Prepare for a period of value outperformance when stocks rally

- "Cheap valuations and washed out sentiment suggest a favourable risk-reward for European equities, as long as the global economy is not double-dipping. Our Combined Market Timing Indicator (CMTI) recently reached a buy signal of -0.5 for the first time since April 09. Following a CMTI reading of below -0.5, MSCI Europe has been up on average 9.2% over the subsequent 6 months, with equities up 85% of the time. At the same time sentiment is cautious with the AAII survey reaching its lowest level since March 2009 and 9 consecutive weeks of outflows from mutual funds. MSCI Europe trades on 10.3x 12 month forward earnings compared to a historical average of 14x since 1987. Given the structural headwinds to growth in this cycle 14x PE seems too high to us, however a return to historic averages of 11-12x in the 1970s-1980s would still suggest a further 10-20% upside from today’s levels."
- "Growth and quality factors have trounced value factors since September. From the March 09 lows through to September 09, cheap stocks outperformed expensive stocks by over 30%. In September we noted that the market was not providing sufficient reward to growth and quality factors. Our reliable growth basket traded at record low valuations to the market (see ‘Reliable Growth has never been cheaper’, 14th September 2009) and valuation dispersion became extremely narrow – all of which suggested a need to focus more on growth and quality in addition to valuation. However, since September there has been a significant style rotation away from value and towards growth strategies. High growth stocks have outperformed low growth stocks by over 8% since September, while value stocks have underperformed by 12%. 27 of the top 40 stock picking strategies since September have been related to either growth or quality. This style rotation has become even more pronounced since the market peaked in April as the market has become even more focussed on concerns over global growth."
- "Reliable growth stocks should be long-term winners, but given strong outperformance we would prefer the cheaper end of the reliable growth universe in the next 3-6M. Our reliable growth basket has outperformed steadily over the last nine months and no longer trades at a discount to the market. Structurally these stocks should be long-term outperformers against a backdrop of anaemic GDP in the West. However, given we believe stocks are more likely to go up than down by year end, we would look to rotate toward the cheaper constituents (see ‘Updating our thoughts on reliable growth’, 5th July 2010 for more details)."
- "We would also rotate back into some value screens given the potential for a strong rally in the next 6M. MSCI Europe Growth now trades at an above average premium to MSCI Europe Value. The outperformance of the MSCI Europe Growth index vs the equivalent Value index over the last nine months is high by historic standards – in fact the only occasion where such outperformance was significantly higher than now was 1999/2000. Valuation dispersion has also widened by 1 standard deviation in the last few months. We believe that as and when equities move higher, the market’s focus on quality and defensive growth will become less binary. As such we feel that it is an appropriate moment to screen for stocks that are either oversold or offer exceptional value."
Morgan Stanley European Strategy 20100712

Risks to the global economy leave investors cautious

- "In the past month, financial markets have been hit with a bad case of the jitters on worries that the global economy will not be able to withstand the implementation of fiscal austerity measures in Europe and slowing growth in some emerging economies. Central bankers too have assumed a more cautious tone with both the U.S. Federal Reserve Board and the Bank of Canada pointing to risks to the outlook coming from developments abroad. While we have not changed our baseline forecasts for U.S. and Canadian growth or inflation, recent events suggest that downside risks to the growth outlook have risen leading us to revise the timing and magnitude of tightening in some countries."
RBC Financial Markets Monthly July2010

Beware of the 'Great Correlation'

