Research Dept. News
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Monthly Report, num 357 - May 2012
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Financial markets - Monetary and capital markets
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Turmoil once again, with Spain at the epicentre
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Investor confidence suffers from the emergence of new obstacles.
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During the month of April, some of the pillars that had started to support an incipient but promising improvement in the economic-financial scenario have wobbled. Firstly, the macroeconomic figures for China and the United States ran out of steam, the two big drivers of the world economy. Secondly, there was another rash of nerves regarding the debt crisis in the periphery of the euro area, particularly in Spain. These factors merely served to undermine the already fragile confidence of investors, who shifted back towards a search for safe investment options instead of yield. Logically, this change in behaviour has led to a loss in value of high risk assets, hitting Spanish equity particularly hard. Judging by their fundamental condition, the aforementioned pillars should be resistant, although they may continue to suffer in the short term. The negative surprises provided by figures for the United States and China look like no more than outward signs of the ups and downs due to the turning point that both countries are going through (revival in the first, a soft landing in the second). Tensions regarding Spain will be eased if the local authorities persevere with the reforms and with rationalizing public accounts, at the same time as progress is made in the redesign and political reinforcement of monetary union at the level of the euro area. The next few months will be crucial, given the upcoming elections in France and Greece, together with the implementation in Spain of the measures approved, announced and other additional measures. Should these fronts progress satisfactorily, this would undoubtedly help riskier assets to recover more firmly.
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Central banks are starting to think that greater stimuli are needed
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Investors turn their attention towards the actions of the central banks.
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The slump in the global economic and financial scenario in the last few weeks has bolstered investor expectations regarding a possible increase in monetary stimuli by the central banks in the United States and the euro area. The authorities have not made any official announcement along these lines but there does seem to be some internal debate on this issue.
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The Fed believes the US economy still has some weaknesses.
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In the United States, the Federal Reserve (Fed) seems to be facing the dilemma of whether to approve a third round of quantitative easing. Signs of some improvement have been seen in the US economy since last autumn, albeit fragile and irregular. The conditions under which families, firms and financial institutions operate have evolved favourably but there is still a long way to go before we can talk of a scenario of sustainable growth. The top people at the Fed have identified several obstacles stopping the rate of growth from being more vigorous. In the case of households, the high degree of indebtedness and the delicate situation of the labour market are hindering decisions to spend. For firms, the uncertainty perceived in the environment is slowing up investment. And for financial institutions, regulatory changes are making it difficult for them to operate. Given this circumstance, in his latest appearances the Fed Chairman, Ben Bernanke, has insisted on the need to prioritize economic growth and to bring down unemployment. To this end, the Fed has repeated its aim to keep to adaptable policies. At the moment, the basic elements of the Fed's monetary policy are to place interest rates within the lowest possible range of 0%-0.25% and to maintain the size of the huge bond portfolio it has acquired over the last few years, at the same time as extending medium-term maturity.
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The Fed's policy continues to be based on low interest rates and the use of quantitative measures.
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In the area of interest rates, all the evidence points to the Fed repeating its commitment to prolong the current low level until the end of 2014. The options are open concerning the second instrument. Given the end of the twist operation in June and the insistence on the part of leading Fed members that they would be prepared to reinforce monetary strategy to boost economic growth, many economists and investors are expecting the announcement of additional quantitative measures before the year ends. The content of these measures is still unknown, however, and hardly any clues have been given.
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The ECB might buy up debt from peripheral countries if tensions worsen.
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For its part, the ECB is also facing an impasse. Within the context of the sovereign debt crisis of the countries on the periphery of the euro area, the monetary authority has used several instruments in order to alleviate the harmful effects on the real economy and to get the region's credit markets back to normal. Firstly, the authority lowered the official interest rate to 1%. Secondly, the ECB has carried out various injections of liquidity at different maturities, the most important being the last two LTROs at three years (carried out in December 2011 and February this year). And thirdly, the central bank decided to buy up public bonds in the secondary debt markets given the increased turmoil in the peripheral countries. According to the appraisal of the ECB's governing body, the overall effect of all these instruments is relatively favourable but it is in no way a panacea for all the region's problems. In fact, the intensification of sovereign crisis tensions during the second half of the month has been a further obstacle to the authority's efforts. On this occasion, Spain has been in the epicentre, with the fear of the country falling into an «adjustment-recession» spiral. This was reflected in Europe's credit markets via a rise in public financing costs, not only for Spain but also for Italy and, to a lesser extent, France. Given the deterioration in investor confidence, Benoît Coeuré, a member of the ECB Executive Committee, declared the appropriateness of slowing up the decline in the Spanish debt market. Specifically, he suggested that the institution still has several powerful resources available, particularly the public bond acquisition programme. Although other ECB members have disassociated themselves from this measure, we cannot rule out another phase of direct ECB intervention if the debt markets don't stabilize soon. Similarly, this raises the possibility of reinforcing operations to inject liquidity via banks, although right now this does not seem to be the bottleneck, after the two three-year operations mentioned previously. Lastly, in the area of official interest rates, there is little leeway so no news is expected in this respect.
