- Despite a month of macro disappointments, especially from the US, the earnings story remains upbeat, with momentum edging up on a three-month basis. The valuation landscape also remains supportive, reminding us that equity markets are clearly not priced for perfection (see Focus below).
- The Eurogroup decided to postpone confirmation of further financial support for Greece until early/mid-July. It issued a statement saying that the new package would include “informal and voluntary” arrangements with creditors to produce a “substantial reduction” in the amount of new financing required.
- The minutes of Reserve Bank of Australia’s June MPC meeting shows that the tightening bias remains in place. However, the urgency to act is diminishing. Our key takeaway is that the RBA is not responding in its usual manner to its own forecasts. We retain our expectation that the RBA will tighten in Q3.
FOCUS
European equities: Up (by year-end) is the path of least resistance
Edmund Shing, Dennis Jose, Yu-Chieh Chiang
Despite a month of macro disappointments, especially from the US, the earnings story remains upbeat, with momentum edging up on a three-month basis. The valuation landscape also remains supportive, reminding us that equity markets are clearly not priced for perfection.
However, we see dark clouds looming over the macro universe. Economic momentum is showing a classic mid-cycle slowdown in both the developed and emerging worlds, with scope for further mean reversion in the short term.
Yet investor positioning, sentiment, valuation, earnings momentum and downside skew all suggest that the path of least resistance may actually be to the upside. Even when we stress test our Equity Risk Premium model, in the worst case we see a maximum decline in the market of only 10%.
Consequently, we think our structural bull case for European equities remains valid. However, on a tactical basis, the market could move sideways for a short period amid the current macro gloom, a situation with similarities to 2004-05 and May-August 2010. Potential catalysts include an end to China’s rate-hike policy, a resolution of political opposition to the Greek MTFS program and a resumption of normal macro performance.
European earnings momentum remains positive: Amid the prevailing macro uncertainty, it is easy to forget the earnings side of the equation. Twelve-month forward earnings estimates for the STOXX 600 have edged up over the past three months, reflecting the fruits of the structural improvement in productivity among European corporates. Let us not forget that real 2011 earnings for the STOXX 600 are expected by consensus to be 40% above the long-term average, something we discussed in European Equity Explorer: Peak earnings still some way off, 9 May 2011. All of this has occurred with valuations that are certainly not priced for perfection.
Mixed macro signals from the US and Europe: A slowdown in macro data is neither unusual nor surprising. Despite the notable slowdown in US job growth in May, income growth was stable as hours worked and hourly earnings remained firm. Gasoline prices have started to ease from the peaks observed in the prior months. However, given that US gasoline prices affect economic growth with a time lag, there could be further fallout from demand destruction. Our economists expect real US GDP growth to rebound in Q3 by 3% (SAAR), as one-off supply chain effects from the Japanese earthquake taper off. European economic data outcomes have not fared too well, either. For now, we believe that the slowdown is in part a normalisation of above-trend growth observable across geographies, which could very well continue through to the next quarter.
However, the potential downside on the markets seems capped (at 10% in our bear case), for several reasons:
- We assume that: a) the equity risk premium increases to hit all-time high levels (observed in March 2009); and b) the risk-free rate consequently contracts to the lowest levels observed in the past 22 years. Based on the aforementioned assumptions, we arrive at a worst-case downside scenario of 10%. Note that this assumes equity risk aversion will hit the highs observed during the financial crisis, which is clearly not the current situation. Note also that the expansion in the cost of equity (because of the fall in the markets) is partially offset by the contraction in bond yields.
- Not much protection buying in derivatives land: Derivatives markets have remained quite benign, with the VIX at 19.65 (at the time of writing) and the 90-100 skew near its lowest levels since March 2009.
- Positioning and sentiment look extreme: Investor short positioning seems overdone when we look at both the bull-bear spread and net shorts on the S&P. Finally, equity hedge funds have also been caught unaware this year and would be unlikely to oppose a consistent market uptrend.
MARKET INSIGHTS AND EVENTS
Asia Pacific
Australia: RBA minutes (June meeting) – Changing its modus operandi?
Gavin Stacey, Joaquin Vespignani
Given the surprising nature of the RBA’s June commentary, the market went into the release of today’s board minutes looking for answers. The RBA board continued to signal a lack of urgency to act on its explicit tightening bias. Two possible explanations are: the RBA has downgraded its growth and inflation forecasts; and/or the RBA acknowledged the fact that Australia is both a ‘growth and price taker’. Q2 CPI, the August SoMP forecasts and Q2 wage cost index are the key releases to watch.
Taiwan: Export orders show tentative signs of stability in May
Wai Ho Leong
May export orders rose 11.5% y/y, beating consensus expectations (+9.5%), marginally closer to our forecast (+10.3%). On a seasonally adjusted m/m basis, orders rose 1.2% m/m in May, reversing the 3.4% drop in April. On a 3m/3m trend basis, export orders showed tentative signs of stability in May, to 7% from 6.4% in April, though much lower compared to the 40% peak in January. In our view, the moderation since the early months of the year is in line with the steady softening in the May US ISM new orders index, which receded to 51 in May from 61.7 in April and the peak of 68 in February. However, the stabilisation of orders momentum is pointing to a bottom for IP momentum in May, which could in turn suggest that the moderation in activity indicators will occur gradually.