- "Throughout the crisis, there has been an increasing level of market correlation, in particular in times of panic. This tail dependency can be found on the level of different asset classes (stocks vs. credits vs. rates vs. exchange rates) but also on the level of individual assets. The central message can summarized in the following way: If everything is going down the drain, really everything is going down the drain. In this publication we focus on the elevated correlation in current markets and its potential implications. Moreover, we describe a simple model that allows to quantify the "average" correlation within a portfolio."
Macro Outlook: "A double-dip recession scenario is not our core view, but the latest
battery of early indicators revealed an astonishing congruency in the slowdown of the headline readings across economies."
Micro Fundamentals: "As the global growth momentum has peaked, we are likely to
observe higher variability in sector earnings and greater dispersion in sector spreads in the near future."
Debt-Equity-Linkage: "Given a significant rise in risk aversion, the level of correlation
among equities also jumped to new highs. The "average" correlation of single stocks within the EuroStoxx 50 index increased above post-Lehman levels recently."
Credit Quality Trend: "The subdued growth outlook brings about great uncertainty
regarding future default rates, due to the correlation between default and economic cycles."
Market Technicals: "While fundamentals are key in the long run, new bond supply and liquidity are a major driving force for credit markets in the short to medium term."
Valuation & Timing: "On a tactical time horizon, the next big topic is the 2Q10 earnings release season, which will keep investors busy over the next few weeks. While for nonfinancials, earnings will probably be in line with OK-ish expectations, earnings data for European financials will meet more scrutiny from investors."
Other Credit Markets: "Credit Derivatives: The relationship between credit spreads and the exchange rate has an impact on the pricing of credit risk in different currencies.
Securitization: in the wake of the sovereign debt crisis, ABS issuance has become scarce again due to high spread volatility. EEMEA Credits: Uncertainty about the outcome of the euro zone debt crisis led to a re-coupling of EEMEA corporates with global credits."
Allocation: "We reduce our sector recommendation for Basic Resources to MW from OW. With this step, we continue with our de-risking strategy that we announced last month: we missed an opportunity to reduce exposure to this more cyclical sector, however, we were reluctant to act in the middle of a panic. All other recommendations were kept unchanged."
Model Portfolio: "Our financials portfolio underperformed the benchmark by -64bp, while the non-financials portfolio outperformed by 11bp due to the recovery in cyclicals."
Unicredit Euro Credit Pilot July2010

Will central banks be able to use Taylor Rules again?

- "When the economic situation is normal, central banks use interest rate rules similar to Taylor Rules (the central bank’s intervention rate depends on inflation and the capacity utilisation rate). However, when the economy is depressed and inflation is low, Taylor Rules can no longer be used since they would lead to negative nominal short-term interest rates. Central banks then have to implement unconventional policies: purchases of bonds in order to drive down long-term interest rates, Quantitative Easing (monetary base target), changeover to an exchange rate target, an objective of liquidity in financial markets — all these policies have been used since 2008."
- "We wonder whether economic conditions will enable, in the future, renewed utilisation
of Taylor Rules, or whether central banks will have to continue using unconventional
policies. If we forecast key intervention rates of central banks by drawing on econometrically
estimated Taylor Rules, we find that only the United States should currently maintain
unconventional policies (until mid-2011)."
- "The euro zone and the United Kingdom ought to renew with conventional policies in 2010. However, this approach does not take into account further developments of the crisis (banking risk, sovereign debt crisis) which would force central banks to continue conducting unconventional policies even though the Taylor Rule would lead to a positive interest rate."
Natixis Flash Economics 352 20100706

Market Slip Worse Than the Dip

- Risk aversion migrates to overstated double-dip concerns — "sovereign sensitivity has diminished, but the ongoing downward revision to growth expectations is weighing on markets. The negative momentum probably isn’t over, but the full double-dip being discounted by an increasing part of the market isn’t reflected in the forward-looking data."
- Expect mixed messages in 2Q earnings — "strong activity data in 2Q should sustain momentum in non-financial earnings growth, but outlook statements are likely to reflect weaker economic sentiment. Bank earnings will be dented by difficult market conditions, which may cause some negative surprises, but on the whole we believe the downside is priced in."
- European banks – "stressed to impress? The stress tests will probably find individual weaknesses, but systemic solidity. With parameters likely to generate a manageable result, we think the ‘feel-good factor’ in the market will prove relatively short-lived."
- Maintaining a long bias in credit — "the resilience of credit spreads over the last
month suggests positioning is now much more balanced. Against attractive valuations and our impression that cash holdings have been built up, we continue to believe that credit spreads can perform – or at least hold their ground – despite the challenging backdrop."
- Keeping beta, but staying short peripherals — "we have made few changes to the portfolio this month. So we maintain beta exposure in banks and global cyclicals, but we stay short credit linked to periphery sovereigns."
Citigroup Credit Outlook 20100712

