EDRG: Sharp rises in medium and long term yields on most European bond markets hit sentiment on equity markets

In contrast, growth in the eurozone remained sluggish, rising 0.2% q/q. Surging yields on Italian and Spanish debt will increase the debt burden in these countries but more importantly, falling bond prices are bad news for the banks which hold them. Italian bonds are the most concerned as Italy’s debt is the largest in Europe. This could seriously disrupt bank financing circuits and, ultimately, the economy. The ECB is still providing the necessary liquidity but has slowed down sovereign debt purchases to EUR 4bn according to the latest weekly data available. To date, the bank has spent a total of EUR 187bn.

EUROPE
Europe continues to progress step by step. Italy’s prime minister Mario Monti has formed a government composed entirely of technocrats with himself as finance minister, the Greek parliament passed a vote of confidence and Portugal received a fresh EUR 8bn tranche of financial aid. This is all going in the right direction but markets were unconvinced: they want more radical measures and indices fell yet again.
However, news that third quarter GDP growth in France and Germany rose as expected by 0.4% and 0.5% respectively tempered fears that growth was slowing. In contrast, the Bank of England considers the UK economy is in poor shape and suggested that it might have to inject more liquidity into the UK economy. This could mean as much as an extra GDP 50bn in stimulus when the next inflation report comes out in February.
Spreads on France’s debt are still widening and this week hit a symbolic 2% compared to Germany for the first time in more than 20 years. As a result, the EFSF’s intervention capacity is under pressure. Even so, France managed to complete its mid-term EUR 7bn refinancing. But it had to accept higher coupon payments than previously.
Companies in sectors which are the most exposed to the economic slowdown are continuing to introduce restructuring plans. Peugeot (autos) is to lay off 6,000 people in Europe. In the banking sector, BNP Paribas has followed Société Générale’s lead and will be shedding 1,400 jobs in its investment banking division.373 of which in France. Unicredit disappointed, posting operating profits hit by higher provisions, stagnating loan volumes and declining deposits. Above all, the bank announced an unexpectedly hefty EUR 7.5bn increase of capital to meet Basel III Core Tier 1 requirements of above 9%. Intesa, meanwhile, lost its CEO Corrado Passera to the new Monti government where he will be minister of economic development. UBS unveiled a restructuring programme which will target ROE ranging from 12% at times of market stress to 17% when markets are operating normally. A Core Tier 1 ratio of 13% is also targeted. Planned reductions in RWA (risk weighted assets) have been raised by CHF 50bn and now depend on reducing scope in investment banking.
Banks may be battening down the hatches but the civil aviation sector is thriving. At the Dubai Airshow, EADS booked EUR 20.5bn in new orders for 211 planes. But in the military sector, Finmeccanica saw new orders fall 21% and the order book lost 2%. Sales for the first nine months fell 5% and the company recorded an operating loss of EUR 188m compared to profits of EUR 856m a year earlier. The group sees reduced spending in its main markets hitting the full year result which could be lower than that over 9 months. Sales in 2011 should only be slightly lower than expected but EBITDA is seen in negative territory (-EUR 200m) compared to consensus estimates of EUR 1.5bn. Contrary to expectations, the company will pass on the 2011 dividend and expects to sell EUR 1bn in assets by the end of 2012. Amid such poor visibility, investors cheered results from Vivendi (telecoms and media) and its opportunism in buying the UK music major EMI. This contrasts with other media groups like TF1 which have recently revised down guidance. The retail sector also saw encouraging results. Dia’s sales rose 4.5% on a like-for-like basis with Spain up 1%, France down 6% and emerging countries jumping 17.1%. Operating margins improved by 30bp to 5.2%. In the same vein, Ahold saw US growth of 4.5%, more than double the pace expected. The group says it has won market share across all its major zones. Lastly, Burberry’s operating profits beat expectations but the market was disappointed when it failed to revise forecasts higher.

US
US equities fell sharply over the week amid worries over the conclusions of the bi-partisan Supercommittee on debt reduction and persistent concerns in the eurozone. But economic data was rather encouraging. Housing permits rose 10.9% and confidence levels among property developers improved sharply. October retail sales advanced 0.5% vs. expectations of 0.3%. Manufacturing data was more mixed with strong rises in New York and Chicago offset by disappointing data from the Philly Fed.
In company news, Dell, Salesforce.com, Applied Materials and Netapp in the tech sector beat expectations and posted healthy margins. But most lost ground due to disappointing sales figures or company caution over coming quarters. In apparel, results at GAP, Urban Outfitters, Limited Brands showed no clear trend. All beat the consensus but Limited brands maintained its guidance, Gap made no change and Urban Outfitters said sales had fallen in October.
Over the last five trading sessions, all sectors moved lower led by financials and materials.

