Will the ESM to be granted a banking licence?

Australian June CPI rose by just +0.5% in the 2nd Q on a Q/Q basis, or +1.2% annually, down from +1.6% in the 1st Q. Lower inflation will enable the RBA to cut rates further – likely. Futures suggest a further 75bps of interest rate cuts by the year end, with the 1st rate cut in September fully priced in, but the RBA may indeed move in August;

Japan posted a trade surplus of Yen 61.7bn in June, as opposed to a deficit of Yen 140bn forecast. Lower oil prices helped materially. However, exports declined by -2.3%, though better than the -3.0% forecast. The trade deficit for the 1st half of the year, came in at Yen 2.9tr and it is unlikely that the much better than expected June trade data can be maintained. The Japanese economy is expected to grow by +2.2% for the fiscal year ending in March 2013 – seems optimistic.
The Japanese finance ministry warns (yet again) about possible intervention in the forex markets, given the strengthening Yen – highest in 11 years against the Euro and also strong against the US$;

The Bank of Korea warns that its forecast for economic growth of +3.0% this year, (announced just 2 weeks ago), is likely to be be optimistic, mainly due to the crisis in the EZ. Exports are declining, as is consumer and business confidence;

The IMF report that “the pace of activity (in China) has slowed and downside risks are significant”. They add that China relies far too much on fixed asset investment (around 50% of GDP) and that the authorities should promote measures to increase consumption, whilst reducing investment into housing. China is heading for a “soft landing” and “is well placed to respond forcefully, if needed, to a deterioration of the external environment, in particular through fiscal policy”, they say. Hmmm. In addition, they repeat that the Yuan is “moderately” undervalued – the Yuan has declined by -1.4% against the US$ YTD. The IMF predicts that GDP will rise by +8.0% this year and +8.5% next – without a material stimulus programme, these forecasts look particularly optimistic. However, further stimulus is inevitable – simply don’t understand why they have not announced further measures as yet. Chinese markets are at their lowest levels since 2009;

EU officials are beginning to acknowledge that a further restructuring of Greek debt will be necessary. This time the official sector creditors (the ECB and EU governments, though not the IMF) will have to take hits. A loan of E3bn+ is due to be repaid to the ECB in mid August – I guess this will be fudged, with the money going to Greece, who will then repay the ECB in full. The Troika is currently in Greece and it is clear that they will report that Greece has failed to meet most of its targets. However, the EU stated that it was too early to comment on their results, but would return in September and then make a statement ie Greece is a total mess, but as nothing can happen in the EZ till September at the earliest, lets not rock the boat at present and leave (the inevitable tale of woes) till September;

The Spanish central authorities are facing opposition from a number of their semi autonomous regions, especially the largest region, Catalonia, which accounts for approx 20% of Spanish GDP. The regions oppose demands to limit their budget deficits to 1.5% this year and further oversight. Moody’s reports that the regions will post deficits, at least 1% point higher than the 1.5% target, for the current year, making even the upwardly revised Spanish 2012 budget deficit target of 6.3% impossible to achieve. A number of the regions (between 6 to 8, out of a total of 17) will request aid from the central authorities this year, in addition to Valencia.
The EU has requested that Spain submit a multi year budget plan by the end of July. The German finance minister made some positive comments about Spain yesterday, which is 1 reason that Spanish bond yields are lower today.

Italian consumer confidence rose to 86.5 in July, from 85.4 in June and better than the 85.0 forecast. The Italians must have found new ways of avoiding the taxman. Interestingly, some Italian economic data has been better than expected, which seems counter intuitive;

The outlook for French 3rd Q manufacturing demand came in much weaker at -14, from +4 in the 2nd Q. PPI is seen at -0.1% in the 3rd Q from the previous Q, as opposed to +0.1% in the 2nd Q on a Q/Q basis;

In addition to downgrading Germany, Holland and Luxembourg yesterday, Moody’s downgraded the outlook for the EZ temporary bail out fund, the EFSF, from stable to negative;

The important German July IFO index came in at 103.3 (105.2 in June), the lowest in 2 years and worse than the expected 104.5. It is also the 3rd consecutive monthly decline and the lowest reading since March 2010. The current situation component declined to 111.6, from 113.9 in June, whilst future expectations fell to 95.6, from 97.2. Many analysts had expected Germany to weather the storm, but this data, not surprisingly, clearly indicates that this is not the case. The IFO institute expect GDP to be just +0.1% in both the 2nd and 3rd Q’s, though the German economy minister stated that GDP should be around +0.7% this year. Germany is relying on domestic consumption (the retail sector continues to perform), which is holding up, but weaker manufacturing/exports will feed through, which suggests that consumption will decline. Investor confidence (ZEW index) fell for the 3rd consecutive month and the DAZ is approximately 10% lower in the last 4 months;

Deutsche Bank announced that they would strengthen capital ratios by cutting risk ie deleveraging to you and me. Most banks in Europe will continue to reduce their balance sheet size – not good news for the European economy. Deutsche, as is the case with other banks, will reduce the headcount in their IB business, in particular. Overall, their results were disappointing, to say the least;

