U.S. earnings and margins are peaking, China may surprise by devaluing its currency, and the fate of France depends on its banks; welcome to the third quarter of 2012.
Both before and after the financial crisis of 2007/08 investment performance was highly correlated amongst sectors. Now, in an attempt to aid global economies, it is the economic catalysts themselves that are correlating: notably the expansion of central bank balance sheets and the convergence of major developed economies’ interest rates towards zero. For example, recently, a few soothing words from ECB President Draghi were sufficient to calm markets, with more quantitative easing (QE) and other unconventional measures almost certainly on the way in several major economies. However, the difference between the current situation and both: a) the March 2009 expansion by the Fed of its November 2008 MBS-buying program; and b) QE2 in November 2010, is that those two previous episodes enjoyed a tailwind from improving leading indicators. The positive impact on risk assets and negative impact on volatility was assured by a combination of liquidity expansion and already-improving leading indicators. If the Fed is to deliver QE3 soon (not a slam-dunk), it is unlikely to enjoy a similarly happy coincidence since corporate earnings and margins seem to have peaked. With the current US earnings season more than half completed, over 70% of S&P500 companies that have reported earnings have beaten consensus expectations (despite only 41% reporting sales above expectations). However, these earnings “surprises” have to be seen in the context of heavy downward revisions by analysts ahead of the earnings season. The more crucial points are that annual earnings are down 1.5% and margins are contracting slightly.
On the other side of the world, Chinese authorities may turn to devaluation in an effort to prevent a worsening of their current economic downturn. This would indicate that the weakness on the Mainland has been much greater than official headline numbers suggest. Given the current weakness in China and the prospect that the rate cuts will not have been enough to lend strength to the flagging equity market, it is small wonder that funds are leaving the country. In fact, whether it is the markets or the authorities that are driving the exchange rate, renminbi depreciation is a very strong indication that the promised economic soft landing is not at all going as planned. The real reforms that are needed are exactly those that would expose the serious state of the Chinese economy.
Meanwhile, as the euro crisis continues, markets have found it difficult to make up their minds on France’s prospects. Does France have more in common with Germany or the troubled Mediterranean nations? France’s desire to have less austerity and more financial backing on the table seems like the right kind of solution to the euro-crisis but is stymied by its own inability to cough up enough resources to help. Equity markets have looked favorably on France (at least as favorably as Germany) since the crisis began; the correlation between the French and German equity markets has stayed tight. The bond markets, however, behaved quite differently throughout 2011 as France’s close links with Greece and concerns over the security of its credit rating came to the fore, but the relationship between French and German bond yields has been strengthening in 2012.
At the end of the day, the fate of the French equity market lies squarely with its banks. French banks’ Achilles’ heel has been their reliance on wholesale dollar funding (the five largest French banks rely on the US dollar markets for 20% of their total debt funding) and substantial exposure to Greece. To a certain extent, the Greek debt restructuring defused investor concerns over French Banks’ exposure to Greece’s sovereign debt, with holdings written down by 75-80% (although, ultimately, these will probably need to be written down by 100%). French banks still have subsidiaries operating in Greece with about 10bn euros of exposure. They also have large exposures to other troubled EA countries, including 30bn euro of Italian sovereigns. Thus, French banks remain vulnerable to further losses and contagion in the event of a Greek euro exit.
We expect economies in July and August to be buffeted by talk of further monetary easing as well as investor curiosity regarding what will happen to markets as European leaders take their August holidays.
Michael Ashley Schulman, CFA