Sunday, November 28, 2010

Equities: Where should we be looking? Focus shift from earnings to Ireland to macro

Equities: Where should we be looking?
Focus shift from earnings to Ireland to macro

We expect that market focus, which was first trained on the Q3 reporting season and then
the Irish crisis, will now shift back to global macro indicators. It is now that we need clear
signs of sustainable global growth in jobs and consumer demand. Corporate earnings
have lived a life separate from the rest of the economy, but non-existent top-line growth
in Q3 underscored that if the strong profit cycle is to continue in 2011 it will require a
marked improvement in OECD job markets and the OECD consumption cycle plus a
resurgent global industrial cycle. Sales growth is the only impulse that can drive the profit
cycle forward now that companies are being squeezed by input price inflation on the one
hand and falling sales prices on the other. There have been a few isolated indications of
global economic growth becoming increasingly sustainable. We reiterate our
recommendation of overweighting banks and maintain our defensive stance on Cyclicals
but we are listening to the signals and have moved a little closer to the middle ground by
going neutral on Industrials and overweighting Energy. In the near term, however, we still
expect equity markets to remain soft though risk adjustment is taking place as downside is
gradually eliminated.

Consumer is important at the tail end of the year
Action in the final months of the year will be seen in industrial groups strongly correlated
with the macro data that a sustainable 2011 is so dependent on. The impact could of
course go either way, depending on data. It would appear that much has been wagered on
the consumer in the final months of 2010. US retail chains increased their inventories by a
hefty 4.6% q/q in Q3 in the hope that consumers will ignore the subdued tone of the
economy and consume as usual in the run up to Christmas. These expectations appear to
have already been priced into the sector according to multiples such as P/E, P/B and
relative P/E. Likewise, both analyst and market expectations on earnings growth are

The week ahead
The coming week will see an intense focus on some key data from the US that may point
the way to an exit from this mid-cycle slowdown. First up are US ISM manufacturing
index (30/11) and Chinese PMI manufacturing index (30/11), which will colour
earnings expectations for global Industrials in coming quarters. Next, all eyes will be
trying to spot signs of a pick-up in consumption in the short term, with Retail chain sales
in the US (2/12) and Europe (3/12) and US Consumer confidence (3/12) and in the
longer term, with the US Jobs Report (3/12). Any announcements from Brussels from
the AFME’s conference on securing financial stability in Europe (30/11) could have a
short-term impact on Financials. Equity markets will be concentrating on Trichet’s
speech at the monthly ECB meeting (2/12). Statements concerning Europe’s sovereign
debt crises could prompt risk aversion in the equity market depending on the wording.

Fixed Income: A tug of war
Yields higher amid escalating Euro debt crisis
There is a tug of war going on in the bond markets. On the one hand the escalating Euro
debt crisis should be putting downward pressure on bond yields as it hampers risk
appetite and increases the flow into more safe bonds, but so far this has been outweighed
by strong German data and higher US bond yields, which has been pushing German and
Danish yields higher.

This is a bit surprising to us, as the debt crisis seems to be moving into a new more
dangerous phase, where the risk of contagion is rising. It now seems increasingly likely
that Portugal will have to ask the EU/IMF for help, which in fact might turn out to calm
the market. The current concern is the rising funding costs for Spain that is now paying
4.5% on a 5-year bond and above 5% on a 10-year bonds. With this kind of interest rates
Spain might soon be approaching dangerously high funding costs, which will make it
tough to meet the budget – even if there are more spending cuts. The market clearly needs
a circuit breaker to stop the sentiment from deteriorating.

One can argue that the European Financial Stability Facility (EFSF) will act as a safety
valve, which is why German bond yields are not moving lower, but then why is the
sovereign spread between Spain and Germany at the highest levels since the Euro debt
crisis began? Clearly, the markets now seem to be taking a view beyond the period to mid
2013 for which the ESFS is covering.

Something else might be going on. Maybe we have reached a stage where a further
deterioration in the PIIGS debt markets is no longer positive for the German bond market.
If the market needs an even bigger rescue package, even more bad credit exposure will be
transferred from the periphery to Germany. In an ultimate crisis situation Germany might
end up guaranteeing a huge bulk of less credit-worthy debt from other countries. If this is
what market participants are eyeing, a further deterioration in the eurozone periphery
might not send German yields lower, but higher.

However, that will depend on how such a scenario would affect global risk appetite and
US bond yields. In any case the current situation is unusually complicated and the outlook
for the bond market is pretty blurred in the short term. We believe that the signs of a
turnaround in US and core European macro data are genuine and that this will ultimately
lead to rising yields next year, but in the short term the tug of war between improving
data and the European debt crisis will continue.

Next week: ECB meeting, payrolls and ISM
Apart from the development in the European debt crisis, there will be plenty of events for
the market to focus on, such as the ECB meeting. The big issue is whether the central
bank will continue its full allotment policy under the current terms. We think so, as there
is no need to rock the boat given the current turmoil in the European debt markets (see
market movers). In the US we think that the payrolls and the ISM report will confirm the
recent tendency for improvement in data, which will add some fundamental support to the
recent higher level of long bond yields.
Full report: Equities: Where should we be looking? Focus shift from earnings to Ireland to macro

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