Weekly Pulse: European triple play

Admittedly, it’s a bit of stretch to make the connection between baseball’s World Series (Go Cards Go!) and the European debt crisis. However, Europe’s politicians turned the proverbial ‘triple play’ as they announced their plan to solve the sovereign debt crisis.

First, the lenders who are now stuck holding Greek bonds have “volunteered” to take a 50% haircut on their holdings. Volunteering is the key because it prevents the billions of credit default swaps from being triggered and stabilizes the risks involved in a default. Sadly, it only allows Greece to reach a 120% debt to GDP level by 2020, hardly what one would call fiscal health.

Second, the Euro zone banks will have to increase their Tier 1 capital ratios to 9% by 2012. The banks can raise the required capital either privately, through their national governments, or from the European Financial Stability Fund (EFSF). Lastly, the EFSF will be leveraged up to €1 trillion; an amount sufficient to cover Italy and Spain’s financing needs over the next three years. Risk markets cheered Europe’s efforts in a relief or short covering rally this week, but it is hoped the plan will turn into a longer term homerun rather than a strike-out.

In addition to the widely positive reaction to Europe’s plan, investors also rejoiced in what is becoming another favorable earnings season. Blue chip American companies like Caterpillar, Boeing, and Chevron all blew away earnings expectations showing they can perform well under adverse economic conditions. Canadian firms also began to report their results with Barrick, Imperial Oil, and Canadian National Railway beating expectations.

Economic data out of the United States and China also reassured investors that the economic outlook was slowly turning for the better. Americans dug a little deeper in their pockets which helped Q3 GDP grow at the fastest pace in a year. Chinese manufacturing also looks like it expanded for the first time in four months which gave a nice lift to commodities and the cyclical stocks tied to them.

Copper experienced its biggest weekly gain since 1988. The Canadian dollar hit its highest level in a month (US$1.0109) despite the fact the Bank of Canada left interest rates unchanged and cut its official growth outlook for our economy in 2012.

The trading week ahead

Markets are expected to try to focus on the economic and earnings data in the coming week, but as usual, Europe will continue to feed uncertainty since many open questions remain regarding the implementation of Euro zone debt plan.

Speculation and rumours will persist and the capital markets remain exposed to the threat of further headline news. In order to sustain the positive market sentiment, Europe must deal with the outstanding issues related to the structural reforms and implement the entire plan quickly. Speed has not been European policymakers’ forte and with further credit rating downgrades looming possible backlash from the bankers taking the ‘voluntary’ haircut.

The G20 meetings in France begin next week and may provide the opportunity for the G7, the IMF, and the increasingly powerful emerging economies to endorse the European plan.

Reporting season in the U.S. actually begins to slow with only 206 firms reporting their third quarter results. Canadian reporting season kicks into higher gear with some key Energy, Financial, and Industrial companies due to report. While defensive industries in Canada will be more likely to meet analyst earnings expectations, concern will likely hang over the resource companies due to the decline in most commodity prices during the difficult summer months.

Results so far this quarter seem to be exposing a wider gap between those firms that are able to maximize corporate efficiency and those that cannot. As Warren Buffett would say, “Only when the tide goes out do you discover who’s been swimming naked”.

On the economic front the North American focus will be on Friday’s employment reports. Canadians will see if the Bank of Canada’s dovish view on our economy is reflected in our October employment data. September saw the biggest surge in hiring in eight months mostly due to back to school hiring. Also, August GDP is released but the data is already priced into the markets.

Our central bank is of the belief there is no need to remove stimulus anytime soon as the global economy will undergo a brief soft patch before picking up in the second half of next year. Have you wondered how commodities will do in November? Much depend on the movement of the U.S dollar. November has been good for some commodities and bad for others. Since 1986, the most consistent commodity in November is corn, seeing gains 62.5% of the time. Corn is closely followed by gold, which has seen gains 60% of the time. The worst commodities have been silver and natural gas, seeing losses 48% and 50% of the time respectively.

Question of the week

Can American consumers keep the U.S. economy from slipping into a Japan-style economic malaise?

The Q2 GDP report was a little better than expected and a big reason why was the better than expected personal consumption expenditures.

Consumers cut into their savings to boost their purchases but was the spending really that strong? When we take a step back and look at the bigger picture we can see just how weak the consumer remains. The biggest drop in incomes in two years, along with declines in home prices and consumer confidence also casts doubt on whether the increased spending can be sustained.

The Q3 real personal consumption expenditures (“RPCE”) came in at 2.2% year over year. Since 2008 RPCE has averaged only 0.8% but since 1950 it has averaged 3.4%. Bottom line, we are still in a secular weak period for the U.S. consumer as the de-leveraging process continues. It’s a muddle through scenario, but thankfully, it’s not a collapsing growth scenario.

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