Sheer Lunacy staring at the Heavens

- "This paper presents a study of correlations between the moon phases and behaviour of financial markets, and suggests a medium-to-long term trading strategy, which can significantly increase profits. It also takes a quick look at planetary alignments and what could be significant in terms of timing for the coming weeks (really bad for stocks)."
- "For many years, people have been monitoring relations between natural phenomena and industrial performances or markets behaviour in order to be able to estimate future performance and adapt to changes to either maximise the profits or minimise losses. In many cultures, it is well accepted that moon phases could influence peoples’ behaviour, (90 countries in the world today use the Lunar calendar as the basis for time measurement), whereas scientists established its relation to rising and low tides. New moon traditionally symbolise the period of low energy, or energy accumulation period, whereas the time of full moon is the period of high energy or spending period. The question arises of whether this observation could be extended to markets behaviour."
RBS Equity Special 20100707

Asia: votes of confidence

- "After a brief pause in June, Asia’s central banks are tightening again"
- "In the past two weeks, Taiwan, India, Malaysia and Korea have all hiked interest rates"
- "This is bread-and-butter economics. GDP in Asia is far above precrisis levels; inflation is nearly back to average. Interest rates must return to normal too, and they are"
- "The rate hikes are a loud vote of confidence from Asia’s central banks that growth will continue, despite weakness in Europe (and more generally, the G3)"
- "The world has not decoupled. The G3 matters, but Asia matters more"
DBS Economics 20100709

What will happen if growth in the euro zone remains persistently weak?

- Possibly, because of short-term reasons (increase in savings, slowdown in wages, rapid reduction of fiscal deficits) as well as long-term ones (low level of productivity gains, population ageing) growth in the euro zone will remain durably far weaker than in the rest of the world.
- One would then have:
• persistently lower interest rates and return on equity in the euro zone, as well as smaller capital outflows, and a depreciation of the euro;
• accelerated de-industrialisation in the euro zone, because companies will focus on markets enjoying more rapid growth, low levels of investment, and this will lead to self-perpetuating weak growth and hamper deleveraging;
• increasingly pronounced internationalisation of European companies;
• Central European countries pursuing a different strategy from economic and financial integration with Western Europe.
Natixis Flash Economics 351 20100706

Russia: to build confidence

- "Of all the BRIC countries, Russia suffered most in the global recession and it seems to be seeing the slowest recovery. GDP fell by 7.9% in 2009, compared with a fall of 0.2% for Brazil and growth of 6.7% in India and 8.7% in China. In the first quarter of 2010, Russia’s GDP grew by 3% year-on-year, compared with charts of 9% in Brazil, 8.6% in India and 11.9% in China. Comparing Russia with other major oil producers in the Middle East and Africa leads to a similar conclusion."
- "This article seeks to identify the reason of this poor performance, particularly during the recovery phase. Recovery in domestic demand and a return to more ‘normal’ internal liquidity conditions both seem to be lagging relative to the improvement in the oil market and the recovery of the global economy. The crisis of confidence, with a lasting effect on consumers and businesses, appears to be playing a key role in this underperformance."
- "The first two sections of this article describe the trend in the real economy since 2008 and the effects of the financial crisis. The third section looks at the effects and limits of the fiscal stimulus policy, whilst the fourth examines monetary policy."


Is something really scary coming in October? - FT Alphaville
The banking ‘miracle’ debunked - FT Alphaville
New thinking on executive compensation: Pay CEOs with debt - VoxEU
Commercial Real Estate Deleveraging Update July 2010 - Financial News Express
The accidental CMBS recovery - Fortune
Should You Be Worried About Inflation? What About Deflation? - CBS Money Watch
The capital tsunami is a bigger threat than the nuclear option - China Financial Markets
G20’s “Violent Agreement” on Austerity Will Smash Global Economy - New Deal 2.0
Nobody understands the liquidity trap (wonkish) - Paul Krugman
Can infrastructure-led growth save the economy? - Salon
Rising imports offset U.S. sales abroad - Washington Post

The road to normalisation?

