Equity Markets

Even with Citi reporting a miss on the top line of $18.6 billion (Exp. $19 billion), but a bottom line beat courtesy of more loan loss reserve releases amounting to $984 million, or 35% of the entire pretax net income number, sentiment has been very quiet this morning, with hardly any sharp moves, aside from the now usual leak in Spanish sovereign bonds, following Bloomberg's confirmation of the WSJ story that the ECB is willing to impair Senior bondholders, while Swiss nominal bonds continue to trade below 0.4% and the EURUSD drifts lower. Today's lethargy may be interrupted at 8:30 am when the Empire Manufacturing and Advance Retail Sales data are released, but unless we get another massive, and very convenient, EUR repatriation out of Europe at just the moment when the US market opens, we doubt much will happen today ahead of Bernanke's semi-annual congressional testimony tomorrow.

Life ain’t fair

Since the EU-Summit, US and European equity markets have (in general) outperformed. From being in sync before the Summit, US equities went into the weekend with a sell-off, which then spurred a short-squeeze push as the S&P 500 was over-exuberant (relative to European equities) on the way up at the start of last week. That cracked back to reality at the end of last week - squeezing the over-levered longs to a significant underperformance relative to European equities. It would appear that in the last 24 hours, US equities are now rallying back to that European 'surreality'. Surreal because European stocks remain dramatically exuberant relative to European (peripheral spreads unch and AAA massively bid) and US (Treasuries bid) bonds and European corporate and financial credit. As we stand, the S&P 500 has retraced back to Europe's 'fair' perspective.

With record low Treasury yields it is clear that the bond markets think we are about to embark upon a difficult journey while the equity markets are still regaling in the quarters past. The bond markets have read the charts and looked at the weather ahead more correctly he fears and the length of our European journey changes nothing about the difficulty of the upcoming passage. Having been asked so many times and by so many people over the last couple of years how to fix Europe that the question is now commonplace in Grant's thinking, here is the must-read reality short version. The main issues bended about in a number of significant ways would be the total and uncompromising loss of all of the nations’ sovereign status. There would be virtually no more Spain, France, Italy et al. Every nation and their cost of funding and their standard of living would have to merge at some average or mean. So we ask Europe; are you prepared for this? Do you want this? Are you willing to pay the price for this because if you are not then we suggest you end the charade and protect your own interests before you fall down the rabbit hole that you have created by your own political and economic deceit!
 

Because I pay attention to these things; I have the sense that there has been a lot of praying recently. Prayers for QE3, prayers for Quantitative Easing mortgage bond buying, “Please SIR;” and for words to the effect in each and every FOMC minutes that “Money will be printed forever and ever Amen.”

“Now I know I'm not normally a praying man, but if you're up there, please save me, Superman!”

                          -Homer Simpson

Now I hate to do this to you and I feel like the bad boy with the pin about to prick someone’s bubble but these prayers have gone unanswered as you know and are not likely to be answered any day soon unless Europe goes up in pixie dust which, while certainly possible, will be far more serious for the markets and will more than offset the Fed dragging out their printing presses and plugging them in once again.

With 15 days until the Olympics, we introduce the first in a five-part series of market-and-economy related discussions centered on that glorious event. As global equities exhibit their own 'Citius, Altius, Fortius', Goldman looks at the impact of the Olympics on stock markets. They note that, aside from the benefit of raising the international profile of the host country as both a tourism and investment destination, the announcement of a winning Olympic bid means major investment in infrastructure, including stadiums, accommodation and transport to prepare for the Games. Interestingly, all recent Olympic hosts have outperformed the MSCI World index in the 12 months following the Olympics. This is true of recent hosts regardless of the size of the economy or state of development, suggesting either the local market is boosted by the international profile of the Games, or is perhaps relieved to have the Games behind them. Given the below-average performance in the UK since the Olympic announcement, UK investors may hope for a continuation of this trend, looking forward to a positive year in equities following the London 2012 Games.

If anyone still actually cares, or trades, we just saw the third California muni bankruptcy in two weeks, German bonds priced at record low yields, and Spanish 2 year nominal yields just hit all time lows of -0.37%. Abroad Spain promised to crush its middle class even more by impairing retail held sub debt and hybrids, while forcing them to pay more taxes, a move which will lead to some spectacular Syntagma Square riotcam moments, yet which has sent Spanish bonds slightly higher. As for US equity futures, they continue the headless chicken dance higher even as company after company now rushes to preannounce horrifying Q2 earnings. And that's it in a nutshell.

The Island-Renaissance fusion was a vision of the future in which high-speed AI-guided robots would operate on lightning-fast electronic pools, controlling the daily ebb and flow of the market. The AI Bots poured their valuable liquidity into Island, which, in turn, made it possible for the Bots to operate at high frequencies. They fed off one another, creating a virtuous cycle that would become un- stoppable. Little-known outfits such as Timber Hill, Tradebot, RGM, and Getco would soon start trading on Island, forming the emergent ganglia of a new space-age trading organism driven by machines. Tricked-out artificial intelligence systems designed to scope out hid- den pockets in the market where they could ply their trades powered many of these systems. In the process, the very structure of how the U.S. stock market worked would shift to meet the endless needs of the Bots. The human middlemen, though they didn’t know it, were being phased out, doomed as dinosaurs. And the machines were breeding more machines in an endless cycle of innovation, as programmers pushed the boundaries of speed more ruthlessly than Olympic sprinters. Trading algorithms would mutate, grow, and evolve, feeding off one another like evolving species in a vast and growing digital pool.

