International Trading

The stream of macro data during the past few weeks, specially the later one, is leading global markets to price that the US growth in 2H10 will turn out to be worse than initially expected. On this point, the probability of an abrupt halt, albeit still low, is also increasing. Some demand components, mainly residential and non-residential investment and employment, are evolving below our expectations thereby suggesting an alarming weakness which preludes even darker clouds on the horizon. Nonetheless, downside surprises are so far not quite large enough to already consider such a picture. Next week’s private payroll will be a relevant test to gauge the feasibility of a gloomier scenario. The release of the FOMC minutes will also be a key event, together with the ISM surveys for August, as recent info reveals a deep split within the Committee that will meet again on September 21st. If economic data follows current trends, we can not discard this meeting to be a decisive venue in terms of whether keeping policy unchanged or taking further easing actions.

In Europe, on the contrary, 3Q data is still consistent with a robust growth, although the recovery is losing some steam, in line with our projections for 2H10. Germany also continues outperforming the remainder of the Eurozone after the release of soft data for August this week. Nonetheless, we also expect German activity to slow in coming quarters as the global recovery falters.

Markets

The primary credit market, one of the keys to September
Following the low levels of activity seen in recent weeks, companies’ capacity to issue on the primary market will be a key driver to follow. At present, Banesto’s 600 million euro issue of covered bonds is not enough to be considered a catalyst.

M&A and dividend yields support the equity market
In our view, the increase in M&A activity seen in recent days (BHP/Potash, GDF Suez/International Power, Dell-HP/3Par, Intel/McAfee) is a reflection of various factors: 1) Companies are continuing to accumulate Free Cash Flow after having defended margins well during the crisis, and are not planning major investments since there is still excess capacity in many sectors. In fact, according to FED figures for June, in the US the cash accumulated totalled USD1,840bn, the highest amount as a percentage of assets since 1960; 2) it is possible to find attractive valuations if our scenario is not of a marked deterioration in earnings, as proved by the fact that the P/E 12m fw of the S&P 500 is 11.7x, that of the EuroStoxx 50 9.3x and that of the Ibex 35 9.4x; 3) Access to new markets, if possible emerging economies, with better growth prospects.

In our view, unless the cyclical situation deteriorates significantly, M&A activity will continue, and together with dividend yields (S&P 500 2.1%, EuroStoxx 50 4.29% and Ibex 35 5.5%) may support equity markets.

The cyclical deterioration is driving down sovereign yields in Germany and the US, with the market discriminating between non-core countries.
Short-term sovereign yields remain at lows (0.58% 2Y German and 0.52% 2Y US), and long-term yields have dropped even further, hitting new lows (2.14% 10Y German and 2.53% 10Y US). This performance has led to continued flattening of the curves: the 2/10Y curve is close to 156bps while the US curve stands at approx. 200bps.

These very low levels reached by German rates have contributed to the widening of core-non-core spreads in Europe, which increased by around 7bps in Spain (184bps), around 30bps in Ireland and Portugal, and more than 60bps in Greece (in the latter three countries spreads have returned to May highs). The market is therefore differentiating between two groups of non-core countries: i) Spain and Italy; ii) Portugal Greece and Ireland. In the first group the widening of spreads has occurred above all as a result of the safe-haven effect of German debt, while in the second there has been a rise in yields, especially following the downgrade of Ireland’s rating.

Highlights

ECB: What to expect in the next Thursday’s meeting?
The most important decisions in the September ECB council meeting will be those related to the ECB liquidity provision policy, in particular, whether to extend the 3-month full allotment LTRO which are scheduled to finish with the auction of September 29th. Recent declarations of Mr. Weber, a hawk ECB member, suggest that the provision of liquidity will be maintained in actual terms at least until 1Q11. While optimism reigned in the last ECB council meeting and it is true that the excess liquidity is reducing in the eurozone, the eonia is steadily normalizing (although at a very slow pace) and the size of the Sovereign Bond Purchase Program is almost unchanged since July 7th, the situation is far from being completely normal (as the last days’ increasing tensions remind us). The concentration of liquidity on some of the most affected EMU countries (Spain, Ireland, Portugal) is rising and many uncertainties still remain, specially regarding the degree of openness of debt markets from September onwards. As a consequence, we expect –in line with Weber’s comments- the maintenance of ECB liquidity provision policy in actual terms at least until 1Q11, and a more cautious tone than in August meeting.

