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Eurozone peripheral markets remained relatively volatile throughout the week, as the movement both Italian and Spanish government bond yields were sufficient to get the EUR's attention and could well explain the recent strengthening of the EUR. There has been little in the way of actual progress in the peripheral countries to account for the improvement and the market seems to prefer to relate this strengthening to the broader pattern of consolidation that followed the dramatic improvement that occurred from late July through earlier in October. That said, markets have noted comments by Spanish PM Rajoy, who said that while he has not ruled out seeking an international aid package, there is no urgent need to do so given progress on deficit reduction and the fact that nearly all of this year's financing needs have been completed.
Meanwhile, focus on Greece continues to intensify as the coalition’s majority becomes increasingly precarious ahead of the 7 November parliamentary vote on labour reforms, but the market has already priced-in the eventuality of less-than-positive headlines. Furthermore, the Bundesbank board member Dombret said that Greece was “way behind” in its reform tasks.
Less good news was seen in Eurozone economic data, where aggregate Euro-zone unemployment rose to another new cycle high of 11.6% higher than expected and following an upwardly revised 11.5% reading in August. In addition, October Eurozone CPI fell to 2.5% year-on-year, from 2.6% in September. While that is still above the ECB's preferred target of near 2%, the inflation backdrop in Europe is not viewed as an impediment to further ECB easing. Meanwhile, September German retail sales surprised on the upside, rising 1.5% month-on-month, but the improvement in that volatile series will not likely sway broader indicators which continue to show a marked slowdown in the Eurozone's anchor economy.
It remains the case that economic data has tended to be less of a factor for the EUR and developed-economy FX markets generally in a world where risk-on/risk-off and central bank policy continues to take centre stage. Nonetheless, the economic backdrop and potential ECB policy speculation will likely be a more prominent feature in the market in the approach to next week’s November 8 ECB council meeting, where markets may anticipate a further reduction in the ECB policy rate.
Hurricane Sandy, month-end dynamics, the lack of progress with regards to Greece and Spain and the upcoming US elections have meant that the markets have traded below average volumes over the last week in a largely sideways pattern. At this point, it is difficult to pinpoint the damage and loss of business due to Hurricane Sandy for the insurers as well as on US growth dynamics, as estimates range from $5bn to $15bn for the insurers, while the impact on the US economy will take months to assess. Without a doubt, the impact will be substantial and Sandy is likely to go down as one of the costliest natural disasters in US history. An estimated 6.2mn homes were without power on 31 October, more than 16,500 flights had been cancelled and regional and local train services were at a standstill with salt water and downed trees a hurdle to resuming service. The infrastructure damage in the region is significant and will take years to repair. On the other hand, the rebuilding efforts could also serve to be economically stimulative in nature over the medium-term and could increase growth prospects. The combination of the elections, the fiscal cliff and the positive and negative impact of Hurricane Sandy is likely to create a great deal of volatility in the incoming data and hence uncertainty in the markets.
Heading into the weekend, much focus will be on the final debates between Obama and Romney. With only days to go, it appears that the outcome of this year’s presidential election is still very much up in the air. Historical precedents suggest that one-term incumbent Presidents such as Mr Obama normally have a strong advantage going into the election. However, national polls of voter preference put the race at a virtual tie between the incumbent Democratic President and his Republican opponent, Mitt Romney, with most of polls within the so-called margin of error. Market are expected to trade sideways over the coming days till the results are announced and the market begins to factor in the implication of the results of the forthcoming presidential elections.
Italy – A shrinking economy
Italian economic fundamentals have not really improved despite some improvement in market condi-tions. The negative feedbacks from fiscal austerity on growth have been severe as the ability of the private sector to absorb fiscal tightening by lowering their saving rate is limited. Recent policy actions suggest a softer stance from the current technocratic government towards fiscal austerity. This is understandable ahead of the general elections next spring. Market perceptions on Italy’s commitment towards fiscal consolidation and reforms may start to be questioned due to either expectations of a non-definite electoral result or expectations of a newly elected political government that is less committed to austerity the much-needed reform.
