Report From Europe: Waiting for Anglo

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 |  Includes: DIA, QQQ, SPY
by: The Mole

US stocks opened lower Tuesday selling off sharply in response to a much weaker than expected consumer confidence number. But after the knee jerk reaction lower, equities found their footing and grinded higher for the remainder of the session with major indices finishing up 5.54 points on the S&P 500. Walgreen Co. (WAG) led a rally in consumer staples and health companies and investors speculated the Federal Reserve will buy more debt to safeguard the economy. Walgreen, the largest U.S. drugstore chain, surged 11% as earnings topped estimates. Elsewhere Pfizer (NYSE:PFE) and Johnson & Johnson (NYSE:JNJ) paced gains in health care shares as the Supreme Court agreed to hear an appeal by pharmaceutical companies seeking to block thousands of public hospitals from suing over a federal discount drug program. But Monsanto (NYSE:MON) slid 8.1% on concern its SmartStax corn seeds aren’t performing as well as predicted.

Stocks on the move this European morning include miner Vedanta, which is controlled by billionaire Anil Agarwal, has dropped 4.9% Wednesday as the stock tracked a selloff in rival Sterlite Industries (India) after a court ordered the nation’s largest copper producer to shut its only smelter for breaching environment standards.

UK banking stocks area also soft today with RBS (NYSE:RBS), the U.K.’s largest government owned bank, slipping 1.1%, while HSBC (HBC), Europe’s biggest lender, fell 1.9% and Standard Chartered shed 0.9% after Adair Turner, the chairman of the U.K. Financial Services Authority, said big banks should face higher capital requirements than smaller lenders, since the risks in the event of bankruptcy are greater, Les Echos reported, citing an interview.

To the upside today we have Rolls-Royce (OTCPK:RYCEY) which is better by 4.3% after Morgan Stanley raised its recommendation for the engine maker to “overweight” from “equal-weight” and lifted its share price estimate to 720 pence. Analysts named the company as their “top pick’ in the European aerospace & defence industry, saying the market is “missing the potential for improved profitability.”

Carnival increased 1.8% after Goldman Sachs Group Inc. raised the cruise liner to “buy” from “neutral” and increased its price estimate for the U.S. traded shares to $44 from $36, citing a “solid improvement’ in cruise demand.

In Europe, H&M (OTCPK:HNNMY), Europe’s second-largest clothing retailer, slumped 5.8% after it reported that third quarter net income rose 23%, missing analyst estimates, as the company spent more on its products to increase sales growth. Net income climbed to 4.24 billion kronor ($630.11 million) in the three months through August, from 3.46 billion kronor a year earlier, Stockholm based H&M said today in a statement. That compares with the 4.54 billion-kronor average of 17 analyst estimates compiled by Bloomberg.

Sky Deutschland is down 1% as the German pay television operator sold about 169 million shares of the 270 million on offer at €1.05 apiece, it said yesterday in a statement published on DGAP. The sale raised €177.4 million ($241.48 million), the “first part” of measures that aim to generate at least €340 million.

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Today’s Market Moving Stories

  • A fairly disappointing batch of UK data this morning. For a start, the housing market still appears to be weakening, with the number of mortgage approvals for new house purchase falling from 48,300 to 47,400 in August, the fourth monthly drop in a row. And the recent falls in the RICS balance of new buyer enquiries suggests that approvals could drop even further. Meanwhile, unsecured borrowing fell by £0.1bn in August, suggesting that banks still aren’t keen to lend and/or consumers don’t want to borrow. The monthly index of services showed that services output contracted by 0.2% m/m in July, heightening the risks of a sharp slowdown in growth in Q3. The one bit of good news is a robust 0.8% monthly rise in August in the MPC’s preferred measure of the broad money supply, so called M4 ex. But this measure has been jumping around recently and the MPC has warned of possible distortions from seasonal factors. So I doubt it will do anything to change the minds of those MPC members (like Adam Posen) who are moving towards doing more QE.
  • The pro and anti QE MPC members are showing their colors. Speaking in Hull, external member Adam Posen added a point to 30 year gilts by expounding the view that further large scale asset purchases should be implemented. Although we think that QE2 is not the appropriate thing to do in the UK, and that other alternatives like an SLS extension would be more beneficial, our trade recommendations are well-positioned for the move.
  • Japan: The BoJ Tankan’s headline sentiment index for large manufacturers improved to 8 in Q3 from 1 previously the sixth consecutive improvement to take the index to its highest level since March 2008. The outcome also exceeded the consensus forecast of 6, but the index is seen sliding to 1 in Q4 the first time big manufacturers have expected the outlook to deteriorate since December 2008. Large firms plan to increase capital spending by 2.4% in the financial year to March 2011 below the consensus forecast for a 4.2% rise.
  • China: HSBC’s manufacturing PMI rose to a five-month high of 52.9 in September, up from 51.9. The sub-index for new orders rose to 54.4 from 52.7 and new export orders climbed back into positive territory after three months below the 50 marker. The sub index for inventories of finished goods came in below the neutral mark of 50 for the second month in a row.