Very interestingly Mr Nowotny, an ECB council member, stated on Bloomberg that he can see arguments to provide the ESM with a banking licence, a move which has been vigorously opposed by the ECB to date. However, he downplayed an imminent move, stating that he is “not aware of specific discussions within the ECB at this point” and, in addition, markets have overreacted (positively) to his comments, which was nowhere near suggesting a commitment. However, at the end of the day, the funds available to the EFSF/ESM are simply insufficient to meet its likely demands (Spain is almost certain to require a full scale bail out, for example) and, as a result, either the ESM gets a banking licence and/or the ESM issues bonds, which can be used as collateral to obtain ECB financing ie attractive to potential investors such as banks. There is no alternative, as I have banged on for a long time, though to grant the ESM a banking licence, ahead of the decision by the German Constitutional Court, seems unlikely to me.
He added, that the ECB was not considering introducing a negative deposit rate (to avoid banks parking funds at the ECB) at present and that growth and inflation expectations were lower than initially estimated. June’s ECB data will be revised lower in September, something Draghi has already acknowledged. Personally, I believe that the ECB will indeed look at introducing negative deposit interest rates seriously, in spite of its negative effects eg closing down money market funds.
On a negative note, he dismissed the idea that the ECB would be buying bonds of the peripheral countries, in spite of Spanish yields climbing close to 8.0% – the 10 year rose to 7.75% today, but is currently lower (7.53%) at present, due to Nowotny’s comments. Mr Nowotny can “say” that the ECB will not resume its bond buying programme, (though he couched his comments carefully), though if Spanish 10 year bond yields climb to 8.0%+, I really cant see how they can avoid intervening. In the meanwhile, Spain will continue to issue short term bills to cover its financing needs, a policy which is clearly unsustainable, other than in the short term;

Given the Spanish problems (including its insolvent banks) the EU is racing to submit a plan for a single banking supervisor by early September ie banking union, which they want to be in place by the year end. Inevitable turf wars will occur between the EU, who will want to get involved and the ECB, who are to be the supervisor/regulator? and will want to safeguard its independence. In addition, the French Commissioner involved in drafting the rules, Mr Barnier, will want to retain his fiefdom and, in addition, will inevitably try and ensure that the rules apply to all EU (rather than just EZ) countries, which will be a major problem for the UK ie, its not going to be easy;

UK 2nd Q GDP declined by -0.7%, much worse than the -0.2% decline expected and the 3rd consecutive quarterly decline. On an YoY basis, GDP declined by -0.8%, much worse than the -0.3% expected. Yes, the extra holiday, (which the BoE stated would result in a -0.5% reduction in GDP), and bad weather had a negative impact, but these are awful numbers. Construction (weather related) declined by -5.2%, production was down -1.3%, though the much more important services sector declined by just -0.1%. The bleak numbers suggests that the BoE will increase its QE programme (currently £375bn) in November, unless there is some material improvement/positive announcements in respect of the EZ. Having said that, I continue to believe that the GDP numbers released by the UK’s statistical office, the ONS, are inevitably worse than data from other sources, a view expressed by the BoE, as well. For example, UK unemployment actually fell to 8.1% in the 3 months to April, from 8.2% previously and lower inflation ( which fell to 2.4% in June, the lowest in 2 1/2 years) will increase disposable income and therefore consumption, which is very important component of UK GDP. However, given the awful reported GDP number, a strong rebound in the 3rd Q should be expected. Clearly Sterling is weakening on the news (recovering somewhat), though the FTSE shrugged off the news;

Outlook

Whilst Asian markets closed lower, European markets opened higher and continue to rise, ex the FTSE, which is flat, with Spain and Italy both around +2.0% higher (lower bond yields, following Mr Nowotny’s comments), though Spanish/Italian markets generally remains fragile to say the least. US futures have continued to rise through the day and suggest that markets will open some +0.7% higher.

The Euro is strengthening (currently US$1.2144 – Mr Nowotny again), though I don’t see any reason to close my short (against the US$), with Brent at US$103.47 and gold US$1600.

I continue to believe that China will introduce additional stimulus measures (which should help the miners, Australia, A$, for example), though I must admit they are taking their time. I’m a bit more cautious however, as previous good news (unexpected cuts in interest rates, better home sales volumes with rising property prices), has been treated with a yawn by markets.

Difficult to see much positive action in the EZ (other than from the ECB potentially, especially if markets tank) ahead of September, which is a major concern. However, the ECB does not believe that the situation is critical enough for it to intervene !!!, especially as they believe (rightly) that the necessary solutions are political/policy issues (and not their responsibility), which EZ governments are failing to address. However, Germany sees its hands tied (given domestic public opinion, Constitutional Court decision, etc) until September, at the earliest. This creates a policy vacuum over the next 7+ weeks which is particularly dangerous, given the crisis in the EZ.

US GDP looks as if it will disappoint – analysts have been reducing forecasts. In addition, Apples earnings/revenues/margins miss yesterday is a negative, though the release of a new I phone ahead of Christmas should help materially. Cat’s results were good though and their statement positive – will help today. However, forward looking statements generally have been particularly defensive/negative. The other positive is that US residential property shows signs of having bottomed and, indeed, is improving which could turn out to be a major positive for the US.

The lack of policy action, especially by the EZ, continues to worry me, in particular.

The FED is likely to introduce additional monetary easing measures, quite possibly as early as August, but most suggest in September – the WSJ suggests that the FED could provide banks with cheap financing to on lend to businesses, introduce further QE, announce a change in public communications (they could say that they do not expect to raise rates beyond the currently stated end 2014 – to mid/late 2015?), reduce deposit rates paid to banks, (though this will negatively impact money market funds, as is the case in the EZ) and narrow (lower) its benchmark interest rate (currently zero to 0.25%) even further. Mr Geither is to testify today – going to be grilled re Libor.

Cant see any major reason to buy the markets at present and don’t believe that the today’s rally has legs, though am reluctant to short at these levels. The currency/bond markets look more interesting. German 10 years are higher, at 1.26% at present (up over 10 bps points since yesterdays Moody’s downgrade of Germany), though their 30 year bond auction today went well. I remain of the view that yields at these levels are crazy (particularly in the medium/long term), unless you believe that the EZ (other than a Grexit) will break up, which is certaionly not my view.

Volatility should continue.

Kiron Sarkar

25th July 2012

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