The global economy is an entangled affair, make no mistake in your calculation here, and the numbers from around the globe are telling and will affect both the U.S. bond and equity markets. Much of the financing for the Emerging Markets was provided by the European banks and as they pull back and reorganize based not just on Basel III but based upon problems of the sovereign where they are domiciled the situation exacerbates. Two of the world’s financial axises are slowing and troubled and to not think that this will not affect America will lead you to conclusions causing you to play the Great Game badly. What did the meeting of the European Finance Ministers accomplish; not much. They nodded to the Spanish banks and agreed to inject $30 billion by the way of the sovereign, increasing the debt of Spain, with veiled promises of a new ESM fund which would lend money directly to the banks at some point in the future and this point is highly subjective depending upon to whom you listen. The Spanish claim within days or weeks while the Germans indicate it may be sometime next year. There is now a “maybe-maybe” timeline in Europe for almost anything as the weaker nations prod the stronger nations for more money.

European equities are seen firmly in the green at the North-American crossover, with outperformance noted in the peripheral bourses. Overnight news from the Eurogroup has confirmed that the EFSF/ESM rescue funds will be given the powers to intervene in the secondary bond markets, easing sentiment towards the European laggard economies. Gains are being led by a particularly strong technology sector, with the riskier financials and basic materials also making solid progress. Asset classes across the board in Europe are benefiting from risk appetite, with the Bund seen lower and both the Spanish and Italian 10-yr yields coming below their key levels of 7% and 6% respectively. The moves follow a spurt of activity in Europe with a number of factors assisting the way higher.

SSDD. Europe has a late night conference, regurgitates stuff, gives no details, makes lots of promises, peripheral bonds tighten only to blow out, etc, etc, etc. Seen it all before. Unlike a week ago, Spanish bonds, when Spanish bonds ripped by 1%, this time we can barely muster a 25 bps move tighter, with the 10 year "down" to  6.82%. It was 6.25% a week ago. Expect the blow out as has been empirically proven time and again. Hint: there is no magic money tree nor is there a magic collateral tree.

By now, it seems clear that the US earnings season will be softer than was forecast a couple of months ago. In fact, there was more negative guidance during the second quarter than any time in this cycle and Morgan Stanley, like us, believes these soft results and weaker guidance are not fully discounted into a QE-hungry market. Lower oil, a stronger dollar (e.g. a one-standard deviation appreciation in the US Dollar against a basket of currencies decreases expected S&P 500 earnings by 2.6%), lower 10-year yields and a preponderance of evidence of lighter growth from economically sensitive companies are reasons for a lower view of Q2 EPS than we previously expected as UBS notes the 'official' US Q2 reporting season kicks off in earnest today with Alcoa followed by over 3,000 global companies reporting in the next two months. At the sector and stock level UBS sees particular risk around some of the higher rated areas such as consumer staples and consumer discretionary, where relative multiples are high and expectations are demanding and while they see consensus estimates for 2012 global EPS growth have been falling - at 9.7%, they remain too high given the Eurozone crisis / policy response; deteriorating global macro data; and the corporate profit cycle - and in that order of importance.

It should come as no surprise to anyone that major commercial banks manipulate Libor submissions for their own benefit. As Jefferies David Zervos writes this weekend, money-center commercial banks did not want the “truth” of market prices to determine their loan rates. Rather, they wanted an oligopolistically controlled subjective survey rate to be the basis for their lending businesses. When there are only 16 players – a “gentlemen’s agreement” is relatively easy to formulate. That is the way business has been transacted in the broader OTC lending markets for nearly 30 years. The most bizarre thing to come out of the Barclays scandal, Zervos goes on to say, is the attack on the Bank of England and Paul Tucker. Is it really a scandal that central bank officials tried to affect interest rates? Absolutely NOT! That’s what they do for a living. Central bankers try to influence rates directly and indirectly EVERY day. That is their job. Congresses and Parliaments have given central banks monopoly power in the printing of money and the management of interest rate policy. These same law makers did not endow 16 commercial banks with oligopoly power to collude on the rate setting process in their privately created, over the counter, publicly backstopped marketplaces.

More of the same is not working, and it just may require lower equity prices for investors to get what they really wish for.

European credit markets - sovereign, financial, and corporate - have all slumped dramatically in the last two days - massivley underperforming the ever-hopeful equity markets. Even though broadly European stocks (the BE500 or STOXX) are only retraced by around 25% off their post-summit highs, individual markets (and especially financials) have retraced almost 100% of the gains with Spain's IBEX seeing its biggest 2-day drop in 7 months and closing unch anged from pre-Summit levels. EURUSD is the story though as it plunges to two-year lows  at 1.2266 - over 400pips from its post-summit euphoria highs as QE3 hopes are dashed by muddling through US data. The disconnect between US and European equity indices and the rest of the world's more idiosyncratic risk markets remains unsustainable and as we have said before again and again "credit anticipates and equity confirms".