Saturday, December 11, 2010

Weekly Focus: Equity - Fixed Income - Forex

Equities: One down 
One down – Bush’s tax cuts extended 

One of our key short-term concerns for the equity market has been removed. President
Obama has extended the Bush tax cuts, which would otherwise have expired on 31
December 2010. Obama’s compromise with the Republicans means, furthermore, there is
potential for a two-year stop for unemployment insurance tax, equivalent to 0.7% of
GDP. Thus an additional potential damper on the US’s fragile recovery is gone. That
leaves the PIIGS crisis – which has mostly been affecting global risk appetite, along with
job creation, deflationary pressures and the housing market – as factors constituting the
most important macroeconomic obstacles to the continued rise of the equity market. The
PIIGS crisis will probably flare up regularly over the coming year and so fears of yet
another PIIGS nation collapsing will therefore probably remain in place, even though the
real economic effects of the crisis appear  unclear. The overall effect on the stronger
European economies is positive, as they can benefit from lower funding costs for both
companies and consumers. At the same time, exports from these countries are particularly
exposed to the new growth markets. Hence the euro weakening will be a boost to
competitiveness, which should subsequently help lift corporate profits. One result of the
crisis continuing into 2011 could therefore be a further rotation from the southern/central
European equity markets to, for example, the Nordic equity markets, as we have already
seen in 2010. The crisis will have a mixed impact on Financials in Europe. Banks mainly
exposed to the economically strong countries will perform much better earnings-wise
than banks exposed to the debt-ridden nations. Likewise, there will be a great difference
in the funding costs of households and companies. Overall though, there is some basis for
banks – driven by northern Europe – to surprise in Q4.

Christmas is coming 
Given the weak job situation in the US we remain worried about the shift from global
growth powered by the industrial cycle to growth powered by final demand from
consumers in particular. However, it would seem that our worries of a lacklustre
Christmas season can be ignored. Sales reports from the major US retail chains for
November were positive. Hence the sharp increase in inventories in Q3 appears at least
partially justified. Solid US retail sales have also been reflected in equity price rises
among retailers. However, rises driven by Christmas season earnings momentum can
quickly reverse if the job market does not pick up. Likewise, one should bear in mind that
these strong retail sales are mainly due to massive sales campaigns and heavy price
discounts that may simply have brought forward sales that will then be missing from Q111.

The week ahead 
A busy week, with plenty of indicators on the OECD industrial cycles  (USA: NY Fed
15/12, Philly Fed 16/12, Germany: PMI 16/12, Ifo 17/12, Europe: PMI 16/12) and the
pressure on margins via inflation reports  (USA: Producer prices 14/12, Consumer
prices 15/12, EU: Consumer prices 16/12). There will also be indications of the impact
on the US housing market  (NAHB Housing market index 15/12). A picture of one of
the most important growth engines for sustainable growth will come with the US’s NFIB
small and medium enterprise optimism, due 14/12. Possible indications of a coming
turnaround in the US economy could show up in the  Leading indicator 17/12.  An
exciting week for equity markets indeed.

Fixed Income: Bond carnage 
Another week, another sell-off 
The global fixed income sell-off intensified this week. German and Danish 10-year
government bonds reached the highest levels seen since April or May, leaving curves
significantly steeper.

The main source of weakness continues to be the US Treasury market. During Tuesday
and Wednesday the 10-year US Treasury bond sold off by some 35 basis points on news
that the Obama administration and the US Congress agreed on a new stimulus bill. While
it was hardly surprising that the Bush tax cuts were extended the Bill added USD150-
200bn of further stimulus on top of that. However, with the Fed buying USD110bn of US
Treasuries each month, this additional supply of bonds should be no big deal for the

Ostensibly, much of the sell-off – in our view – still appears to be driven by position
squaring (profit taking). Going into QEII both real money and speculative investors have
been very long duration – buying the rumour. But then after QEII everyone seems to have
been selling on the fact. In a thin year-end market, this has amplified the impact from
positive growth data and fiscal stimulus.