JAPAN
The Topix plunged by 3.4% in JPY, falling for four of the five days and hitting a new year low. Markets were still in thrall to eurozone instabilities. In EUR terms, the index lost only 0.5% thanks to the weaker EUR. Trading was thinner after most firms reported earnings and TSE1 volume on Tuesday sank to JPY729bn, the lowest since March 2009. Japan’s robust GDP growth for the July-Sept. quarter came in, as expected, at an annualised 6% so failed to impress investors who see only dismal growth in coming quarters. The JPY/USD lost 0.9% while the JPY/EUR slumped by 2.9%. All industry groups lost ground with mining, shipping and property the hardest hit. The bleak outlook led oil exploration company INPEX to plummet 11% and leading property companies to fall by more than 7%. Reflecting weaker demand, chip-related firms such as Toshiba, Tokyo Electron and Rohm as well as major steel makers all plunged by 6% or more.
Trading houses were also among the big losers as material prices softened. Sony ended the period at a year low as its deal to buy part of EMI met with a lukewarm response. Only a handful of stocks moved higher. Most drug firms posted year lows, but Astellas Pharma rose 1% on the back of strong prospects for dealing with its patent cliff much sooner than peers. FUJIFILM gained 1% after an agreement with Kyowa Hakko Kirin (TSE1, 4151) to co-develop bio-drugs. Nidec edged lower but remained solid as investors applauded its quick remedies for a number of critical fabs hit by the Thai floods; the situation should be under control soon. SMC and Fanuc fared better as stabilised Chinese inflation was seen as a sign that Beijing might ease monetary policy.

ASIA
Weak European auto sales in October –down 1.5% in volume compared to October 2010- had no impact on South Korean auto makers Hyundai and Kia which are part of the same group. Their European car sales for October were up 18% and 32% respectively, taking their combined market share to 5.7% vs. 4% at the end of 2010. (In the US, they are already above 8%). Their advance on Toyota (3.7% market share) is increasing all the time and they could well move above market share of 6% in the first quarter of 2012 when they launch new versions of the i30 and Ceed models which are already very popular in Europe. The group will emerge stronger from the European crisis at a time when several European auto makers are struggling.
In its third quarter report, China’s central bank (the PBoC) has underlined its success in controlling growth without hurting the domestic economy’s strengths. Monetary policy will remain cautious with more of a bias to very gradual easing, so nothing new on that front.
The real shift in monetary policy looks like coming from India. The central bank is to intervene on the market on November 24 to buy back EUR 1.5bn in government debt. This is the first move of its kind this year from the bank and reflects its determination to inject liquidity. Another intervention is expected for December. This is a sign that Asian countries are already moving to support growth in 2012. Indian inflation is still high (+9.5%) but should start to fall back in coming months. There is talk of 7% over the next 6 months. That sort of deceleration would help the central bank adopt a more accommodating stance and help underpin local stock markets in 2012.
Indonesia continues to see rapid growth in foreign investment projects. Companies like Caterpillar, Bayer, Lenovo, Adidas and Nike have recently announced bigger-than-expected investment for 2012, namely USD 500m for Caterpillar, 350m for Adidas and Nike and 22m for Bayer. Not to be outdone, Indonesian companies are also part of the trend. The country’s biggest private airline, Lion Air, has just placed a gigantic USD 22bn order for 230 planes, upstaging Emirates’ USD 18bn order which received massive media attention last week. Lion Air also has an option to buy a further 150 planes for an additional USD 14bn. It is the sort of investment programme that highlights the strength of the domestic economy and the robust growth outlook for the next 10 years.

OTHER EMERGING MARKETS
To boost liquidity in the banking system, the Reserve Bank of India is to buy back Rs 100bn (EUR 1.3bn) in government bonds and it could also increase the share of non-domestic investors in government bond auctions from 10% to 15%. The government is also thinking about increasing investment limits for non-domestic investors in mass distribution and air transport. In company results, infrastructure companies as expected generally disappointed due to higher commodity prices and the cost of capital which is weighing on order books. Monetary tightening is probably nearing an end. This is why we would advise investors to return very gradually to the Indian market.
In Brazil, the market this week slid 0.5% mainly due to commodity prices declining overall by 1.32%. Brent crude fell 2.78%. Volatility continued to increase due to mounting concerns on European debt. The Central Bank of Brazil started to reverse the macroprudential tightening implemented in 2010, which should help stimulate consumption. Other important news related to a new S&P rating on Brazil’s debt, and domestic bonds moved up a level. Sovereign bonds have been upgraded to BBB+ from BBB and domestic issues to A from BBB+. The rating agency reaffirmed that upgrades could continue in the long-run if Brazil maintains its strict policy on public accounts. The Petrobras share did not react well, even after new oil field discoveries off the coast of Brazil and better-than-expected net income in the third quarter. The market remains concerned about higher lifting costs and ongoing investments to boost production.