Anglo Irish Clarity Tomorrow… Finally

There really is only one story dominating the headlines as the malignant shadow of Anglo Irish continues to darken Ireland’s skies, bloat their bonds spreads and cause it’s citizens to crash cement mixers into the gates of the country’s parliament building.

Though it’s been two years and the sloth like actions of the current Irish coalition government have made Godot seem punctual, tomorrow at least we are finally to get clarity after the London / Dublin market closes on the governments:

(1) estimate for the final cost of bailing out (the nationalized) Anglo Irish (that said the true figure may not be known for may years).
(2) which category of bondholders (if any) will share the pain
(3) whether other banks will also get a fresh capital injection

Expect a two phase reaction:

(1) Given the number of issues here, their complexity and the distinct possibility that parts of the announcement get misreported or are misunderstood the market will not know which way to jump on the headlines, and will instead just trust the verdict of sovereign bond investors. If they tighten, euro should be supported, if they widen further then the euro’s gonna run into trouble.
(2) Next phase of reaction will be determined by the rating agencies S&P / Fitch / Moody’s and journalists. S&P said yesterday that final cost of Anglo will be 35bn (20% of GDP) and says, if this is the case, then another downgrade is probable. But if government estimate is wildly too low, S&P may downgrade anyway citing lack of credibility. The tone taken by journalists will also have an impact. Chairman of Ireland’s fan club (not) EAP in The Telegraph could have a field day. Take your pick:

So how will the market react ? Sell the rumor buy the fact ?

(1) Well at last, some clarity runs the argument to buy . So unless their greatest fears are realized, the initial reaction is more likely to lead to a tightening of Irish sovereign spreads given the pronounced and dramatic widening of late final cost.

(2) Thanks to yesterdays S&P remarks, the market will probably be happy with anything less than 35bn (and it’s very unlikely government will pitch above that figure). The informed local press saying government will release a base case estimate of 28-29bn and a worst case scenario cost of “well above” 30bn but less than S&P’s 35bn estimate). Question is, who will the market believe the government or S&P? The government should be better placed to judge (it owns the bank and has seen the loan book), but it also has a vested interest in understating ultimate costs.

(3) What will happen to holders of Anglo corporate bonds?

Will government decide to default/restructure Anglo’s corporate bonds? Doing so would reduce the need for capital by making bondholders take some pain. There are 3 categories of corporate bondholders: holders of subordinated debt, holders of senior debt that “is” government guaranteed, and holders of senior debt that “is not” government guaranteed. If only subordinated debt takes a haircut, then that would probably please sovereign bond investors as it would reduce Ireland’s funding requirement by around 1bn (S&P thinks this is very likely it cut their rating to junk a few days ago). Political stability would also improve as it would quell public disgust that the taxpayer is footing all the bill. However, if the government also chooses to hurt holders of unguaranteed senior debt, yes it would save the taxpayer about 1-2bn, but it could easily backfire as it would be the first default of senior bank debt inside a G10 economy since the crisis started in 2007. Sovereign bond investors would anticipate the ugly headlines, and the knock on effects for the rest of the Irish banking system, and would probably choose to sell Ireland instead (S&P downgraded this debt 3 notches on Tuesday, so the risk is real). Finally, there also remains the theoretical possibility that Anglo decides to force a haircut on government guaranteed senior debt (I say theoretical in the sense that it is also theoretically possible that Ireland will one day win the World Cup). It’s just not going to happen though. If it did, it would be a sovereign default unthinkable given Ireland has 8 months worth of cash reserves and, even if it didn’t have so much cash, it could still activate the European Stability Fund or just go direct to the IMF to avoid default.

