EDRG: Market Flash – The most recent European indicators still show the economy slowing down

When Slovakia votes on October 11, the EFSF ratification process will theoretically be complete. But the disbursement of aid to Greece will only occur in November and the conditions under which private investors will be able to exchange their holdings of Greece’s debt will probably be challenged. Although the European Banking Authority (EBA) has denied it is looking at introducing new bank stress tests, any more rigorous and objective approach to sovereign risk would highlight the need for some banks to bolster their capital buffers. But any subsequent recapitalising would benefit from the EFSF’s financial clout.
The ECB and the Bank of England have decided to leave their benchmark rates unchanged at 1.5% and 0.5% respectively. The ECB will be offering long term financing operations (LTRO) of around 12 months and will reopen its covered bond purchase programme for EUR 40bn. The BoE will be extending its bond buying programme from GBP 200 to 275bn.
US statistics came in better than expected. September auto sales reached an annualised 13 million compared to 12.1 million in August which is a remarkable achievement given the ongoing difficulties of Japanese manufacturers who are battling with insufficient inventories. Sales of light duty trucks made a notable contribution to the final figures. September’s ISM index rose to 51.6 vs. 50.6 and the slight fall in the services index to 53 vs. 53.3 suggests soft growth but rules out an imminent slide in activity.

EUROPE
European markets forged ahead, putting the index close to 10% above its 2011 low seen on September 23. Grounds for optimism included an FT article suggesting that Europe’s finance ministers were looking at way to coordinate recapitalisation of European banks. The idea was later taken up by others including Angela Merkel. The IMF’s head in Europe then said his organisation had the means to join the EFSF in taking preventive action on bond markets. But he quickly backtracked and admitted that the legal structure for such action had not been discussed. Investors still chose to treat this as a sign that international bodies were all working to find a quick solution to the euro zone crisis. For many, the disappointment from the ECB’s decision to leave its benchmark rate at 1.5% was offset by its decision to offer longer term financing and reopen its covered bond purchase programme. Another positive signal came from the Bank of England which unexpectedly added GBP 75bn to its QE arrangement. And with Dexia becoming the first casualty of the European sovereign debt crisis, markets need all the help they can get. Three years after rescuing Dexia by injecting EUR 6bn, France and Belgium are now organising its break-up. Fears of a run on banks seems to have triggered this move as the Belgian daily De Tijd said as much as EUR 300m had been withdrawn in one day from Dexia Banque Belgique. In addition, Dexia’s French business is not supported by retail banking deposits so the group is particularly vulnerable to current tensions on the interbank market. The breakup will involve: (i) creating a defeasance structure or bad bank that could be managed by France and Belgium, (ii) tying up the local authority financing business in France with the Caisse des Dépôts and the Banque Postale and (iii) selling assets like the valuable DenizBank in Turkey. The head of the Bank of France, Christian Noyer, sees no reason why France’s involvement in Dexia’s rescue should undermine the country’s triple A rating.

Macroeconomic data remained weak. The manufacturing PMI index retreated further in September to its lowest level since August 2009 while new orders fell at their fastest pace since June 2009. New industrial orders in Germany in August increased less than expected by 3.9%.

There was little company news just ahead of the official earnings season apart from the British distributor of building materials, Wolseley, which posted results up 38% or 5% above expectations. The group won market share in key zones like the US and Scandinavia, improved its gross margin and managed to reduce costs.
At its investors day, the steel pipe manufacturer Vallourec confirmed that Brazil was a promising market but lowered its expectations for the second half of 2011 due to the slowdown in non-energy markets and unfavourable foreign exchange rates. Margins in 2012 will also be hit as factories in Brazil and the US increase capacity. This means that the real pay back for current investments should be 2014/2015 rather than 2013.

US
Markets rebounded over the week, putting a halt to the downward spiral. Jobs data for September were a big surprise for the US economy. 137,000 jobs were created in the private sector compared to estimates of 90,000. And the figures for August and July were revised up from 17,000 to 42,000 and 85,000 to 127,000 respectively. This all concurred with statements from companies like Macy’s and Kohl’s which said they had created about 78,000 and 40,000 seasonal positions respectively, a 5% increase on last year. Manufacturing and services ISM indices also remained in expansionary territory, coming in higher than expected at 53 and 51.5 respectively. In company news, Carlyle paid USD 3.9bn to acquire Pharmaceutical Product Development (diagnostics) and bid rumours resurfaced on Research in Motion and Yahoo. In consumer goods, Constellation Brands beat expectations mainly due to higher sales and raised guidance for 2012. In autos, Ford signed an agreement with United Auto Works, which should create around 10,000 jobs by 2015.
Over the last five trading sessions, materials, energy and consumer discretionary were the best performers.

