Report from Europe: Farewell V, Hello W

Friday was a frightening day for stocks as the exuberance seen on Thursday following the GDP report evaporated following a weak US consumer sentiment reading and amid CIT bankruptcy fears. The Dow experienced its largest one-day fall (-2.5%) since late April, while the S&P and Nadsaq also shed more than 2.5%. Leading the decline were financials. Weighing on sentiment was also investor Wilbur Ross’ warning that a “huge crash in commercial real estate” was beginning and comments from analyst, Michael Mayo, that Citigroup (C) may have a $10 billion writedown of deferred tax assets in Q4. Volatility has resurfaced, rising back to early July levels,and now hovers above 30. Other markets followed in due course with risky currencies selling off, driving gains in the dollar and yen. The NZD, CAD, SEK, AUD and BRL all fell in excess of 1.5% for the session as the USD rallied.

The data Friday showed that US consumer spending fell 0.5% month-over-month in September, the largest drop since December, after a 1.4% increase in August. The decoupling between US consumer spending and the manufacturing PMI is startling. Of particular interest this week will be US consumer credit and Non Farm Payrolls. Consumer credit has been falling for seven months in a row (i.e. redemptions have outpaced new lending).

With ISM manufacturing, construction spending and pending home sales all coming in much stronger than expected US equities have gone bid and are likely to quickly erase most if not all of Friday’s losses. Homebuilders and basic resource stocks should be very bid.

Today’s Market Moving Stories

• It was another bank failure Friday as US authorities seized nine failed banks, the most in a single day since the financial crisis began and the latest stark sign that substantial parts of the nation’s banking industry are being crippled by bad loans.
• In commodities, oil fell back below $78 while metals also slipped with renewed dollar strength encouraged selling as the month came to a close. According to commodities traders, Monday will be the biggest day of the month as far as they are concerned, as they receive an early gauge of new-month flows. US ISM data is seen as a leading indicator for the important metal-relevant indicators and Asian exports.
• In other news, the ECB’s Noyer alluded to the weighted effective rate of the euro being only slightly above its long term average.
• The UK’s Daily Telegraph warns that it is Japan that should be causing all the concern, not the US. Uber-bear Ambrose Evans Pritchard noted that Japan is approaching a ‘dramatic fiscal crisis’ as its public debt moves beyond the point of no return. His observations aren’t especially new – that its debt to GDP ratio will be well above 200% this year and that its CDS cost is ever increasing. Indeed the Bank of Japan (BoJ) hardly gave the strongest signals last week when it warned of GDP not much better than 1% while deflation will persist for at least the next three years. Pritchard brings it all together: "No one knows exactly when a country tips into a debt compound trap. But Japan must be close, even allowing for the fact that liabilities of the state Loan Programme have fallen by 40% of GDP since 2000." The trouble is, the BoJ plans to allow many of its special programs to expire at the end of the year.
• The long goodbye to the 101-year-old commercial lender CIT Group (CIT) ended Sunday as it filed for Chapter 11 bankruptcy protection, with a pre-packaged plan of reorganisation. It is hoped that CIT will emerge in its new format before the end of the year. It said its operating entities are largely unaffected and highly liquid. It said its expected to cut its total debt by $10 billion under the reorganisation plan. Bank of America (BAC) has exposure of $7.5 billion as an administrative and collateral agent on a term facility, while Goldman Sachs (GS) has $1.935 billion in a swap agreement. It is unlikely that any of the $2.33 billion provided through the TARP will be recovered.
• The Wall Street Journal jumps the gun, assumes the Fed is about to tighten policy and previews the three stages of the next cycle. First, it notes that the initial section is going to be all about communication. Officials don’t believe the economy is in anywhere near good enough state to actually tighten rates now, but there will need to be nudges in the right direction. Second, the tightening cycle is unlikely to look like the last one. Third, the behaviour of the markets is likely to be critical to the decision making process. For now, then, the important considerations are going to be the language changes needed (moving away from extended period) and then an indication as to what conditions will need to be in place for tighter policy – jobless, inflation expectations, market levels, economic growth prospects, asset prices.
• Chancellor Darling is expected to announce that Lloyds (LYG) and RBS (RBS) will be stripped down and various parts sold to new owners, potentially creating three new institutions. The move could cost yet another £40 billion of taxpayers’ money. In reality this action is being forced on him by the EU (on the grounds that State aid / bailouts = an unfair competitive advantage) following on from the move against ING (ING) which forced them to sell their insurance business. The deal could see Lloyds being forced to sell off TSB Scotland, Cheltenham & Gloucester and the online bank Intelligent Finance. RBS is likely to give up NatWest branches in Scotland and its insurance businesses, including Churchill, Direct Line and Green Flag. Santander may be allowed to bid for RBS’s business banking group. RBS will call for an additional £19 billion support which will take the government’s stake from 70% to about 84%. RBS is down 8% today.
• The Sunday Times reports that Prime Minister Gordon Brown is keen to use the autumn pre-budget statement to announce a new “fiscal stimulus”, with “billions of pounds of extra money for housing, infrastructure projects and training.”
• Data Monday morning included UK PMI for October surprised on the upside by rising to 53.7 (consensus 50.0) from an upwardly revised 49.9 in September. New orders and output both rose strongly. Euro Area PMI for Oct was 50.7, unrevised from the flash estimate, the highest in 18 months.

