Month: October 2011

Of the US economy

The US economy in the third quarter of 2011 grew at a 2.5% annual rate according to the first estimates released yesterday. Thus earlier fears of a recession have proved much exaggerated. Inventories rose at a slower rate in the quarter, enough to reduce the estimated growth rate by 1.1%. This must be regarded as good news – investment in inventories grew more slowly because final demand was unexpectedly high, implying that output and orders to come will be augmented by planned restocking. Final demands were hugely boosted by a 17.4% surge in spending on equipment and soft ware and spending on non-residential structures that were up by a 13.3% per annum rate in the quarter. US companies are drawing on their piles of cash to add capacity and competitiveness but remain reluctant to add to their numbers of employees.

Of banks everywhere

Banks in Europe were required to write off €100bn of Greek government debt. The banks, against their own wishes, have also been required to boost their impaired capital to 9% of the assets on their balance sheets. Where this capital is to be sourced is not fully known but the much augmented European Stability Facility may well be called upon in addition to shareholders. The upshot of the weekend action taken by European governments (still lacking in detail) was an enthusiastic response recorded in the markets, and in particular in the market for bank shares (and not only in Europe). By the close in New York the Bank of America share price was up 9.6%, Citibank had gained 9.7% and JPMorgan was up 8.3%.

The losses that banks have had to take on their books has been more than made up for in gains in market value. Which again indicates an important point, that raising equity capital (and diluting existing shareholders) can add to the market value of a banking (or any other) share when it serves to reduce meaningful bankruptcy risks. Private shareholders in banks, when called upon to subscribe additional capital in due course, might bear this win-win prospect in mind.

The Eurostoxx Index of Banking Stocks that had fallen by more than 50% between March and September is now about 16% up from these lows. Of the leading French banks, BNP gained 16.93% on the day, SocGen was up 22.5% and Barclays in London gained 17.6%, while our own Investec shares in London were up a more modest 6.4%.

The prospect of being hanged is said to concentrate the mind. Clearly the European leaders were concentrated very hard over the weekend to find a clear way out of the European debt and banking crisis. Also on hand were the leaders of the IMF and ECB. Full details of the plan to revive the credit of European governments and the banks threatened by the possibility of default will be released on Wednesday. But so far so good as far as the equity and bond markets are concerned. Investors understandably have great difficulty in valuing assets given a small probability of a catastrophic event (particularly when nothing like it has ever occurred), such as the failure of the euro experiment and all the financial commitments and contracts associated with the Euro. The markets before and after a fateful weekend in Brussels appear to have reduced the likelihood of catastrophe.

As we show below, some of the upward pressure on the yields of Spanish and Italian bonds has been relieved. When the market is convinced that 6% in euros from the Italian government is a good deal the crisis will be over and the Italians and Spanish governments can then come up with credible long term plans to further reduce their costs of finance.

The equity markets are well off their recent lows, with the S&P 500 leading the pack and up 10.6% off its recent low of 3 October. The JSE in US dollars (despite a weaker rand), has gained 7.8% since 3 October and the MSCI EM is up 8.8% from its low of 4 October.

The very much revised plans (from July 2011) to avoid disaster appear to have a few essential elements. Firstly a much larger write down of Greek debt (from a 30% write down to something more than 50%) appears to be in the wings. The banks suffering these losses therefore will need significant infusions of fresh capital. Clearly European governments – especially governments with fiscal strength – will be an important source for additional capital. However shareholders and sovereign wealth funds will also be called upon; though to what degree and will have to be revealed.

The market in all other vulnerable European government debt will be encouraged by the utilisation of the European Stability Fund. How best to leverage this fund of €440bn has been the subject of particularly intense debate between the French and the Germans. The French have been calling for what in broad terms would amount to unconstrained support (by European taxpayers in one way or another including interventions by the ECB) for all euro denominated European government debt. The Germans, while emotionally strongly committed to the symbolism of the euro have been reluctant to sign a blank cheque.