JAPAN
The Topix plunged 3.7% in JPY and 1.5% in EUR as investors today seem more concerned about potential recession as well as fears over financial turmoil in the euro zone. The decline for a fourth straight week sent the index to another year low and 17% below the post-quake peak in early July. The JPY/USD, hovering at mid- JPY76 per dollar, rose 0.3% while the JPY/EUR lost 2.2% after falling below a JPY101 per euro mark for the first time since late 2000.
Economy sensitive stocks were sold off while defensive sectors fared better. Selling was intense in exporters, capital goods manufacturers, raw materals and shipping firms, which dominated the worst performing ranks. Major trading houses extended their losses with double-digit declines. Furukawa Electric (TSE1, 5801) plunged 16% after it said it would pay a USD 200m penalty on a plea agreement with the US department of justice regarding alleged price cartels on auto parts including wire harnesses. Its peer Sumitomo Electric, also seen as being involved in the charges, nosedived by 20%. Bellwether stocks Toyota, Honda, Fanuc, Komatsu, Sony and Panasonic hit fresh year lows. Most steel makers dropped by around 8% while JFE HD tumbled 12% after revealing it would incur a one-time charge of JPY 81bn after recognising losses from stock price declines. Similar losses should spread to other firms, namely banks and insurers, and the Topix ended September down 16% compared to the end of March.
Meanwhile, Seven & I holdings rose 3% after it announced the second upward revision for this quarter thanks partly to disaster-induced demand. Best performers were led by Nintendo and Softbank, up 7% and 5% respectively, which reversed sharp drops in previous weeks.

ASIA
Markets bounced sharply at the end of the week against a backdrop of economic and company news which is far from catastrophic.
Samsung Electronics’ Q3 operating results are a good example of the sort of panic afflicting many financial analysts and investors. At the beginning of July, analysts’ estimates were running at Won 3.2 trillion won but they were trimmed sharply to 1.9 trillion a few weeks ago. But the company’s latest forecast has now put the figure at 4.3 trillion, massively higher than expected. Smartphone sales are markedly higher and most probably above 30 million units vs. 21 million in the previous quarter and margins are stable. The ambitious cost cutting plan in the DRAM/NAND division has also paid off as operating margins have risen 16% despite the bleak environment. The weak won has also helped and will continue to underpin the group’s competitiveness.
Elsewhere, the market listing of the supermarket chain PureGold in Manila was hardly a roaring success. The stock plunged 10% at the start of the week but began to recover as the market rebound got underway. The group, nevertheless, has a robust business model with a network aimed at the emerging middle classes. It also supplies many small shops which are dotted all over the country. Earnings growth, including new store openings, will be above 25% in 2012 and the stock is trading on a very undemanding PE of 12. Consumption is still the biggest growth theme on these markets.
And consumer stocks have bounced sharply across the entire zone after a short but severe correction. Samsonite, a global leader in luggage that was listed in Hong Kong at the beginning of 2011, is a good example. In the first half of 2011, global sales rose 35% and operating profit jumped 40%. The company says the third quarter saw more of the same with no signs of a slowdown neither in Asia nor in the US or Europe. 253 retail outlets were opened in Asia in the first 6 months to meet strong demand in China and India. With a PE of only 11.5 for 2012, the stock offers significant upside.

OTHER EMERGING MARKETS
Another volatile week with the Indian market tracking events in developed countries. Moody’s has downgraded India’s largest bank, State Bank of India from C- to D+. The industrial production index saw further weakness, falling to 50.4 in September vs. 53.6 in July (note that the long term mean is 56). Quarterly company results will start to appear next week.
They will give us essential indications on the extent of the economic slowdown. We prefer to remain cautious ahead of the figures.
BRASIL: the market fell 0.6% in USD due to falling commodity prices. Nevertheless, despite the increasing volatility, the BRL delivered a strong performance for the second week in a row. On the macro side, there are signs that inflation continued to rise this month. The commodity price index rose 7.83% m/m and employment remained tight. Reports in the Brazilian press also suggested that the government was looking to reduce taxes. We had already seen signs of this last week, when the government announced the reduction in taxes on gasoline and postponed an increase in IPI taxes on cigarettes until 2012. On the micro front, we met the senior management team at Marco Polo (a bus chassis producer) who reaffirmed that demand remained strong. PDG (homebuilder) announced strong Q3 2011 operational volumes with launches already at 70% of full year guidance. In the near term, we expect volatility to remain high due to ongoing concerns on sovereign debt and economic growth.

