Wednesday, September 12, 2012

>Draghi’s announcement of Open Market Transactions (OMT) to support sovereign short-end bond markets

Key Takeaway
Following Draghi’s announcement of Open Market Transactions (OMT) to support sovereign short-end bond markets, global equity stock prices and volumes roared. The jump in share turnover after weeks of moribund activity signalled that investor conviction over a euro break-up and peripheral contagion has receded. However, the ECB did not cut rates and GDP forecasts
both for 2012 and 2013 were lowered.

Longer term, it is supply side reforms that both Draghi and equity investors will need to see, in the short-term, the ECB has bought the most precious commodity of all, time. We are reinstating our Long EuroStoxx short German bund trade. We continue to believe that the Scandinavian and Swiss markets will outperform the EU region as their central banks loosen rates faster to counteract the slowdown in economic growth. Investors appear to have missed
that Sweden cut rates again last week while Denmark flirts with negative nominal rates (see Scandinavia: Embracing unorthodox monetary policy, 3 September, 2012).

“It is easier to rob by setting up a bank than by holding up a bank clerk”, Bertolt Brecht
The disappointing US August nonfarm payrolls data (96,000) puts the spot light back on
the Fed’s meeting this week with the likelihood of extended rate guidance and possibly a
MBS QE program. We continue to recommend a long position in the S&P homebuilders
and building materials (see US: For the price of one HK carpark you can buy 5 US homes,
6 August, 2012). The weakness in Asian economic data has been reflected in Korean and
Taiwanese industrial production for some time but the evidence of an unwanted inventory
build-up seems to have been overlooked by investors. The week-end’s release of August
Chinese industrial production (8.9% y-y) and inflation data points (CPI 2% y-y, PPI -3.5% yy)
to further softness in GDP data and trade data for the rest of Asia. There is plenty of room
for Asian central banks to cut rates and of course for the BoJ to follow suit.

For the first time in many months, it was a bad week for bonds. It was a good week for stocks and more importantly for equity volumes. Draghi essentially took away the tail risks of an imminent currency crisis with the backing of all but one dissenting EU central bank. Although the EU sovereign crisis is far from over, Draghi has bought time for the EU to undertake the supply side reforms to manage the fiscal crisis. While he did not commit to yield or spread targets, the markets appear to have missed that once again he reduced collateral rules and made further comments towards inflation targets. While the EU crisis has manifested itself as a fiscal problem, the reality is that there has been underlying balance of payments crisis. Ultimately, Europe like the US and the UK is going to have to run negative real interests for some time. Financial repression will be good for real returns of stocks versus government bonds, difficult for financials but extremely good for the lowest cost operators in each sector (see The long run, the short run and the in-between, 3rd Quarter 2012 outlook). Much like the transfer payments made between the core rich Europe to the periphery via TARGET 2, financial repression ultimately means changes in competitiveness between countries. Aside from changes in the exchange rate, higher inflation rates will ultimately erode competiveness if companies cannot make productivity gains quickly enough.

To read report in detail: INDIA STRATEGY