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The authorities of the emerging countries continue to relax their monetary policy.
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With regard to the emerging countries, the actions of their central banks are still decisively aimed at relaxing financial conditions. Most of these countries have focused their efforts on avoiding any abrupt deterioration in their growth rates. To this end they have employed successive cuts in the official interest rates and quantitative measures that improve the financing conditions for firms and individuals. In April, the actions that caught the attention of the financial markets were carried out by Brazil, China and India. Brazil cut its interest rate to 9%. In China the central bank announced that it will increase open market operations and reduce reserve requirements for banks, all to release liquidity and ensure its economy has a soft landing. For its part India, hoping to boost growth, lowered its official rate from 8.5% to 8.0%.
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Interbank interest rates enter a phase of stabilization.
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With regard to interbank interest rates in the euro area and the United States, April has been characterized by the continuation of a slow fall in the Euribor rates and the stabilization of Libor dollar rates. With regard to the latter, it can be noted that the ECB's two LTROs have calmed this market considerably, leading to a fall in counterparty risk. However, Europe's monetary market is still showing clear signs of dysfunction. This aspect has been highlighted in the high volume of overnight deposits banks are still carrying out with the ECB.
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The European crisis sets the pace of public debt
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Highly solvent sovereign bonds become a safe haven again in April.
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Whereas, in March, the international financial situation brought about an incipient preference by investors for higher risk assets, in April the sovereign bonds of the United States and Germany regained their safe haven status. As the calming effect of the ECB's liquidity injections on the euro area's financial conditions at least partially wore off, doubts re-emerged regarding the capacity of some countries to meet their budget targets imposed by Brussels. Specifically, this nervousness centred on Spain, with Italy in second place. This led investors to once again prefer the certain yields, albeit smaller, achieved by buying US and German bonds. The key attraction of these bonds is both countries' great solvency, their relatively solid economic outlook and an environment of very lax monetary policies. In the United States, the IRR (internal return rate or yield) of ten-year bonds fell in the last few weeks of the month, returning to below 2%. In addition to the rise in credit tensions in the euro area, this movement was also caused by the perception among many analysts that the messages given out by the Fed's representatives suppose an acceptance that new monetary stimuli will be implemented in the coming months.
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German debt benefits from the problems of peripheral Europe.
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In the euro area, the yield on German ten-year debt decreased due to the re-emergence of doubts related to the sovereign debt crisis, falling to around 1.70%. Although it's true that the delicate budget and debt situation currently being experienced by some countries in the area is grabbing investors' attention, this was not the only reason why European markets became more nervous. The poor activity figures for Europe's real economy also helped to increase tensions, as well as uncertainty regarding the coming elections in France and Greece. The outcome of these events will be highly significant in terms of the political negotiations that will decide the future of the Economic and Monetary Union. Focusing on peripheral Europe, the last few weeks of the month were characterized by a sharp rise in the spreads of these countries' debt compared with German bonds, with Spain being particularly of note. The ups and downs of the fiscal budget target for this year (finally established at 5.3% of GDP) and the presentation of Spain's annual Budget increased financial tension due to fears that our economy might enter a spiral of spending cuts and economic recession. This helped to push up the yield on Spanish ten-year bonds to 6%. In addition, the deterioration in Spain's debt also resulted in a rise in the risk premium of Italy and France. However, the ECB and some governments of the euro area have appealed for calm from investors, pointing out that, based on an analysis of fundamentals, the attacks suffered by these economies are unwarranted. Given the results of the recent issuances in the primary market of public bonds from Spain, Italy and France, it seems that the pressures in the debt markets have become contained, although tension is still very high.