The Week Ahead
The coming week is chock-a-block with potential market moving events. In the US, once we get past Monday’s ISM and pending home sales reports, attention will turn to the outcome of the two-day FOMC meeting on Wednesday. While there has been some talk in the market of potential changes to the Fed’s language, don’t expect the Fed to make any significant changes to its communique on this occasion. The Fed has likely upgraded its forecast of economic activity and this will be reflected in an improved tone in the description of the economy. But, policymakers will retain the sentence that rates are on hold for “an extended period” so as to be sure the economy gets full monetary traction. The Fed does not want to begin its exit strategy from a super-accommodative position until there is more confidence the labour market is stabilizing, and we are just not there yet. On that score, both the US ADP employment report and non-manufacturing ISM – also out on Wednesday – will garner attention ahead of Friday’s October non-farm payroll report, with the market presently penciling in a 175k decline, causing the unemployment rate to nudge up to 9.9%.

In Europe this week the focus will likely be on the UK. On Thursday, expect the BoE to announce a £50bn extension of the Bank’s QE program in reaction to the disappointing estimate of Q3 GDP. Before that the manufacturing and service sector PMI ’s on Monday and Wednesday respectively will shed some light on the outlook for Q4. In Euroland, the ECB also meets on Thursday. I expect the Council to continue to conclude that the current policy setting is “appropriate”. For now, expect the ECB to remain “prudent and cautious” although the language on growth and bank funding can afford a mild upgrade. The final manufacturing and service sector readings for October will be released ahead of the meeting on Monday and Wednesday respectively.

In Asia-Pacific, Australia’s RBA will announce the outcome of its latest monetary policy deliberation on Tuesday (expect a 0.25% hike in the policy rate to 3.5%) and then explain its strategy in more detail on Friday when it publishes its Statement on Monetary Policy.

A Year End Dollar Rally?
The latest US mutual fund data, for September, shows US investors raised the proportion of foreign assets in their portfolios to 25.5%, close to the summer 2008 peak of 26%. Over a half a dozen years, US mutual funds sharply increased the share of their assets abroad, from 12.5% in 2002 to 26% last year. In the risk aversion that followed the collapse of Lehman Brothers, however, funds trimmed their overseas allocations to 23% in the second half of 2008. This year, US mutual fund managers have returned to foreign markets as investor confidence has rebounded. This has helped push the USD down again. But US fund managers’ exposure to foreign assets is now close to its all time peak reached last year. Such holdings are vulnerable to a return of risk-aversion, increasing the risks that the USD can rebound further into year end.

Company News

• Basic resources stocks and miners are bid on a rise in copper on gold prices on Dollar weakness. Before opening in the US, Alcoa (AA), Proctor & Gamble (PG) and GE (GE) were all looking perky, while Office Depot (ODP) and Palm (PALM) are likely to struggle after downgrades. But the big US equity news relates to Ford (F), whose shares are up strongly in pre-market US trading (6%) after they posted a totally unexpected $997 million net income for Q3. The company also spoke of being “solidly profitable” in 2011.
• Ryanair’s (RYAAY) results today were in line with guidance with an unchanged outlook. Key components of Q2 were very strong volumes (18.4%), but yields were down, as expected, by slightly over 20%. Ancillaries were also very weak (up 3% or down almost 13% per passenger), driven by changes in consumer behaviour and partly driven by Ryanair (<40% of checked in bags) and the sterling/euro effect. Guidance remains unchanged at the lower end of €200-300 million. Disappointingly little progress has been made on the Boeing (BA) deal of 200 aircraft for delivery between 2013 and 2016. If the discussions are not successful, Ryanair will cancel orders and run the airline for cash. However, the preference is to grow in Continental Europe. So overall a strong-ish performance in a brutal market leaving them with a business model that will thrive when the storm passes. But the shares are down 5% on the day.
• Kraft (KFT) is likely to make a formal bid for Cadbury (CBY) post the US based group’s Q3 results tomorrow. The UK’s Takeover Panel ruled in late September (via a put up or shut up notice) that Kraft must make a bid by November 9th or walk away for at least six months.
• Reports that Cable & Wireless (CWPUF.PK) will use its interim results on Thursday to confirm its demerger plans. The demerger would likely be positive for bondholders who would be left with the stronger of C&W’s two businesses. In addition, either business is a more likely takeover candidate post de-merger which again would likely have a positive impact for bondholders as any buyer will, in all probability, have an investment grade profile.
• Lufthansa (DLAKY.PK) has decided to keep BMI for the moment, after it ceased negotiations with potential bidders (reported to include BA and Virgin) as bids were lower than the German airline hoped. Lufthansa was reportedly hoping to achieve a sale price of £500 million, but bids apparently fell well short of that. Lufthansa is now likely to focus on restructuring BMI, which is likely to include selling its regional and low cost (bmibaby) subsidiaries, and possibly disposing of some slots at Heathrow. Not completely unexpected, but still a negative for Lufthansa as it will firstly not receive any proceeds in the short term and secondly absorb the ongoing operating losses of BMI.

And Finally… J&R Music World’s Wall Street Commercial

Disclosures: None