- "Risk appetite has stabilised and EGB peripheries have performed. The front end of Europe remains under pressure as Euro money market conditions continue to normalise. While confidence remains fragile, we have taken the first steps towards near-term stabilisation."
Barclays Global Rates Weekly 20100709

Japan: Impact of Upper House election, Part 1

- Major defeat for DPJ — "The ruling coalition must be reshuffled for the DPJ to retain control of the Diet. The DPJ, People's New Party, and independents affiliated with the ruling coalition now have 110 seats after Sunday's Upper House election, short of the 122 seats required for a majority. The Kan cabinet's approval rating has fallen sharply in the month since Kan became PM."
- Focus turns to September 20 DPJ leadership election — "When the ruling party
has lost an Upper House election in the past, the PM has resigned immediately or soon after. Sosuke Uno and Ryutaro Hashimoto resigned immediately, and Tomoiichi Murayama and Shinzo Abe resigned within a year."
- Consumption tax hike looks unlikely — "If political leadership weakens, it will be
difficult to implement large-scale tax reform. Hiking the consumption tax requires strong leadership, so it is unlikely to happen for now. We do not expect an increase until 2014 at the earliest."
- Major corporate tax cut also unlikely — "The DPJ had hoped to fund this by scaling back special taxation measures. Those affected are strongly opposed to the ¥5.9trn (net) reduction in tax cuts (the naphtha exemption alone is worth ¥3.6trn). However, a small-scale reduction seems possible."
- Deregulation, selling off government assets — "Regardless of what shape the next administration takes, given the enormous size of Japan's budget deficit we think it needs to 1) ease tourism and real estate regulations and 2) sell off government assets. Selling government assets and deregulating real estate would be positive for the real estate, transportation, construction, internet, and service sectors."
- Political realignment and share prices — "If the DPJ sacrifices the postal reform bill and ties up with Your Party (a strong advocate of small government), we think it would actually be good for stocks. We highlight Sumitomo Realty & Development, JR Central, Rakuten, Yahoo, ANA, and Oriental Land as stocks that could benefit."
Citigroup Corporate Securities Strategy 20100713

The most worrying trend in the United States and the euro zone: The decline in the weight of industry

- "Many analyses focuses on the public finance situation, the unemployment level and the real estate market situation. But in our opinion, in the United States and the euro zone, the most significant and worrying trend is the decline in the weight of industry in the economy."
- "Now, this implies:
• a fall in average job skills and wages;
• a slowdown in productivity gains and long-term growth, hence, in addition, greater difficulty in reducing public and private debt ratios;
• greater balance of trade problems and greater dependence on emerging markets."
Natixis Flash Economics 350 20100706

What happens if investors refuse to invest in asset markets in which liquidity can disappear and where there is excessive price volatility?

- "The financial crisis has definitely discouraged investors from allocating large portions of their portfolios to:
• financial asset markets in which liquidity can disappear;
• asset markets where equilibrium prices show excessive volatility."
- "Many investors have liquidity requirements and fair value accounting ("mark to market") penalises assets for which price volatility is excessive. The problem is that most financial assets come under these two categories: equities, credit, emerging-market assets, commodities, ABS, even covered bonds, public debts of small countries, and bank debt."
- "The only liquid assets left, with fairly stable prices, are US, French and German government debt, hence the relatively high price of these assets."
Natixis Flash Economics 349 20100706

Happy birthday, global expansion

- "As manufacturing comes off the boil demand and labor indicators become the keys"
- "The European growth bounce has arrived but is likely to be short-lived"
- "Next week’s China releases likely to signal downshift toward 8% growth"
- "Headline inflation is dropping fast; will temper EM policy normalization"
JPMorgan Global Data Watch 20100709