Ireland, a new risk episode?
This week S&P cut the sovereign credit rating for Ireland by one notch to AA, mainly driven by the deterioration of the public finances derived from government support to the financial system, raising fears of a new episode of sovereign risk in the peripheral countries. We consider that there is no risk that the deficit (excluding NAMA) deviates from what the government projected: a reduction from 14.3% to 11.9% of GDP. On the banking sector side, we deem that the S&P estimate of banking sector fiscal cost represent the very worst case outcome, because: 1) Irish financial variables show a relatively robust trend, 2) the two main Irish banks passed the CEBS stress test in July and 3) public guarantees program will be renewed, but there are sources of concern such as: AIB nationalized bank which needs constant injections of capital and the reliance on ECB funding of Irish banking sector (5.6% of banking assets). In this context, the market impact was limited (Ireland sold 0.6 bn € of treasury bills this week), and among peripheral countries only Greece was affected.

Is the revival in M&A activity sustainable?
A reactivation of cross-border M&A activity is currently undergoing after several months of relative calm when companies reduced corporate movements after the crisis in order to strengthen their balance sheets. It suggests that international companies have recovered their appetite for risk as financial markets have stabilized and worries about sovereign risk have eased. However, despite the revival of activity during this summer trading volume becomes much lower than it did before the crisis, but such a setting, deals’ pickup has boosted the market in recent weeks. We consider that the M&A activity will continue in the medium term, as companies have been very conservative in previous months and most of the arrangements being made in cash (not dependent on funding), although this activity will be sensitive to U.S. economy slowdown in coming months.

Calendar: Indicators

USA: ISM Manufacturing Index (August, September 1st)
Forecast: 53.5
Consensus: 53
Previous: 55.5

Comment: Regional manufacturing surveys indicate that economic activity in August is slowing down. Therefore, ISM PMI is expected to decline but continue to be above 50 which indicate expansion in economic activity in August. We expect a 2 point decline in the index in August. Market impact: Manufacturing activity comprises about 70% of industrial production and significantly slower than expected manufacturing activity could indicate a slower than expected economic expansion in 3Q10.

USA: Non-Farm Payrolls (August, September 3rd)
Forecast: -90K
Consensus: -108K
Previous: -131K

Comment: Nonfarm payroll employment is expected to shed 90K more jobs in August. Although private sector is expected to be a net contributor to the job creation, it will likely to be short of job losses in construction and public sectors. Weak housing market data indicate that job losses in construction sector will continue. Deterioration in state and local budgets and latest higher than expected initial jobless claims data also indicate a market labor deterioration. Therefore, the market is expecting unemployment rate would rise to 9.6% after decreasing 2 consecutive months. Market impact: A larger drop in nonfarm payroll employment would point to a slow down and increase uncertainty about the pace and sustainability of the economic recovery.

Eurozone: Flash estimate HICP inflation (August, August 31st)
Forecast: 1.6% y/y
Consensus: 1.6% y/y
Previous: 1.7% y/y

Comment: In August, inflation is expected to have declined marginally; following the moderation of energy inflation due to base effects (the largest annual decline in energy prices was in July last year). The flash estimate does not provide information about core inflation, but we expect it to remain stable at around 1% y/y. We see some upside risks resulting from both the impact of tax increases and upwards pressures from food prices. Market Impact: A negative surprise could be seen as a sign of renewed risks of deflationary pressures, but a large positive surprise could raise fears of earlier than expected rate rises by the ECB, after positive growth figures in Germany.

Eurozone: Unemployment rate (July, August 31st)
Forecast: 10%
Consensus: 10%
Previous: 10%

Comment: Unemployment is expected to have remained broadly stable in July, as has been observed since early this year, supported by the rebound of economic activity. However, the trend of unemployment will be to increase slightly over the second half of the year, in line with a scenario of a weaker economic growth. Market Impact: A negative surprise would be interpreted as a sign of renewed downward pressures in economic activity, with negative effects on economic confidence.

China: Purchasing Managers’ Index (August, September 1st)
Forecast: 51.8
Consensus: 51.6
Previous: 51.2

Comment: Comment: Domestic demand is cooling on government efforts to restrain credit growth, and real estate market. In line with recent activity indicators pointing to an economic soft landing, we expect the August manufacturing activity will remain at the same pace. However, due to a seasonally effect China’s PMI will climb slightly in August. Market Impact: A weaker than expected reading, could trigger concerns of a hard landing, and renew worries about the sustainability of global growth.

Brazil: GDP growth (2Q10, September 3)
Forecast: 0.4%
Consensus: 0.7%
Previous: 2.7%

Comment: GDP will show a sharp moderation of the economic activity in the 2Q10 in comparison to 1Q10. Market Impact: Limited impact on Central Bank’s SELIC decisions as monetary meeting will be hold 2 days before the release of the GDP (both the market and us expect SELIC to be left unchanged). Exchange rate and future interest rate markets could be impacted in case GDP surprises significantly in any direction.

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