CONVERTIBLES
It was a calm week on the convertibles market with prices generally remaining stable. Markets sold off on Thursday when Spain’s 10-year bond auction only managed to sell EUR 3.5bn instead of the 4bn planned with a bid to cover ratio of 1.54 compared to 1.81 between June and October. Yields rose to 6.95% or 100bp more than in last July. The news out of Italy was more reassuring as Mario Monti announced his new government in which he will also act as minister of the economy. He has exclusively chosen unelected technocrats with solid experience rather than personalities from the political class. The European banking sector has been hit by a wave of cost-cutting measures and redundancy plans at banks like BNP Paribas, Société Générale, UBS and Crédit Suisse. Other industries are expected to follow suit in the near future. On Friday, Cap Gemini issued a bond with a coupon of above 5% that implies a wider credit spread for the Cap Gemini 2014 convertible (not held in our funds).

COMMODITIES
Persistent market worries over Europe’s future have entailed a flight to liquidity that has brought oil and gold prices down. Gold lost 4% this week despite good third quarter supply and demand figures (source: The World Gold Council). Traditional demand has effectively fallen with jewellery down 11% compared to 2010 but this has been more than made up by investment demand (+23%) and a sharp increase in central bank purchases (148 tonnes in Q3 compared to 23 tonnes in the previous year). On the supply side, only recycling is capable of expanding to meet higher demand. Even so, its 13% rise compared to 2010 looks insignificant when set against the average 39% rise in the gold price over a year. There may be another deal pending in the gold mine sector. China’s Shandong Gold is said to be on the verge of paying a 73% premium for Canada’s Jaguar Mining which has gold mines in Brazil. In bad news, Ghana has joined the countries which want to levy heavier taxes on gold mine profits. A 10% increase and an exceptional levy have already been tabled in the 2012 budget. Not only G8 countries are increasing taxation! The gold price has, in the main, benefited from Europe’s sovereign debt woes and risen more in EUR than in USD since the beginning of the month. However, the media spotlight could shift to the US where next week the bi-partisan Supercommittee is expected to announce USD 1,200bn in costcutting measures. This is a real emergency as the US debt mountain has just gone above USD 15,000bn, a level that is dangerously close to the USD 15,200bn ceiling which was meant to keep the US afloat until the upcoming presidential elections. Iron ore prices have rebounded sharply in the last 10 days and are now close to USD 150/tonne. This comes after an uninterrupted descent from USD 170 to 117 in October. As expected, the standoff between Chinese steel makers and iron ore producers in Australia and Brazil has been won by the mining companies. The fact that the Chinese have started buying again also shows that the economy is still buoyant if less so than before. Brent crude ended the week almost 5% lower. Note, however, that the US benchmark WTI rose this week and even topped USD 100. The narrowing Brent/WTI spread is due to the future pipeline that will come on stream in mid-2012 at Cushing where the WTI price is fixed. The pipeline is seen freeing up inventories more rapidly than expected.

ASSET ALLOCATION
Sharp rises in medium and long term yields on most European bond markets hit sentiment on equity markets. Between November 10 and 17, the major indices performed as follows in local currency:
– Standard&Poor’s 500 -1.9%
– Euro Stoxx 50 -0.5%
– TOPIX -0.3%
– MSCI Emerging markets +0.8% (in EUR)

European bond markets have been thrown into turmoil in recent weeks and the upward trend in yields has accelerated over the last few days. Yields on Italy’s 10-year debt jumped to record levels above 7.2%. In Spain, they hit 6.9% compared to 5-5.5% earlier in the autumn. France’s debt also came under pressure.
The USD continued to rise against the EUR, advancing to 1.36 from 1.35 but the euro’s resilience given the eurozone situation is quite remarkable. The JPY was strong against the USD, moving below 77 for the first time since the Bank of Japan stepped in at the end of October. The RMB was unchanged at around 6.35. Markets, especially in Europe, tracked changes on sovereign bond markets. Except for Germany, yields are rising across the zone, exacerbating investor worries over the eurozone’s ability to keep the situation under control. After last week’s relief rally on political change in Greece and Italy, investors now want to see concrete decisions. We took advantage of falling equity markets to adjust allocation options, notably on options, but there were no fundamental changes. In Europe, we have tended to overweight Spain ahead of its parliamentary elections and underweight the Netherlands.
After a very good third quarter, the US market looks unlikely to go higher over the short term and we have consequently sold options.
In the face of massive selling of the EUR vs. USD, we bought euros ahead of the November 23 deadline for a recommendation from the Supercommittee on how to reduce the US deficit. The results could well prove disappointing.
As the WTI oil price has moved back above USD 100 despite the persistently bleak economic picture, we have started a short position. Edmon de Rothschild Europe Flexible: we increased exposure to 55% as markets corrected. Our hedges on the Footsie, which significantly underperformed other indices, helped to provide good portfolio protection.