According to the Online addition of the Wall Street Journal this morning (24 October 2011):

Options for the fund, the European Financial Stability Facility, were narrowed to two after a meeting of euro-zone finance ministers Friday. One is an insurance plan that foresees the fund’s setting aside a pool of money that could be used to offset part of any losses suffered by purchasers of the debt of weak countries, such as Italy. That could entice buyers and keep Italy financed.

The other would be to create a special, separate fund. That fund would raise money from private investors and others, like sovereign-wealth funds, to buy debt of weak countries. The EFSF would also participate in the fund—but would suffer the first losses. Officials said the two options could be combined.

Meanwhile, in other parts of the world …

The markets woke up today on their good side following a strong close in New York. However not all the good news may have emanated from Brussels. It seems very clear now that the US economy grew satisfactorily in the third quarter with the initial growth estimate, to be released, expected to be at about a 3% rate. The US third quarter earnings updates are by now well in hand and the results appear highly satisfactory, with earnings per share estimates for calendar 2011 in the process of being revised upwards again to above $100 per share. According to the FT, reported third quarter earnings from US companies have been ‘remarkably upbeat’. The FT, quoting S&P Capital expects a “blended average of actual and forecast earnings for the S&P 500 to rise 14.6 per cent for the quarter from a year ago…That figure is up from 12.4 per cent a week ago but below the mid July estimate of 16.94 per cent..”

The outlook for the Chinese economy also appeared to have improved over the weekend with official statements indicating no need for additional stimulus or any change in the policy tack. Should the market decide that a solution for the European debt and banking crisis has been found (even as the outlook for minimal European growth remains largely unchanged) the focus of market concerns will revert to the outlook for Chinese and Emerging market growth, helped or hindered (as the case may be) by the outlook for US growth. Brian Kantor

The equity markets have reacted favourably to the G20 meeting over the weekend that promised a comprehensive solution to the European debt and banking crises. Stabilise the debt markets, recapitalise the banks and finally deal with Greece: these are all necessary to calm the markets and are now fully recognised in the highest European circles.

The equity markets over the past two weeks have recovered some of the ground lost in late August, so much so that (including dividend income), the S&P 500 is now about flat for the year. The emerging equity markets, including the JSE when valued in US dollars, continue to lag well behind the S&P 500.

When it strikes, risk aversion appears to infect emerging markets regardless of the sources of the dangers to the global economy that emanate from the developed world. Nonetheless, if the tolerance for risk improves further, the value implicit in emerging market companies and government bonds will attract renewed attention.

The US dollar value of the rand continued to follow the direction of the emerging market (EM) Index and the JSE (which are so closely connected). As we show below, the rand/US dollar exchange rate, while it continues to track the EM Index on a day to day basis may be regarded as somewhat undervalued relative to the EM Index. Fair value for the rand/US dollar (given the level of the EM Index on Friday 14 October) would have been close to R7.50 rather than the R7.80 at which the rand traded. Where the S&P 500 goes the EM Index, the JSE and the rand will follow if the recent past is anything of a guide to the future.

One of the features of the equity markets in recent months has been the extreme daily movements in the indices. It has been reported by the Wall Street Journal that the S&P 500 moved by more than 1% on 56 of the past 57 trading days.

As risks rise and fall, as reflected in daily price moves and the price of options, share prices move consistently in the opposite directions. Volatility is good for the bears but not the bulls in the market: we show below the strong negative relationship between daily percentage moves in the JSE All Share Index and daily moves in the SAVI (the volatility Index priced into options on the JSE). The correlation is -0.710 for the period since 1 July.

The SAVI and the VIX (the volatility Index for the S&P 500) show a similar pattern. The recent decline in the VIX and the SAVI to below 30 must be regarded as encouraging for equity investors. If this declining trend persists (consequent on any gathering belief that the Europeans will sort out their problems) the share markets will move higher. It is not risks that determine returns or returns that determine risk. It is degrees of uncertainty about the future that simultaneously drives risks and returns in the opposite direction as may be clearly seen in the markets on a daily basis.