Much pain, little gain for Q3

By David Andrews | October 3, 2011 | Last updated on October 3, 2011
5 min read

Following last week’s substantial market selloff, investors were on the hunt for some good news heading into the final week of what has been a remarkably miserable quarter. Lacking any significant catalyst, investment markets continue to take their cues from the ebb and flow of the macro headlines and the flurry of economic data releases.

Investor optimism initially rose on news that the eurozone officials were working on new measures to help deal with the debt crisis and the German ratification of the recently amended European Financial Stability Fund (EFSF). As it stands, 12 of the 17 euro-zone nations have now ratified the enhanced EFSF with more set to vote on it in the weeks ahead.

Most of the economic data this week was viewed as mixed serving only to add to investor confusion and higher volatility. Weekly U.S. jobless claims dipped below the key 400,000 level but it was mostly due to seasonal adjustments rather than a change in trend. Home prices in America continued to decline and consumer spending has now slowed since American incomes fell for the first time in almost two years in August.

The scarcity of jobs is clearly preventing the U.S. economy from gaining ground. The major U.S. stock indexes sizzled and then fizzled this week, managing to hold on to only modest gains at the close. 10-year U.S. government bond yields remained below 2% as a reminder of persistent uncertainty.

September’s decline in the German business climate indicator was modest relative to other surveys, but it did suggest that the euro-zone’s economic locomotive will stall before too long. Perhaps most concerning to equity investors was news that China’s manufacturing shrank again for a third consecutive month with new orders and export demand both declining. China has long been viewed as the global safety net given its ability to buy up both euro-zone debt and U.S. treasuries but with bear markets in copper and the Shanghai composite, investor sentiment towards China has deteriorated in the past two weeks.

Fears of a hard landing have since intensified. Canadian investors need to pay attention to developments in China given the strong correlation between the S&P/TSX and Chinese economy.

The Canadian dollar lost value this week dipping to a one-year low against the U.S. dollar as uncertainty about the global economy weighed on our currency.

The trading week ahead

We are still a couple of weeks away from third quarter earnings season so the macro and financial problems facing the market will still likely be the main drivers behind equity, commodity and currency price performance in the week ahead.

In Canada, the key release this week is September’s employment report. Following weaker than expected job figures in July and August, expectations are for an increase of about 12,500. The unemployment rate in Canada will most likely remain unchanged at 7.3%.

In his final meeting as European Central Bank (ECB) President, Jean-Claude Trichet will likely strike a more downbeat tone as he suggests interest rate cuts for Europe are not far off. Expectations are for cuts in December and March, but given the faltering economy, they might easily come sooner. The ECB might increase its support for commercial banks by offering more long-term funding. However, hopes that the ECB might fund a radically enlarged EFSF to bail out indebted economies are likely to be dashed.

In the U.S., the two monthly ISM activity surveys should show little change in September relative to August, hovering in positive territory just above the break-even 50 level. In his testimony this Tuesday, U.S. Fed Chairman Ben Bernanke will try to sell the benefits of ‘Operation Twist’ to Congress. He will probably also reaffirm that the Fed will take more action if necessary. Payrolls on Friday are expected to be just over 50,000 with no change in the unemployment rate at 9.1%.

Question of the week

It seemed Europe was getting closer to resolving their debt crisis issues this week?

Three developments this week suggested policymakers were inching closer to resolving the euro-zone crisis. First, the German parliament ratified the changes to the European Financial Stability Facility (EFSF) agreed on by the euro-zone heads of state in July.

These changes are due to bring the fund up to €440 billon. The fact that Chancellor Merkel was able to garner enough votes from within her own coalition rather than rely on support from opposition parties was viewed as a major positive. Second, the International Monetary Fund (IMF) put forward a plan to leverage up the EFSF to around €2 trillion. That would be enough to cover Greece, Portugal, Ireland, Spain and Italy’s financing needs until December 2014 and also leave a substantial sum to recapitalize Europe’s banks.

Third, the IMF was also suggesting Greece be able to write off far more of its debt than had so far been proposed. While this is bad news for the bond holders, it may allow the Greek government some hope of addressing its problems.

Here’s the problem. Germany’s politicians also hold a veto on any further changes to the EFSF. Merkel’ s coalition would not likely hold together if asked to pass further enhancements. Leveraging up the fund comes with risks and it assumes someone will lend to the EFSF with bonds of highly indebted nations as the only collateral. Assuming there is a willing lender (the ECB has been opposed to funding government deficits in the past) you can expect the cost of financing the additional leverage to be extremely high.

Lastly, many of those inside the euro-zone have balked at allowing Greece to walk away from a higher portion of its obligations. Progress towards a resolution remains painfully slow and tension is growing both within and between euro-zone governments. This week’s main event will be Thursday’s ECB’s policy meeting where the bank is likely to hint at interest rate cuts in the near future. It is likely to rebuff suggestions that the central bank finance a radically expanded EFSF.

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