Market awaits EU heads of state meeting

Australia’s Labour party seems to be slipping in the polls – they are some 10 points behind the Liberal-National coalition. With a slender majority of just one (an independent, who votes with the government, though his position is threatened), Ms Gillard’s position is weakening. There are increasing suggestions that the Labour party may have another leadership challenge;

 

The Chinese Yuan is at its lowest level in seven months. The PBoC set its daily fix by -0.3% lower at 6.3230 against the US$, though the Yuan is trading slightly above that level at present. The Yuan is allowed to trade by 1%, +/- the daily fix. Chinese shares declined to a five month low today;

 

Moody’s reports that they will keep India’s rating outlook on stable, despite a marked slowdown in GDP growth. They added that the current negative trends are unlikely to be permanent, or even a medium-term feature of the economy. However, both Fitch and S&P warned of further downgrades recently.The decline in the oil price, by some 25% recently, will certainly be of considerable help, as India imports some 75% of its oil needs and, in addition, should reduce inflation significantly, which will allow the RBI to reduce interest rates in coming months. In addition, India is not (unlike China) dependent on exports – the domestic economy is far, far more important. However, the policy gridlock in Delhi remains a serious problem, though given the recent serious economic problems, seems  to be moving – by how much? and/or by enough?. To ease the pressure from foreign funds exiting India, the Government, today, increased the amount of Rupee denominated government debt that can be bought by foreigners, from US$5bn currently, to US$20bn. Should help the beleaguered Rupee. There are also reports that India will allow foreign companies to control 51% of supermarkets (possibly civil aviation, as well) in the country, though each state can decide as to whether it intends to enact the measure in respect of supermarkets. Further measures are also expected;

 

Islamist leader, Mr Mohamed Morsi, has become Egypt’s first democratically elected president, defeating Mr Ahmed Shafiq, the former air force commander and official in Hosni Mubarak’s administration. To date, Islamist parties have won in Tunisia and Morocco and are expected to win in Libya. Whilst clearly nervous, most governments worldwide feared that the military would rig the election results in favour of Mr Shafiq. However, the military has stripped the presidency of many of its powers. In addition, Egypt’s economy is weak and tourism remains a significant factor. Fundamentalism and tourism do not mix. At the end of the day, the Egyptians will look to the economy and if Mr Morsi does not perform (its going to be difficult), well…….In addition, Egyptians have had a degree of freedom in the past and will be opposed to measures that restrict such rights;

 

Fitch cut Cyprus credit rating to junk today, to BB+, from BBB-, outlook negative. Cyprus, a member of the EZ, has a serious banking problem, due to its linkages with Greece. Its thought to be negotiating with the Russians (and the Chinese), but help from the EZ remains the most likely, especially in the medium/longer term;
Spain formally asked for a bail out for its banks this morning, though no amount was specified. To date, Germany has refused to accept that the funds (estimated at E100bn), to be granted to Spanish banks, would rank equally with existing sovereign debt, held by private sector bondholders, (effectively ranking the EZ bail out funds ahead of existing debt, thereby creating a subordination problem) and/or that the funds would be channeled directly to the banks, rather than the State. Channeling funds through the State would increase Spain’s debt to GDP by around 10% points, to an expected 90% by the end of this year. There may be some movement on both, but one (possibly on the subordination issue), is possible, if the funds come from the EFSF, as EFSF funds do not result in subordination. The Spanish need to sort this out by 9th July, the date the ESM is expected to come into effect – funds from the ESM will result in subordination – though the start date of the ESM may be delayed due to German constitutional court issues. Germany is taking a particularly hard line at present. Oversight over the Spanish banks to be recapitalised will be a major issue – expect Spain to capitulate on this issue and, in effect, allow oversight, by the ECB and/or another organisation – the IMF?. With proper oversight, the EZ may agree to the bail out funds being injected directly into Spanish banks ;

The French finance minister reports that France needs some E7bn to E10bn of additional savings to meet their 2012 budget deficit targets. Given Hollande’s rash promises ahead of his presidential campaign, its going to be interesting to see how France achieves these savings, particularly as his supporters will want delivery on his (expensive) promises. Mr Hollande is to meet Mrs Merkel this Wednesday, ahead of the EU heads of state meeting on the 28/29th June. One of the critical issues for France is whether it will be willing to give up political control to a central body, as effectively demanded by Germany, as part of any fiscal union. To date, France has resisted giving up any major political powers, but I’m not sure that they have much choice. Having said that, the Socialist Party was deeply split on this issue previously and further difficulties (to say the least) are expected. As the WSJ puts it, “France has preferred intergovernmental – as opposed to supranational – solutions ……(which) is why the euro zone was largely designed along French lines, as a club of sovereign states”. I remain of the view that, ultimately, France will remain the main (and most serious) problem in the EZ;