(4) Capital needs of other banks

It’s likely the government will also announce plans to inject more capital into Allied Irish (not Anglo Irish) on Thursday too. This could lead to Ireland taking a controlling stake. European stress tests showed Allied Irish had a 7.4 bn capital shortfall, but was given a passing grade anyway (what a joke, and a farce those tests were!) on the assumption that the capital would be raised by year end. Allied Irish has since been selling assets in Poland and in the US, but still needs more capital, maybe another 3-4bn. The lower the capital requirement the happier sovereign bond investors will be.

(5) And of course, the EU still has to agree to the Anglo Irish rescue plan. They effectively already rejected “Plan A” behind the scenes by criticizing it publically (original plan was to keep Anglo alive as a fully functioning bank). We are now on ‘plan B’ (no new loans will ever be issued, but the bank will be wound down over years as the property market recovers and the assets recover some of their value). The EU seems to be happier with this plan, but still has some reservations. I think the EU will be quick to approve the plan, and their approval may even come on Thursday too. But, should the EU reject it on competition grounds, there is no “plan C” there is only vacuum and the inevitability of further spread widening.

The Irish times wrote to EU Commissioner Rehn, asked if some analysts were correct to say that Ireland should activate the European Financial Stability Fund. His reply: “I have no doubt that the Government will continue to take the necessary steps to steer the Irish economy successfully through this very difficult period. In this way, the need for external financial assistance, although available if required, should not arise.” This is also consistent with IMF remarks made after the very dodgy selective misquoting of a research report last week by Irish Independent.

In sum, the sooner the veil on Anglo’s future is lifted the better for all concerned. In the meantime, expect plenty of headlines, some of which will be relevant / informed but most will either be 2-3 weeks old or completely unfounded. Finality on Anglo may curb some of the recent volatility in Irish spreads, temporarily appease rating agency concerns and potentially act as a catalyst to Ireland regaining market confidence but it is only the first on a list of milestones that “Ireland Inc” needs to deliver before year end. Some encouragement can be drawn from the recent comments by The Society of Actuaries and the Irish Association of Pension Fund Managers, who have proposed to the Government that Sovereign annuities be based on Irish bond yields as opposed to German bond yields as a means to ease pension deficits. If the proposal is approved, we would expect to see a significant pick up in demand for Irish Government Bonds. Ultimately this would boost domestic participation in Ireland’s bond market which when compared to some its peers is relatively low with 85% of Irish Debt being held offshore. We note comments from an EU Executive spokesman after the market closed yesterday that “Ireland has not even held any informal talks using the Euro Zone Emergency Fund.”

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Company / Equity News

  • Reports in the equity round up sections in the Evening Standard and Guardian cited speculation that Cap Gemini may be interested in making a bid for the UK based software group Sage, which has a current market cap of nearly GBP4bn.
  • The German Cabinet approved the country’s new Energy Plan yesterday, which includes the 12 year average nuclear life extensions and the additional taxes for the sector outlined earlier this month.
  • BP (NYSE:BP) has tapped the bond markets for the first time since the Macondo disaster with a $3.5bn issue. The sale was well received by the institutional investors with the bid to cover rate believed to be just under three times. The issue was spilt between 5 year ($2bn) and 10 year ($1.5bn) maturities with the bonds priced at 195 and 210 basis points over their respective US Government maturities. We view the sale as positive for BP as it illustrates that the company is returning to the normal day to day running of its business. It is also significant that the majority of the issue was purchased by US institutions as there were fears of a boycott following the disaster.
  • Overnight Hewlett-Packard (NYSE:HPQ) forecast earnings and sales for 2011 that were ahead of estimates. Management also guided they intend returning cash to shareholders through dividends and share buybacks, but spending on cap-ex and acquisitions will be the number one priority for the group. In the tablet market, HP aims to have a 17% market share by 2013. The announcement of guidance ahead of estimates along with a positive outlook for the future supported the stock and shows the value in the tech sector.
  • Michelmersh Brick (the No.4 UK brick manufacturer) has reported sales up 18% and broadly flat operating profits for the six months to end of June. It is no surprise to see management being cautious on the outlook given general economic uncertainty, credit availability and disruption caused by the changes in the planning system. As a result, volumes are expected to remain at current levels for some time but there are shortages of some products. Management also highlight that there is likely to be significant changes in the ownership structure of the industry (90% is controlled by three larger manufacturers, of which CRH is one) within the next 18 months. CRH’s clay brick operations in the UK reported a 15% increase in operations, which along with progress in the Netherlands resulted in a €5m increase in divisional EBITDA. CRH’s European clay operations are small in the context of the group, representing less than 2% of group sales.

Disclosure: None