In Summary

The eurozone will remain in the headlines as this week’s leaders’ summit is expected to agree the draft fiscal compact outlined last December. Enhancing the ESM would be seen as positive

The Fed took an even more dovish tone. No QE3 yet but rates expected to remain low until at least late 2014

With fourth quarter U.S. earnings season in full swing and Europe kicking off, results have not surprised to the extent of recent quarters. Guidance for 2012 remains in general cautious

Chinese growth continues to slow but remains in “soft landing” territory. Policy easing will be more “fine tuning” than 2009-style full blown stimulus



For markets, it looks as if the trend is to trade higher in the absence of further bad news emanating from Europe. This reflects where equity valuations stand, especially in sectors such as materials and financials. There is a lot of hope imbued in the second long term refinancing operation (LTRO) from the ECB due in a month’s time. The key test is whether markets will rally on once the liquidity pump has done its job, for now at least. That is where the trend in the European growth cycle will matter, as will the impetus for fiscal reform. We would not be surprised to see stock markets and corporate debt pause after this decent run-up as the first quarter nears its end.

Meanwhile, Mr Bernanke continues to expend every molecule of policy in favour of a sustained recovery. With GDP in the final quarter largely driven by a re-stocking of inventories, the challenge is still there. Last week also bore witness to what may prove to be a new era of transparency in the communication by the Fed of its policy intentions to the market. The Fed explicitly set out a 2% long run inflation target – aimed at anchoring inflation expectations – and now each committee member projects the year of the first rate hike. This central bank has in fact moved as far as it possibly could to the other end of the spectrum of what used to be “Fedspeak”: the deliberately delphic statements delivered by former chairman Greenspan.

On this occasion, the Fed used the opportunity to signal to the market that it believed that interest rates would remain at exceptionally low levels until at least late 2014. That is quite a message to send. The fact that many of the committee members forecast a hike earlier than late 2014 highlights that the dovish members are firmly in charge of interest rate policy and communication. Furthermore, it certainly shows the Fed is more concerned of the risks of low medium-term growth and high levels of unemployment than fears over rising inflation. It is not going to be swayed in its concerns by more positive shorter-term data.

Market reaction in the bond market has been to take the statement at face value: yields have declined even more. After drifting higher for the first few weeks of the year, U.S. yields dropped after the statement, with yields on the 10-year Treasury bond falling from above 2% back to 1.89%. The 5-year Treasury yield has now fallen to the lowest level in history. The shorter end of the curve did not move as much but this might be ascribed to it already approaching its lower bound of close to zero. With the Fed clear in its objective to lower long-term interest rates to stimulate economic activity, the likelihood is that Treasury bond yields in the medium to long end will remain in the recent trading range. The possibility of much higher Treasury yields is certainly lower given the activity of the Fed.

With the Fed thus committed to do nothing on interest rates for a longer time, the market will continue to pose the question of QE3. It is unlikely to occur in the near term (given the spate of stronger activity data of late) but clearly remains a policy thought for the second half of 2012. The Fed has made no secret of the fact that it views mortgagemarket healing as key to the US economy’s recovery. Should it occur, QE3 could be more focused toward the housing market through additional purchases of mortgage-backed securities. Chairman Bernanke and other committee members continue to express concerns over the housing market and the necessity of an improvement in order to sustain a recovery.

With economic data in the U.S. perking up, Wall Street is dominated by incoming fourth quarter earnings reports, which look in aggregate to be less than thrilling. The end of last week saw 196 of the S&P 500 stocks having reported fourth quarter earnings, according to BofA ML Research. In the worst earnings season in terms of surprises since the last of 2008, 49% of companies have beaten on EPS, 46% on sales and a meagre 32% on both. This is disappointing compared to the established average pattern, but given the de-rating of U.S. equities last year, some of this short fall does appear to have been discounted.

With around 56% of all S&P earnings now reported (as of 30th January), the bottom-up consensus for fourth quarter earnings has followed Q3’s pattern and moved up. Sitting presently at $24.25, this is equivalent to 12% earnings growth year-on-year, somewhat at odds with less favourable top-down consensus. Although the earnings revision ratio (a measure of the number of upgraded earnings estimates divided by the number of downgraded earnings estimates) has improved over the last two months, a lacklustre tone to the season thus far renders it too early to call the bottom for analyst downgrades.

The outlook for European earnings is decidedly weaker. Dow Jones Stoxx 600 earnings are expected at €159 billion, up 6% year-on-year. Flat sales expectations may be accompanied by healthier margins, forecast to be up 10% year-on-year. At a sector level, the European banking sector is forecast to see sales drop nearly 20% compared to 12 months prior, in contrast to 2% growth in the U.S. Guidance by companies has in general been cautious, unsurprising given the economic outlook for Europe. The development of earnings this year, against a difficult macro backdrop, will be eagerly watched, especially given already elevated profit margin levels.

The recent batch of data on Chinese activity in the final quarter has alleviated some of the more immediate worries over a slump. True, annualised GDP growth at 8% in the quarter was the slowest in almost 3 years. Fixed asset investment and industrial production are both slowing with real estate cooling faster than expected. There are plenty of options for the government on the fiscal side to remedy this as the deficit is expected to be held at 2% of GDP. Real retail sales running at 14% over the last 12 months still look sustainable. The general sense now is that after a weaker first half, growth should recover later in the year as recent policy easing has an effect.

Despite this comforting perspective, it would not be advisable to dismiss some of the medium term issues around the dynamics of Chinese growth. Inflation for one looks to have a structural dimension, as high wage inflation is a key factor behind the surge in private consumption. A second potential pitfall is debt. There is a raging debate concerning the size of the Chinese debt burden. Some estimates are as high as 200% of annual output. Regardless, there is certainly a view that the distribution of debt requires attention, especially that carried by the local government-backed investment vehicles and the state owned enterprise sector. The explosion in borrowing here owes much to the emergency stimulus measures undertaken in late 2008 to address the financial crisis.

Some view this as a classic debt ‘hang over’ that may tie the hands of policy makers at this stage in the cycle. Far from initiating a new lending binge, restraint may be the order of the day, suggesting a full reversal of the tightening that got underway in late 2010 is some time away. This may disappoint emerging market equity and commodity investors. Patience is still advised. It also firmly and clearly places the onus on reforms as a source of any new dynamism. This includes support for small and medium sized private enterprises, financial deregulation and greater competition. What worked in the last 10 years in the drive for success may not be the appropriate prescription going forward.

source: Merrill Lynch Wealth Management CIO Weekly