 

Germany’s Bilt reports that 39% of German’s favour leaving the Euro, 28% of Italians 29% of French and 24% of Spaniards. A particularly comfortable majority of individuals in all 4 countries reported that Greece will never pay back its loans, though suggested that a Grexit would increase (“dangerously”) the euro region’s difficulties (Source Bloomberg). As you know, I believe that there is a 75% chance (and increasing) that Grexit is inevitable this year, or by early next, which actually will be considered positive, rather than negative – prior steps to avoid contagion has to be put in place though;

 

Interestingly Mrs Merkel has agreed to debt sharing. Before getting too excited, that policy is restricted to Germany. Essentially, the federal government has agreed to underwrite the debt of German states, starting next year. The deal was to gain support from Germany’s Upper House. Mr Schaeuble was quick to point out that this largess is not extended to other EZ countries;

 

The German Parliament is set to discuss the ESM on the 29th June. It is expected to pass (Mrs Merkel is seeking a 2/3rd majority). However, the German President will not sign off until he hears from the German Constitutional Court. In theory the ESM is expected to come into effect on the 9th July;

 

Details of a document prepared by the EU (Barosso, Rompuy, Juncker and Draghi) and to be discussed at the 28/29th heads of state meeting are beginning to leak. By the way, the only credible person is Draghi – certainly as far as Mrs Merkel is concerned. The plan is to concentrate on four “pillars”, namely banking union, an integrated budget policy (fiscal union basically), steps for deeper economic integration (more fiscal union, leading to political union) and, amazingly how to retain “democratic legitimacy” – wow “democratic legitimacy”, the EU has been the complete opposite for years. For example, the EU Commissioners, who can introduce legislation, effective on EU citizens, are unelected !!!. Other subjects covered, include greater EU labour mobility, improving competitiveness and common taxation.

 

Breaking the links between EZ sovereigns and their banks is critical, but I cant see (other than the usual woolly statements) an EZ wide bank guarantee scheme and/or bank resolution fund being agreed at this stage, though movement towards an EZ wide (wont include the UK) banking supervisor/regulator is an almost certainty. I cant see progress on Euro bonds either or a bond redemption fund. However, proposals that the ESM lend directly to banks (subject to ECB and possibly IMF? oversight), rather than the state are certainly possible, if not at the meeting, in the near term – important as by this means the relevant sovereign will not have its debt to GDP percentage increased. Expectations for the 28/29th meeting are low, so some (surprising) statements/policy (looks unlikely at present) will be well received, but…..It is likely that the EU bureaucrats will be given a mandate (post the 28/29th meeting) to produce additional and more specific plans by October/December – will the market wait till October/December – I very much doubt it – those days are over;

 

It is likely that the US Supreme Court will decide on President Obama’s health care legislation this week. Analysts expect that the Supreme Court will overturn some aspects of the legislation – certainly a market moving decision, whichever way it goes;

 

The US Chicago Fed May National Activity Index came in at -0.45 MoM, lower than expectations of -0.30 and a revised number of 0.08 for April. Just confirms the downturn seen in other US State indicies;

 

Outlook

 

Asian markets closed lower and European markets having opened lower, continue to weaken. US futures suggest a weaker open of around -0.9%.

 

There are rumours that  the EZ will introduce a short term (up to 1 year max) Euro bill to reduce financing costs for the peripheral EZ countries, as a temporary measure. Such a proposal has certainly been discussed and  the introduction of such an instrument will be very positive for markets, as it suggests that Euro bonds will follow. Will need to assess, though looks unlikely in my opinion, based on present indications. The only good news is that (unlike previously) expectations for the EU heads of state meeting are low to rock bottom. Any good news will result in a (significant) market rally.

 

I continue to believe that it is dangerous to be short. Any serious problems following the EU heads of state meeting will (very likely) result in coordinated central bank intervention, in any event. In addition, I am pretty convinced that the ECB will reduce rates (at least 25bps, though possibly even 50 bps) at its next meeting (especially as inflation is declining ) on the 5th July and, in addition, the ECB may also undertake a QE programme thereafter.

 

August Brent is hovering around US$90, with Gold at US$1565. I watch the German 10 year bund, in particular, which are strong today, with yields down by 11bps to 1.47%, given the gloomy outlook.

 

Clearly the Euro is weaker today – currently US$1.2495.

 

US earnings, as is the case globally, seem to be weakening – quite possibly earnings growth will be negative this quarter. Need to watch, especially as analyst forecasts for the current year are way too high, in particular, in respect of growth in the final quarter of 2012.

 

Kiron Sarkar

 

25th June 2012

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