Italian government bonds have been on a positive trend since the summer, with the spread over German Bunds falling steadily to below 350bps on average in October, significantly more than 100bp below the average of the June – August period. The announcement of the ECB’s Outright Monetary Transactions has clearly been the main driver behind recent market performance, as it helped in reducing the near term risks of sovereign defaults and EMU break up. More specifically, the OMT helped to reduce the liquidity risk at times of heightened market stress which affects Italy more than many other euro sovereigns due to its large amount of gross issuance.
On the data front, the economy has not fared well in the first half of 2012, with GDP falling by an average rate of 3.3% q-o-q on annualised terms. Apart from the three quarters at the peak of the global financial crisis in 2008, Italian GDP has never fallen so sharply since 1981. The economic sentiment indicator from the EU Commission is close to all-time lows and the composite PMI is consistent with GDP still falling by around 2%.
Unlike the 2008-2009 recession, the current downturn is domestically-generated rather than inherited externally. Domestic demand has been falling much faster than GDP in the first half of 2012 whilst net exports contribution to GDP growth has improved. Rather than being a positive sign of improving Italian competitiveness, this is a clearly negative sign of how bad the do-mestic situation is as the sizeable fiscal tightening measures are clearly taking their toll.
The key question for the Italian economy at this junction is whether Italy is entering the kind of vicious circle in which other peripheral countries have been stuck in the past three years. That is, large fiscal consolidation efforts leading to higher than expected declines in economic activity which in turn offset much of the benefit of fiscal consolidation on the government’s balance sheet.
On a macro level, sovereign related risk remains an ever present overhang. Spain has continued to be resistant to requesting help from the ESM, as evidenced by public comments from Prime Minister Mariano Rajoy. Credit markets remain in a fragile balance related to Spain, with significant credit being given to the support mechanisms, which have not yet been called upon. At the same time, developments in Greece are also gaining pace. German Finance Minister Schaeuble highlighted in widely reported comments that significant work remains for Greece and the “troika” in the current negotiation process.
With US markets closed earlier on this week given the hurricane on the US east coast, secondary market volumes were considerably lower than average, even in Europe. That said, despite the continuing macro volatility and continued relatively weak earnings trends, markets remained range-bound. Despite the many macro overhangs that continue to worry investors, focus has returned to corporate earnings results. In Europe, more than 200 members of the Stoxx 600 have reported earnings results, with earnings weakness remaining broad-based.
The pace of credit markets slowed into month-end, not least because US markets were closed for several of the final trading days. Despite this loss of momentum, October was another strong returns month for corporate cash in both the euro and sterling markets. This was despite a backdrop of middling Q3 results, further rating downgrades and supply volumes that continue to be supported by a fall in bank lending to corporates. Meanwhile, this week saw further negative ratings action. On Tuesday, Fitch downgraded France Telecom from A- to BBB+/Stable, reflecting continued pressure in core domestic business. More positively, further evidence of companies acting to defend their balance sheets was noted as ArcelorMittal has cut its 2013 dividend forecast by $850mn, with the aim of reducing its net-debt position following an extremely weak set of Q3 2012 earnings.
The European HY market moved higher this week despite lighter volumes early on given the lack of NY-based trading. Relatively robust numbers from the likes of Boparan, Phones4U, and even Air France boosted performance in those names, while disappointments from companies such as CETV and Norske Skog, dragged on returns. Codere bonds also underperformed on broader concerns around Argentina’s unwillingness to pay holdouts.
Bond Picks of the Week
? € 6.375% Commerzbank AG 22/03/2019 (BBB rated) @ 100.50 (Subordinated, Tier 2 Capital)
? € 6.00% Macquarie Bank Ltd 24/09/2020 (BBB rated) @ 106.00 Subordinated, Tier 2 Capital)
? €8.50% Labco SAS 15/01/2018 (B+ rated) @ 101.25 (Senior Secured)
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