Report from Europe: The Wizard of Oz Brings Forth the Bull

by: The Mole

The S&P 500 gained 1.4% Tuesday and is now only 1.6% below the high it hit two weeks ago. The move came as the index reversed its asset allocation-driven weakness, despite the media hype that the Ozzie rate hike was positive proof that the global economy is in full recovery mode.

Equity markets remain for the moment supported by three pillars:

  1. Expectations of growth stabilizing
  2. Q2 earnings season evidence and positive expectations for Q3 earnings season given firms’ cost cutting efforts
  3. US Federal Reserve policy being accommodative

However, the first and third reasons contradict each other as one cannot expect growth while the Fed continues on hold. So if either growth gives up or the Fed makes a move (above 1-2%) then equities are likely to sell off. If not challenged, equities are set to rally.

Wednesday sees the likes of Alcoa (NYSE:AA), Monsanto (NYSE:MON), Family Dollar Stores (NYSE:FDO) and Costco (NASDAQ:COST) reporting third quarter earnings. Home builders stocks, which have perhaps overshot, are under pressure on speculation that the tax break of $8,000 to first time buyers will not be renewed. Coca-Cola (NYSE:KO) was raised to a buy by Deutsche Bank and may see some buying. Avis (NASDAQ:CAR) is under pressure thanks to a plan to sell $250 million in convertible notes, while Viacom (NYSE:VIA) (the owner of MTV and Paramount) may see some buying after an upgrade from Bank of America.

European Farmers’ Anger Literally Spills Into the Streets of Brussels
European Farmers’ Anger Spills Into the Streets of Brussels

Today’s Market Moving Stories

  • The UK Nationwide Consumer Confidence Index for September rose to 71 from an upwardly revised 65 in August. This was the highest reading since April 2008.
  • The British Retail Consortium says that shop prices rose 0.1% month-over-month, but fell 0.1% year-over-year in September. This compares with a 0.1% m/m and y/y decline in August.
  • The HSBC Emerging Markets Index is signalling the strongest quarterly increase in emerging-market manufacturing and service output since the second quarter of 2008. The HSBC EMI rose to 55.3 in the third quarter of 2009, from 50.7 in the second quarter of this year.
  • Latvia is preparing legislation that would limit homeowners’ liability to the value of the collateral, which may boost losses at Swedbank (OTCPK:SWDBY). The government in Riga has confirmed it is drafting legislation that would cap the amount banks can collect from defaulting mortgage holders to the current value of properties rather than the value of the loan.
  • China calls time on dollar hegemony. As an aside you can date the end of dollar hegemony from China’s decision last month to sell its first batch of sovereign bonds in Chinese yuan to foreigners.
  • A few Irish TD’s (including the outing Speaker) may find the “expense it” image below useful.

Expense It

The Problem With The Pound
I have previously set out a bearish framework for GBP that rests on a trinity of unresolved balance sheet issues. In recent history many countries have undergone, and survived, a deleveraging in either the household, banking or government sectors. But we are not really aware of any major country that has attempted what the UK is on the brink of undertaking: a simultaneous deleveraging in all three key sectors of the economy. The combination threatens to turn balance sheet headwinds into a raging gale as far as the economy is concerned.

That sterling is now falling on all fronts, even against the beleaguered dollar and even in the face of continued house price appreciation, suggests that the market has started to focus on these unresolved structural frailties.

Even the government has been forced to acknowledge the scale of the problem and the need for fiscal consolidation. The next major update on the scale of the fiscal challenge will only come with the Treasury’s Pre-Budget report, to be released sometime in late November. What was new over the past week, however, was the trenchant analysis offered by the IMF in its latest Financial Stability report on the disproportionate pressures faced by the UK banking system and in turn the risks to an economy which is starved for credit. The size of bank writedowns and provisions, both current and the additional losses projected by the IMF, expressed as a percentage of GDP, is scary. The losses to UK banks are three times as large as in the US or Euro area, not necessarily because UK banks did any worse a job than their international peers but merely that they were much larger relative to the size of the economy to begin with.

