Part 1: Prior Week Market Movers & Their Lessons For the Coming Week
- EU optimism, upbeat US data fuel rally in risk assets to the upper end of their 2 month trading range
- No fundamental improvement, though markets capable of overreacting to sense of progress in the EU, so rally could continue on hopes (again unjustified) for good news from October 23rd EU summit
- EU optimism not justified until we see commitment to sacrifice both
- Lifestyles to fund austerity and bailouts
- National sovereignty as centralized budgeting needed to ensure no future crises
The EU remains the big threat; the global economy is still sliding. Within that context, however, there were enough positives to feed the rally in risk assets to the upper edge of its 2+ month trading range. Using the S&P 500 as an example, that range has been between about 1100 to 1220-1250.
The big 3 market drivers over the past week were:
- Technical Resistance: Risk assets are now back at the upper end of the trading range established since the big early August 16% drop. For example, the S&P 500 is now back around the top of its range around 1200. That 16% plunge in just 12 sessions from late July to early August was driven mostly by the advent of haircuts for GIIPS bond holders and all that this implied (more on that below). The US budget ceiling debate and resulting credit downgrade didn’t help, but the disappearance of this issue for now hasn’t helped markets to recover, so it wasn’t really a decisive issue. See Part 2 for details.
Markets haven’t gone below the 1100 low of this range because the other two main bearish drivers remain in place but haven’t worsened. In case you’ve forgotten, these are:
- The EU Crisis Optimism (justified?): Talk about plans to resolve the EU crisis, while only talk at this point and lacking details, were enough of an excuse for markets to continue to rally back up to the upper end of their highs for the trading range that’s been in place since August. We really question the justification of this optimism. We’ve seen so many short term rallies based on nothing but plans without details or funding commitments. The bottom line is that to survive, the EU has to commit to a combination of more austerity, bailouts, and loss of national sovereignty as budgeting becomes centralized in order to avoid future crises. We’re not convinced the will exists to bear this much pain.
- Upbeat Data: While China’s trade data was poor, its inflation data was better and US retail spending also gave cause for optimism as it confirmed the message of last week’s monthly jobs reports that the US economy isn’t collapsing. It may not be growing much, but it’s holding steady for now.
Note: Earnings thus far were irrelevant. Markets rallied even while earnings disappointed, because of positive news out of the EU discussed below. Google’s (GOOG) earnings beat was at best a contributing factor to a rally fueled by EU optimism and a US retail sales beat that confirmed the picture painted by last week’s US jobs reports: that the US economy isn’t as bad as feared at this time.
In the end, no real change in the situation. EU crisis remains a dire threat without a solution, and it’s occurring within the context global slowdown too. Within that dour picture though, the week’s news was more positive than negative, and at least justified the trip back to the upper end of the trading range in place since August. The EU is the big driver but so far we’ve just got more hot air, plans to make plans. That’s still some progress, but nothing to justify a real break higher yet. Thus we remain within at the upper end of the trading range.
1. EU Sentiment Was The Main Market Driver
Once again, markets moved primarily with sentiment on the EU crisis. This came in 3 variations this past week.
A. Hopes For A Bank Recapitalization Plan
Mostly there was greater hope that there would be a solid plan to support EU banking so that it could survive Greek and other sovereign defaults (partial or total) likely to follow. If that can happen before the defaults/restructures/haircuts start, another Lehman moment with untold consequences may be avoided or minimized. The alternative, an EU and likely much wider banking collapse, sounds so very, well, 1930s.
The big news supporting this hope for a plan to keep EU banking afloat came on a report Monday of German Chancellor Angela Merkel and French President Nicolas Sarkozy to unveil a solution to the Euro-zone debt crisis by the end of the month.
B. Slovakia EFSF Expansion Approval
The other bullish big EU story (Tuesday and Wednesday) was that the EFSF (bailout fund) expansion, a key part of the July 21st Greek rescue plan, would be ratified by Slovakia. Despite being poorer than Greece, Slovakians have managed their affairs better and have not required a bailout, and so they are understandably reluctant to pony up funds for corrupt Greece. Belief that Slovakia would in fact approve the plan provided enough lift to override a dour start to US earnings season. Such is the strength of the EU’s influence over markets. That Slovakia’s approval of the EFSF (bailout fund) expansion as part of the July 21 plan was a big deal mid week seemed odd given that
- US earnings are often a potent market driver
- The July 21 rescue package is already known to be inadequate and outdated, because of the big bearish story from the EU
C. Fears Of Bigger Haircuts Needed From Banks
Fears of bigger haircuts for private bondholders were reportedly a reason behind the slight retreat in risk assets Thursday. This wasn’t a surprise in itself, but the fact that EU officials are now admitting the inadequacy of the 21% envisioned in the July 21st rescue plan is new, and it ended whatever hope there was of avoiding it. There’s always been a lag between what everyone knew and what the EU would openly admit, and the confession stage always seems to be good for some added market reaction, as markets pulled back a bit Thursday. Granted, markets were back at the upper range of the trading range in place since August, so sheer technical resistance was also a factor Thursday.