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China gives the yuan more freedom
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China widens the yuan trading band to rebalance its economic model.
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As has become customary over the last few quarters, the euro-dollar exchange rate is still dominated by notable volatility, caused by different economic and financial events in both economies. However, the simultaneous support provided by the respective central banks (Federal Reserve and ECB) to boost growth and reduce the risks in financial markets is giving rise to a phase in which the fluctuations in the exchange rate for these two currencies are more limited. This tends to reinforce the view that, in the medium term, the exchange rate will continue to fluctuate around its current levels.
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On the other hand, the People's Bank of China announced that it will widen the daily yuan trading band against the dollar from 0.5% to 1%. As many observers had already expected, this movement represents an attempt by the authorities to redirect the country's development model. In the financial area, it hopes to encourage presence on the international scene. In economic terms, to stimulate the contribution by domestic demand.
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Trade is still brisk in the primary corporate bond market
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High yield US bonds have very low interest rates.
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The first quarter of the year ended satisfactorily for the credit markets. Investors' incipient appetite for risk, the narrowing of corporate spreads and the flood of issuances dominated the pulse of corporate bonds in this period. Although a large part of these aspects remained in April, the worsening climate in peripheral Europe was a further obstacle for the companies in these countries to securing financing. However, and far from reducing the number of bonds being issued, the good tone of the last few months continues to dominate the primary markets. Aspects such as high levels of oversubscription, the good performance by bonds in the secondary markets and the reduction in the premiums demanded by investors are ample proof of this. Regarding issuances, of note is the rise in the number of investment grade bonds being issued by central countries in the euro area. In second place, albeit quite far behind, were bonds issued by the region's banks. The funding facilities recently obtained from the ECB and the possibility to be able to discount so-called covered bonds in the central bank have focused banks' activity on these. On the other hand, companies from the peripheral countries (Spain and Italy) practically stopped issuing bonds, in contrast to their activity in February and March.
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For its part, the economic and financial environment in the United States, which is more stable than in Europe, continues to provide a particularly favourable scenario for the development of corporate debt markets. As has been noted over the last few months, one of the main factors favouring the good performance by these markets is a large flow of capital towards corporate bonds, with particular preference for high risk and low quality (high yield) bonds. From a technical point of view, this rise in demand would not only be due to the increase in net flows of final investors but also to coupon payments and the surplus of liquidity in the hands of many mutual funds.
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Lastly, in the emerging countries, the data highlight the fact that the corporate bond market is going through an excellent period. In addition to good economic prospects and favourable credit ratings, in these markets investors have the chance to secure high yields, attractive gains and shorter investment periods than in the West. However, in the particular case of China, there are fears that the greater flexibility of the renmimbi exchange rate and the consequent greater exchange volatility might temporarily slow up the number of new bonds being issued.
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Spain's stock market is in the firing line
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International stock markets fall, of note being the drop in the Spanish index.
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From the point of view of equity, April was a month marked by losses. Although most stock market indices have been accumulating considerable gains since the start of the year, the slump in growth and activity figures in economies such as China and North America and the worsening of regional tensions in the euro area hit investment sentiment badly. But it is, unfortunately, the Spanish stock market that has seen the biggest falls. In addition to the already mentioned fear of the capacity of our economy, there were two other factors that increased nervousness and pushed investors towards lower risk assets. The first was the Spanish authorities' approval of the plan to sort out the financial sector, requiring credit institutions to increase their provisions and capital regarding assets related to real estate activity. The second was Argentina's expropriation of the subsidiary, YPF, owned by the Spanish petrol company Repsol. Both events contributed significantly to the falls in the Ibex 35. Another aspect that highlights the delicate situation at the moment is the fact that, from the point of view of company valuation, more than half the companies that make up Spain's main index are quoted below their book value.
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The consensus of analysts predicts an improvement in corporate earnings by the end of the year.
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Taking a more international perspective, April saw the start of the campaign of corporate earnings announcements for the first quarter for listed companies on both sides of the Atlantic. The consensus of analysts believe that US company profits will moderate but remain relatively firm, noting the positive news from the financial, industrial and technological sectors. On the other hand, the outlook for European firms is less favourable. The harmful effect of the sovereign debt crisis on the real economy and banks' great exposure to the sovereign debt of member states comprise the main burden on corporate earnings in the euro area. However, most analysts believe that this trend should improve in what remains of the year.
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