In yet another ironic twist, traditional market cheerleader Goldman Sachs, which discusses the factors for the "strong start to the week for equity markets" in the form of the 100 S&P point surge on nothing but hope and more rumor speculation, concludes with rather ominous: "beyond the headlines, it is only the process of grappling with the details and concrete plans that will force the political leadership in these countries to face the difficult tradeoffs involved. And as such, as long as there is not more clarity around concrete proposals – the distribution of legacy losses and the mechanisms for mutual support in the Euro-area going forward – and the details on implementation, we doubt that the current market optimism can be sustained over the medium term, and beyond the upcoming G20 meetings." In other words, precisely what we have been saying: rumors and "plans of plans of plans" are great for short term squeeze induced, bear market bounces, but in the long, or even medium-term, do nothing to address the fundamental math fail which states, quite factually, that going from point A (where we are now) to point B (where Merkozy wants Europe to be), will be virtually impossible absent massive equity losses. Yet, as also pointed out before, Wall Street career risk is always in the "here and now" never in what may happen a day or even an hour from now, now that markets are no longer a discounting mechanism, but a purely headline reactionary one.
1. A Strong start to the week for equity markets
Global markets had a strong start to the week. Equities rallied throughout the European and US sessions, with the S&P 500 finishing 40 points higher on the day, close to the top of its recent range. Financials was the best performing sector in the US, followed by energy and other cyclicals. Banks had a relatively strong day in Europe too, finishing a couple of percent up on the day, behind other cyclical sectors like autos and chemicals. In sympathy with the positive risk sentiment, the dollar was on the back foot for most of the day. US Bond markets were closed for the Columbus Day holiday.
Asian equity markets are mostly higher on the day too. Apart from the strong US close which likely helped sentiment, two pieces of news from the region are worth highlighting. First, on Monday it was announced that Huijin, one of China’s sovereign funds, had added to its equity holdings of Chinese Banks, and that it planned to continue buying shares over the next 12 months. Although the size of the purchases is small, it is an important signal of support for Chinese banks in the wake of market concerns about the Chinese economy, NPLs and the stability of the financial system. Chinese bank stocks moved sharply higher on the open, but markets have retreated from the highs. Second, in Indonesia, the central bank unexpectedly cut its benchmark rate by 25bp to 6.5%, joining the growing rank of monetary policy authorities switching to an easier stance in recent months.
In Europe today, all eyes will be on the parliamentary vote for the EFSF in Slovakia. Otherwise it is a relatively light macro day within a light macro week. Continuing the run of IP releases for August, and after the positive surprises out of Italy and France yesterday, we have the August IP report for the UK where we expect +0.1% (better than consensus -0.2%). In the US the NFIB Small Business Optimism index will provide the latest read on whether the recent disruptions in financial markets are tightening financial conditions for small firms.
2. A better week in markets – is it all ok?
Global markets have traded with a much more constructive tilt for a week now, with the S&P 500 index up almost 100 points in that period. This abrupt shift in sentiment - which seemed to occur last Monday towards the end of the US equity session – was initially sparked by speculation that significant and co-ordinated bank recapitalisations were being discussed by Eurozone policy authorities. It was sustained through the week by macro data, which at least in the US, continue to surprise on the upside relative to downbeat expectations, and paint a picture of an economy that is growing at a moderate pace despite the intense volatility of the past quarter. And over this past weekend, a summit between the leaders of Germany and France provided more headlines indicating that a co-ordinated and comprehensive set of measures to combat the spreading Eurozone sovereign crisis would be unveiled ahead of the G20 summit meeting in early November (November 3-4, 2011).
Coming on top of market positioning and investor sentiment that was unremittingly bearish, this stream of relatively positive headlines, combined with some better than expected macro data, has been sufficient to push equity markets sharply higher over the past week.
3. Growth and Financial risk relief
As we survey the price action across global markets in the past week, three things stand out.
First, there was a moderation in financial and equity risk. Bank equity rallied both in the US and the Euro area, closing about 6% higher in both places. Credit spreads tightened, senior financial spreads in Europe tightened by around 50bp from about 300bp to 250bp. And volatility declined, implied equity market volatility as measured by the VIX index fell from the mid-40s to the mid-30s. To be clear, despite this moderation, financial and equity risk is still at recessionary levels. But if sustained, this type of moderation would go a significant way towards making us more comfortable trading macro views and dislocations elsewhere in markets.
Second, the market upgraded its growth view both in the US and Europe. Over the past week, our equity growth baskets were up about 5% in the US and about 4% in Europe (ex UK). The more consumer-facing cyclicals also moved higher, with our consumer growth basket moving up 4% in the US and by 3% in Europe (ex UK). As we described in the Global Weekly last week (Intensifying ‘Shocks’ to the Global Economy, and Their Pricing, GEW 11/31, October 5, 2011), cyclicals in both Europe and the US have already priced in a pretty significant recession. And in the US, where the data has been encouragingly steady, cyclical equity implementations like our WF US growth basket are pricing in not only something worse than our current forecast, but also something weaker than the kind of moderate recession that seems most likely. If financial and system risk continues to moderate, this is one area – the overpricing of US cyclical risk - where the market will need to catch up to the better data.
Third, whereas growth and financial risk was rerated, what is also interesting is the absence of any noticeable country tilts in the market action. Within Europe for instance, periphery or core countries did not notably outperform. And EM equities, including Chinese equities, did not notably outperform DM either, and China-exposed equities in developed markets also performed more or less in line with the overall markets. So the recent jitteriness over Chinese growth and credit market stresses – that are described by Kenneth Ho in yesterday’s Global Markets Daily, and has caused Chinese equities to underperform globally over the past month – look to be continuing to weigh on markets here.
4. It’s a long, long long road
The repricing of financial system and growth risk is encouraging, although it is hard to be confident yet that these moves can be sustained. In the case of US growth risk, there are firmer grounds for belief in the market rally. The market was arguably too negative and while the recent tightening in financial conditions continues to pose a risk, there has been a consistent drip-feed of positive surprises, even in the forward-looking survey data. The composite (manufacturing and services) PMI index for the US has been stable for two months now, even as it has continued to decline in the Euro-area and the BRICs.
On the financial front too, it is certainly encouraging that recent headlines discuss many of the measures that will need to be part of any eventual resolution of the Euro-area sovereign crisis – a significant restructuring of Greek debt that places Greek public finances on a sustainable footing, a co-ordinated plan for recapitalising Euro-area banks, and ensuring that other sovereigns like Italy and Spain can borrow at reasonable yields that allows them the space to demonstrate real economic growth.
But beyond the headlines, it is only the process of grappling with the details and concrete plans that will force the political leadership in these countries to face the difficult tradeoffs involved. And as such, as long as there is not more clarity around concrete proposals – the distribution of legacy losses and the mechanisms for mutual support in the Euro-area going forward – and the details on implementation, we doubt that the current market optimism can be sustained over the medium term, and beyond the upcoming G20 meetings.