CONVERTIBLES
European equity and credit markets reacted to the “small” political steps taken to address the current crisis and rallied. A joint strategy is very gradually taking shape. It will of course take time but at least it gives markets something to hold onto. It is now clear that European leaders accept that French banks will have to be recapitalised if Greece defaults on its debt.
And this weekend will see another attempt to stabilise markets when Angela Merkel and Nicolas Sarkozy meet in Berlin.
On Friday, the Xover index opened below 800bp. So far this month, equity markets have risen 2.4%. In company news, Polarcus has completed a USD 410m bank loan facility to help the company refinance existing debt and ensure its growth plans. Sacyr is also about to refinance its main credit lines to pay for its stake in Repsol. The rebound will need to be confirmed before we see a turnaround in the upward trend on credit seen since the crisis began. Spreads on Ireland’s debt have moved back below 550bp while Spain is close to 300bp.

COMMODITIES
In such extremely volatile markets, weekly moves in commodity prices and the share prices of companies in the sector do not reflect the wide swings seen during the session. Gold, oil and copper ended the week slightly higher but had flirted with key psychological levels during the week. Brent crude, for example, briefly dipped below USD 100, gold hit USD 1,600 an ounce and copper fell to USD 3 per pound. The market is still in thrall to the European banking drama.
As far as gold is concerned, it is worth looking at traders’ positions on the Comex. They peaked in August at 33 million ounces before tumbling 40% to 19.7 million, the lowest level since July 2009. In other words, speculation drove prices higher and that has now been corrected. Given the current strength of traditional demand for gold coins and bars in various regions, we do not expect a more pronounced fall in the gold price. On the contrary, it should benefit from seasonal factors like India’s Diwali festival at the end of October and real interest rates which are still very low and in some cases negative.
Copper also fell victim to widespread liquidation of speculative positions. The spot price is still well above production costs of USD 2 per pound but these levels should fuel strong demand, especially from China’s industrial groups which have sharply reduced inventories over the last year.
Metal producers like Rio Tinto (aluminium) and Freeport McMoran (copper) have recently pointed to lower demand in Europe whereas it is stable in the US and strong in Asia. Note, however, that Europe only represents 10-15% of metal demand and we are currently in a seasonally slack period. The ability of Asia, and China in particular, to capitalise on current prices will influence short term demand and prices.
Oil is also in a seasonally slack period before the start of winter. Prices could as a result head lower but this will depend on how quickly Libyan output comes on stream and the political situation in Syria will also play a part.
Moreover, recent tension in eastern Saudi Arabia makes it more likely that production will be cut if ever the Brent crude price moves below the pivotal USD 90 mark which allows the country to balance its budget.

ASSET ALLOCATION
Investor sentiment has brightened because euro zone leaders now seem to be tackling Europe’s banking problems headon.
Between September 30 and October 6, the major indices performed as follows in local currency:
– Standard&Poor’s 500 +2.97%
– Euro Stoxx 50 +3.17%
– TOPIX -3.19%
– MSCI Emerging Markets -2.09%
Bond markets fell as equity markets rallied. Yields on the US Treasuries jumped from a low of 1.75% to close at 1.95% and the equivalent Bund saw similar moves (1.72% and 1.93% respectively).
On forex markets, the USD trimmed some of its recent gains, closing at 1.34 against the EUR, down from a high of close to 1.32. The yen trod water around 76.7 against the USD. The RMB has started to move higher again, breaking through 6.38 vs. the USD. This represents a rise of 6.6% since June 2010.
We took advantage of the rebound on European markets following new decisive measures to help the banking sector to continue cutting equity risk in portfolios. To do so, we sold futures and calls as current volatility on options favours this sort of hedging. Falling bond markets are providing opportunities to restore interest rate sensitivity on German debt. EdR Europe Flexible: the first moves towards market normalisation allowed the fund to gain from rising indices. The fund had benefited from the DAX’s outperformance against the Footsie so we reduced the position ahead of the Bank of England’s meeting. After maintaining exposure at 45-50% during the market rebound, we reduced equity risk at the end of the week to 33%.

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