Debt agreements boost European bonds

By David Andrews | July 3, 2012 | Last updated on July 3, 2012
5 min read

The European Council Summit at the end of June surpassed the low expectations of investors.

With Cyprus the 5th country to officially ask for financial aid, the pressure was intense. Markets were pleasantly surprised that EU leaders agreed to address the flaws in their bailout programs, move closer toward a banking union, ease repayment rules for Spanish banks and relax aid conditions for Italy.

The immediate reaction was the biggest rally in Spanish bonds and the euro currency for the year. But while the Summit announcements are a good first step, how long will this relief last?

Follow through will be key. The ball is now in the European Central Bank’s camp as investors look for them to cut rates at their July 5th meeting and hopefully become more active buyers of Spanish and Italian debt.

Read: Look to corporates as Europe heals

For now, Spanish bond yields are dropping, oil and gold are surging, and global stocks are finally moving higher to bring to end what has been a very difficult quarter for risk assets.

With all eyes on Europe, North American economic data didn’t get much hype last week, but there was a more positive tone. U.S. durable goods orders in May were above market expectations for its first gain in three months. Pending Home Sales for May jumped 5.9% sequentially versus 1.5% consensus and Case-Shiller Home Price data was down, but less than expected.

The second quarter was especially unkind to Research in Motion. RIM reported a quarterly loss five times bigger than was expected and once again, delayed its Blackberry 10 product launch.

Shares have fallen 45% since March and the Canadian tech company risks slipping further into obsolescence.

Oil surged at the end of the week from its lowest level in nine months but the move only trimmed oil’s biggest quarterly declined since the post-Lehman, fourth quarter of 2008.

Read: Oil isn’t going anywhere: Tal

Gold rose the most in a month but has still dropped 4.5% since the end of March. Gold is heading for its worst quarterly drop in almost four years. The Canadian dollar extended its weekly advance following news the Canadian economy grew more than expected in April. GDP growth is tracking 2% on a year over year basis.

Read: Could gold fall to $700?

Click through to read about the trading week ahead.

TRADING WEEK AHEAD

Statutory holidays punctuate the first week of July, but the short trading week kicks off a new month, a new quarter, and the second half of 2012.

The short week will be long on important economic data and events, with the release of the forward-looking ISM Purchasing Managers (PMI) data as well as the June employment reports for both the U.S. and Canada.

HSBC’s June Manufacturing PMI for China will be important to commodities investors and the European Central Bank (ECB) meeting on Thursday will be heavily scrutinized to see if the central bank follows up on the announcements from the EU Summit.

Read: Commodity investing no longer straight up

For the U.S., the ISM manufacturing index is expected to test last summer’s low point (51.4). Regional surveys were mixed and a slowing in the ISM would be consistent with the disappointing PMIs from other global economies and trading partners.

The ISM Non-Manufacturing index should be little changed in June. A reading of 52.8 is consistent with the recent downshift in activity, and a smidge below the long-run average of 53.7.

Job growth should be better in June, but that doesn’t mean it will look very good. Consensus expectation for nonfarm payrolls is a rise of 90,000 in June and private payrolls to be up 97,000.

These results would be in line with the average of the prior three months, which showed a significant downshift in job creation compared to the 250,000 average around the start of the year. Three specific industries should play the biggest swing factors. Last month’s outsized decline in construction jobs and weakness in the leisure/hospitality area should bounce back in June.

QUESTION OF THE WEEK

Italian Prime Minister Mario Monti suggested earlier this month that the European Central Bank (ECB) or the European Union’s bailout funds (the ESM and the EFSF) should purchase sovereign bonds of the Eurozone states that are being punished by the market, but which are showing good fiscal behavior. Could the Monti Plan work?

Monti’s proposal does little to resolve the main problems facing Eurozone countries under attack. The biggest problem in the periphery economies is anemic growth. Without economic growth, the fiscal arithmetic of the plan simply does not work.

Read: Italy spends billions to boost economy

Growth has to be resolved by getting the euro closer towards parity with the U.S. dollar and by driving down the peripheral countries’ yields, which lowers the cost of capital in these economies.

A second problem is the solvency of the insolvent. The government debt to GDP is estimated at 106% in Spain and 140% in both Ireland and Portugal.

If Spanish yields fell to 5% after the Monti Plan was unleashed, the Spaniards would still need to implement fiscal tightening of almost 8% of GDP to stabilize the government debt to GDP situation.

This much fiscal tightening seems unachievable, especially given that it would happen against the backdrop of aggressive private sector deleveraging, bank deleveraging, and falling wages. The ESM and the EFSF are the two emergency bailout funds.

Read: Cyprus downgraded, asks for bailout

The problem is the ESM is not yet in place despite the plan to have it up and running by July 1. Only four countries have signed on and the German constitutional court may block it.

The EFSF is up and running, but it has only about €190bn in lending capacity left. The combined ESM/EFSF has a maximum lending volume of €500 billion which may not offer enough firepower to make a sustainable difference in lending costs for the periphery economies.

The ECB has already spent €210 billion to prop up sovereign bonds yet yields have still run up. Any successful resolution to the crisis will have to see the balance sheet of the ECB expand since the ECB is the only agent with unlimited firepower.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP

David Andrews