There are conflicting reports about whether there will be deeper losses imposed on private bondholders. However, the most recent report from the wsj.com from the G-20 conference on Saturday is that talks over deeper losses for the banks are now “all but dead.” That’s because officials correctly realize that this would cause more harm than good. Specifically, it risks sparking a repeat of what happened in the wake of the July 21 announcements of private sector haircuts:
- a flight out of Italian, Spanish bonds, and even French sovereign and bank bonds
- crashing their bank share prices
- further cutting off their credit sources as US, Asian, and other banks see European banks as even riskier
If in fact further haircuts are off the menu, this would ease fears of further private bond holder losses from the G-20 meeting and should be bullish for risk assets going into the week. However, there are German and other officials who still support larger haircuts. The final result of this decision will likely be very significant for determining whether the EU crisis eases or worsens.
Conclusions & Ramifications
Short Version
While the current rally may last longer, it’s just another short term counter move and risk-asset selling opportunity until we see a credible, detailed EU rescue plan. We question if there’s much room left to ride risk assets higher, yet shorting remains risky as markets have proven themselves capable of rallying on mere vapors of hope in the past. In sum, we’re suspicious of new long positions but not ready to go short until we have confirmation of the rally fading. There are times when the best action is no action.
Imposing Haircuts On Bondholders: Self Defeating
If the above reports are true that there won’t be further haircuts imposed on private bondholders (mostly EU banks), then Europe has correctly avoided yet another self-inflicted wound. If they aren’t, and bigger losses are coming for the banks, the past week’s rally could easily be undone as EU banking, and thus the EU, again becomes a concern. When introduced in the July 21st package they may have helped get the bailout package approved, but created a host of new troubles that blew the crisis into greater proportions and rendered this bailout package too small before it could even be ratified.
Specifically, imposing losses on the very banks expected to buy future GIIPS bonds produced the following results:
- Sent markets plunging within a week as they understood the ramifications, which included:
- Hurt confidence in EU and global banks, cast doubt on who will be solvent after direct and indirect exposure taken into account, risking the very Lehman moment everyone wants to avoid.
- EU banks are unable to get long term interbank lending from the US and Asia.
- Spread the crisis to sovereign bonds and shares of banks in Italy and France, which until then were not affected by the EU crisis. These nations, previously regarded as stable, were now seen as riskier given their exposure to now far riskier Greek and other GIIPS bonds. After all, markets would expect equal losses on bonds of other GIIPS once the precedent was set.
- The whole point of the sovereign bailouts was to preserve their bondholders, EU banking system. The EU can continue with smaller GIIPS in trouble. It can’t function without its banking system. These haircuts thus undermine the whole purpose of the bailouts, making the bailout ‘cure’ bring on the disease of an insolvent EU banking system.
- In essence punishes the banks that are needed to buy future GIIPS bonds, discourages further purchases, unless at much higher rates to factor in whatever the haircut taken on Greece and still earn acceptable return.
In sum, while haircuts, aka private sector involvement (PSI) appeals to a sense of social justice that plays well in the street, this approach causes more harm than good and likely makes the final solution even more expensive. Any funds saved will likely go to supporting banks, and GIIPS bonds risk never being sellable at rates GIIPS can afford. Worse, PSI assured the crisis in confidence would spread to core EU funding nations like France.
Data Provides Some Relief
US
The combined influence of the better than expected jobs reports last Friday and retail sales this Friday provide some hope that the US economy is not deteriorating further for now. That’s not enough to really boost markets, but allowed them to drift higher on optimism from the EU. In the longer term, these reports may keep more stimulus plans on hold and reduce downward pressure on the USD, which predictably suffered from the move up in risk appetite in general, and in hopes for an EU solution in particular.
China
Poor trade data was counterbalanced by softer inflation data, no discernible net affect from China this week.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.