The scale of writedowns matter because they impair the ability of banks to extend fresh credit. This cuts to the heart of the problem in the UK – the massive disparity which exists between the demand for credit (both from the government and private sector) and the ability of UK banks to provide credit. The IMF estimates the credit shortfall in the UK at nearly 20% of GDP, compared to "only" 3% in the US and 5% in the Euro area. Not only that, but the IMF estimates that UK banks will be forced to reduce their total loans by 10% of GDP this year, compared to the US and the Euro area where banks are in better shape and are still able to grow their loan books. This is UK bank deleveraging in action.

The unambiguous conclusion from this analysis is that the macroeconomic consequences of the banking crisis are far more serious in the UK than elsewhere, for the very simple reason that UK banks were that much bigger. In light of this analysis it is surely no coincidence that the Bank of England has done substantially more QE than any other Central Bank.

The Problem With The Dollar
The slide in the dollar is becoming one of the biggest financial news stories of the year, especially because the decline is broadly based and is developing a life of its own. There are several reasons for the weakness, with extraordinarily loose fiscal policy and quantitative easing being the most important. The latter has generated fear that policy-makers are willing to risk debasing the currency in order to avoid deflation. However, most major advanced economies are in a similar position, so they are not the only reasons for the dollar’s weakness.

Broken DollarThe assault on the dollar’s reserve currency status is also a major cause for concern. It is coming from a position of being the main reserve currency and unit of trade and finance. However, the financial crisis and subsequent policy response have severely damaged this status. The murky mix of politics and finance makes it hard to work out how things will end up, but it is hard to ignore the steady calls for an alternative global financial infrastructure, mirroring the increasing influence of the BRIC nations.

Interestingly, US policymakers are not trying to resist this shift in any significant way, perhaps because they understand they are fighting a losing battle and they need to concentrate on their own economic problems rather than getting caught up in international politics. At the end of the day, bureaucrats like Bernanke probably feel if they get their own house in order, the dollar will take care of itself. This is probably true, but, in the medium term, if the dollar were to weaken, this would help the US restore external balance and avoid deflation. Consequently, the Fed and Treasury are not mounting an obvious defense of the dollar.

It is probably going to take a looming Fed policy tightening to pull the dollar out of its downward trend. This may take the form of reduction in the Fed’s balance sheet and/or a hike in the funds rate. While Australia’s rate rise has the market thinking about which central bank will be next to tighten, a US rate increase still appears at best a Q2 next year proposition and there are still plenty that believe that rates could hold steady all through 2010.

Companies In The News

  • Societe Generale (OTCPK:SCGLY) may be interested in Bank Zachonia, AIB’s (AIB) Polish arm, adding a twist to the funding. SocGen has long eyed Poland as a key potential area of expansion for the group. But in a recent briefing to Irish brokers, AIB clearly articulated its strong desire to hold onto its foothold in both Poland and the US.
  • The board of Aer Lingus [LON:AERL] has signed off on a broad and deep restructuring aimed at stabilising its finances and giving it an independent future. Up to 676 job losses (17% of the workforce), an average 10% wage cut, the ending of defined benefit pensions, outsourcing and an overhaul of work practices are built into a package that will create significant political and employee unrest. This change program is designed to reduce annual operating costs by about €100 million. The key stakeholders must now make a decision. While difficult to swallow, these proposals offer the best shot at survival and independence for the company.
  • Tullow Oil (TUWLY.PK) rose over 8% yesterday after it was revealed that Kosmos was in talks to sell its stake in the Jubilee oil field in Ghana for at least $4 billion. Analysts have previously reported that the stake could be worth up to $5 billion. It was reported that Kosmos told other bidders today that it’s in exclusive talks with Exxon Mobil (NYSE:XOM) about its interest in the Jubilee field.
  • Banco Santander (STD) raised just over $8 billion from the listing of its Brazilian subsidiary in the largest IPO of this year, while ING (NYSE:ING) sold its Swiss private banking assets to Swiss wealth manager Julius Bear for $500 million.
  • Sainsbury’s (OTCQX:JSAIY) Q2 came in below expectations, with like for like sales excluding fuel up 4.6% against a market consensus of 5.5%. This represents a significant slowdown from the 7.0% recorded in Q1 and is driven by reducing inflation rather than volumes. This largely reflects what Tesco (NASDAQ:TESO) said yesterday, so while initially disappointing it will not be a surprise once digested.

And Finally… The Kids Are Still Alright

Disclosures: None