That the appetite for bonds is not what it used to be, was also visible in this week’s
German auctions. Despite higher yields and the ongoing uncertainty about PIIGS, the
German bond auctions were received very poorly in the market adding to the jitters.
While we do not dispute that yields should be trending higher next year – we have been
forecasting just that for some time – we continue to believe that the recent move has gone
too far and been too fast. The sell-off has essentially provided all the increase in long
bond yields that we had forecast to happen through H1 next year and then some.

Even if growth becomes solid, very low inflation and central banks on hold should limit
upside potential for long bond yields from the current levels. The 2-10 curves are almost
as steep as in the spring.  In our view, it will be difficult to for long yields to move much
higher, without moving expectations for central bank hikes further into 2011. With the
current communication from the Fed, it appears difficult to seriously price Fed hikes
much more aggressively.

Over past few days there have been some signs of stabilisation in the market. The 30-year
bond auction – which was the final this week – went very well and yields are now some
15-20bp off their peak in the US. We believe that there should be room for some reversal
of the increase in rates over the short-to-medium term. But the markets remain fragile and
we may have to test the recent peak levels again before this happens.

Next week will be heavy on events with German Ifo, European PMI, US retail sales, US
CPI and the FOMC meeting as the most important. Given the recent sell-off, we believe
that the bar will be high for positive data surprises to push yields higher. Furthermore, the
FOMC statement could remind the market about the Fed’s relatively soft stance.
In the PIIGS focus will be on Spanish bond supply on Thursday. Italy and the
Netherlands have cancelled their auctions.

FX: Five FX themes for 2011 
This week we once again presented our FX Top Trades for the coming year. The trades
build upon five global themes that we believe will dominate the currency market in 2011.
These are:
1) A global cyclical improvement.
2) A commodity super cycle.
3) Global revaluation and rebalancing.
 4) Monetary divergence.
5) A global fiscal contraction.

1) Our 2011 FX outlook and the proposed trades are based on the view that we will
experience a further cyclical improvement in 2011. Sustained and accelerating growth in
2011 will, in our view, drive risky assets higher, support further appreciation of the
Scandinavian currencies, mitigate downward pressure on the euro and drive the
commodity currencies AUD, NZD, CAD and NOK even further into overvalued territory
– at least during H1.

2) We also base our FX outlook and the trade recommendations on a continued rise in
commodity prices. Our Commodity analysts believe that oil could test USD100/barrel in
H1 2011 and that copper prices could continue to rise, despite already trading at an alltime high. Rising metal prices should notably benefit AUD, CLP and ZAR, while higher
oil prices are expected to support NOK, CAD and RUB. A combination of increasing oil
and food prices should be beneficial for MXN, BRL and NZD.

3) We believe that the global rebalancing will continue in 2011 and that “surplus”
countries – mainly Asian – will continue to experience an appreciation pressure, whereas
the “deficit” countries will suffer. In Asia we believe China will allow its currency to
appreciate significantly more than currently expected in the market. In Europe focus on
balances should support the SEK, whereas GBP is expected to continue suffering.

4)  Monetary divergence is once again expected to be an important driver in the FX
market in 2011. In Europe we believe that both the NOK and the SEK will gain support
from higher interest rates in 2011. But also our bullish EUR/USD outlook is based on the
notion that ECB will continue to unwind its emergency liquidity facilities, whereas the
Fed continues to keep rates low for a prolonged period.

5) Fiscal consolidation is going to be a big issue in 2011 for the FX market. The tough
austerity measures in the UK are expected to weigh on sterling, whereas the SEK is likely
to benefit from very strong fiscal balances. In 2011 Sweden is expected to have a budget
surplus – a very rare thing these days! But also the CHF is expected to get support from
this factor, whereas the high budget deficit eventually is expected to take its toll on the
Full report: Weekly Focus: Equity - Fixed Income - Forex

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