same level since the middle of August. We seized a window of opportunity at the beginning of the week to buy dollars and sell euros. At the same time, escalating worries on Greece’s future led us to reduce exposure to euro zone equities and reinforce Switzerland and the UK instead.

And sterling volatility following the release of the Bank of England’s minutes allowed us to trade EUR vs. GBP. EdR Europe Flexible: exposure varied between 50-57% during the week, within our neutral spread of 40-60%. We rolled over our September options. Our European index hedging is focused on the UK, Switzerland and the Netherlands with a
bias towards DAX appreciation in relative value terms.

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