Thailand: Export momentum softened again in May
Rahul Bajoria
Exports grew 17.6% y/y in May, marginally above our (16%) and the consensus projection (15.6%). The sequential decline in exports (-2.6% m/m) remains consistent with the drag on automobile production and shipments as direct fallout of the earthquake in Japan. While we expect the THB to make modest gains in the coming months, we do not expect it to outperform other Asian currencies. We see risks of slower pace of appreciation in THB relative to our 12m forecast (29/USD).
North America
All eyes on Greece
Anshul Pradhan
On a day with little economic data of note released, Treasury yields were largely unchanged. However, there certainly was more intra-day volatility than suggested by end-of-day changes. Risk aversion also took a back seat on a lack of bad news on the vote of confidence in the Hellenic parliament. VIX declined and belly swap spreads narrowed. European equities, however, declined, as the decision to provide the fifth tranche of Greek bailout was postponed, pending the resolution of political uncertainty in Greece.
On Tuesday, market participants will focus on existing home sales. The consensus forecast for May is 4.8mn, lower than previous (April) release of 5.05mn. This week, we also expect the Fed formally to announce the completion of the asset purchase program at the FOMC meeting on June 21-22. We expect it to signal that it will maintain accommodative monetary policy to support the US economic recovery, considering the recent soft patch in economic data. We recommend being long FFH2, as the Fed will likely maintain current policy for longer than priced in, and keep our recommendation of being long the belly of the Treasury curve, 5s30s steepeners and FRA-OIS spread wideners as the European contagion risk gets priced in.
Europe
Greek update: Destiny in the hands of the Greek parliament and population
Antonio Garcia Pascual, Frank Engels, Julian Callow
Following a seven hour meeting, the Eurogroup decided to postpone confirmation of further financial support for Greece until early/mid July. In our view, the decision is reasonable, since it places Greece’s destiny back into the hands of the Greek government and the parliament. The Eurogroup issued a statement saying that the new package would include “informal and voluntary” arrangements with creditors to produce a “substantial reduction” in the amount of new financing required.
Eurogroup meeting: Update on Greece and the EU
Julian Callow, Frank Engels, Antonio Garcia Pascual
The Eurogroup decided that the ESM would not have preferred creditor status for loans to countries already in a support programme. We also preview Tuesday’s confidence vote and the Greek calendar.
Latin America
Peru: Political shock with economic costs
Alejandro Arreaza, Alejandro Grisanti, Roberto Melzi
Even if the debate about whether President-elect Ollanta Humala will have a radical or a pro-market approach to his government remains alive, the market seems to have given him the benefit of the doubt. Nonetheless, we expect there to be a cost in terms of slower growth and deterioration of fiscal accounts. Inflation, while expected to decelerate in the short term, could increase in the long term.
THE NEXT 24 HOURS
Asia Pacific
Japan index of all-industry activity: We look for an increase of 1.7% m/m in April after a 6.3% decline in March. This assumes a 2.6% m/m increase in the tertiary index, which has a 63.2% weighting in the all-industry index, together with a 1.6% m/m gain in industrial production (18.3% weighting).
North America
US existing home sales: We expect existing home sales to have declined to 4.80mn units in May from 5.05mn in April, a decline of 5.0% m/m. Pending home sales dropped 11.6% in April after rising 3.5% in March, suggesting some weakening in existing home sales. A sales decrease to 4.80mn units in May would be below the Q1 11 average of 5.14mn units and similar to the 4.75mn units in Q4 10. However, we would not view a decline in existing home sales in May as a fundamental weakening, as the housing sector was affected by the severe weather conditions across many parts of the country in April.
Europe
UK public finances: We forecast government borrowing to have increased in May. We estimate that PSNB excluding financial interventions to have increased by ?16.5bn and borrowing, including financial intervention, to have increased by ?14.9bn.
UK CBI industrial output: We expect a small drop in the CBI industrial trends balance to -5 from -2. In the previous month, the balance improved significantly; although we expect it to ease slightly in June, the balance remains consistent with broadly buoyant conditions (the long-run average is -20) as improving demand and new orders should support the output.
EEMEA
South Africa current account: We expect current account deficit figures to show a modest widening in Q1 of -2.4% of GDP, owing largely to a smaller trade surplus and marginally higher transfer, services and income payments in Q1.
South Africa consumer confidence: We expect consumer confidence in Q2 to track modestly lower owing to rising domestic inflation dynamics, consumers’ growing awareness that a hiking cycle is looming, and a still struggling labour market environment.
Latin America
Brazil IPCA-15 inflation: Headline inflation is slowing owing to softer food and fuel prices, which together count for 80% of the inflation deceleration. However, this slowdown should not be generalized, in our view; the average of the three core inflation measures tracked by the BCB should continue to indicate strong underlying inflation, with readings of 0.45- 0.50% m/m.
BARCLAYS CAPITAL
RESEARCH | GLOBAL MACRO DAILY