A few days removed from the official Eurozone statement, peripheral sovereign bonds and global equities appear to remain satisfied with the terms for now.
Spanish yields have declined about 75 basis points from the "7%" level, due in large part to the retracted subordination of private holders' debt rights.
Of particular importance to global markets was further progress on ratification of the ESM, and new legislation that could possibly allow the ESM to fund insolvent banks directly, once the supervisory committee is finally constructed and even then only under some very unspecific guidelines.
Clearly not priced into the market is the reality that with the ESM legislation now completely refreshed, it will have to get through Germany's constitutional court, while Finland and Holland have come out against buying sovereign debt on the open market.
Overall, unless the ESM is fully ratified and funded within the next couple of months, the stability that global markets are currently enjoying seems unlikely to last. The Eurozone economy is contracting markedly, with EU unemployment at record highs and manufacturing PMIs across the region well below the 50 (no change) level.
A significant amount of risk was just priced out of the market, leaving plenty of room for a downside move in the coming months.
The US earnings season is likely to be that catalyst.
S&P Earnings Reality
2Q earnings preannouncements have largely been hidden by EU headline news.
Over the past month, company preannouncements have warned investors about earnings that are likely to come in between 2 and 20% lower than analysts predicted. Huge, global economic bellwethers like Procter & Gamble (PG) have provided guidance that is perhaps most worrisome, with its renewed guidance predicting earnings that are 6% lower than expectations.
2Q S&P earnings estimates have declined from $26.11 at the end of March to $25.38, which would result in the weakest year-on-year (5.2%) since the recession ended. While broader earnings don't have much near-term contractionary risk, their growth rate is at best declining moderately.
Second half 2012 EPS is likely to come in even further below current expectations. The US economy will probably show 2Q GDP growth between 1.3 and 1.7%, and while 3Q and 4Q is projected to be above 2%, I don't see how the US can whether the global economic storm that well. The European economy is deteriorating every month, and the recent Summit will provide a few weeks of market relief at best, with no meaningful implications for the real economy. Chinese HSBC PMI data has also shown contractionary trends.
I expect US GDP growth to remain well below 2% for the remainder of the year, with full year GDP coming in at about 1.5%. This rate of growth is not consistent with current earnings forecasts, and forward estimates also don't appear to be meaningfully considering margin contraction.
Quarterly earnings have a lot to live up to, given the lofty 2012 estimates of $105.07. I expect full year earnings to come in closer to $95, which is in agreement with more realistic GDP estimates.
The end of year S&P (SPY) targets for $95 in operating earnings would come in at the following:
13 times earnings: 1,235
14 times earnings: 1,330
15 time earnings: 1,425
Of course, $95 in full-year operating earnings would drastically alter 2013 earnings estimates, currently $118. Current valuations are pricing in substantial earnings growth in 2013, so the rate of EPS growth that I'm expecting would result in subsequent multiple contraction. With the S&P 500 currently trading at 15.20 earnings, an end of year multiple of between 13 and 14 times earnings seems most likely. With the S&P trading at 1,360, 4-5% of full year market downside remains.