Market Comment 3 July 2012

Markets sprang back to life reporting healthy gains after the European Summit last week. The S&P 500 in the US gained 2.0% on the week, the EuroStoxx 50 index gained 3.6% and the EUR gained 0.8% versus the USD. Russia climbed 5.0% as the price of oil rose 7.5%. Clearly, the market was pleased with the outcome of the European Summit, will the positive dynamic last?

The European equity market has bounced 12.5% from its recent lows and is now close to both its 100 and 200-day moving averages. A clean break higher would certainly indicate increased confidence that political processes have overwhelmed the systemic issues. However, from the current level we may need more help to break through. The market has already rallied quickly and will likely shift its attention back to the macro data, where the picture is more cloudy.

This week we see several key data points. The US employment numbers and manufacturing numbers are of considerable importance gauging that country’s ability to sustain growth without resorting to further stimulus. A raft of European data is expected to reflect austerity pressures. And, most important, the ECB and BoE will hold rate-setting meetings. Consensus seems to expect that the ECB will cut rates and the BoE will increase its government bond purchases. Neither decision will markedly impact the economic situation in the near-term, but either will stimulate further optimism on the part of investors.

The market remains risky as the economics are still difficult, and policy execution risks remain very high. But, the European Union continues to move slowly in the right direction, with continuous steps toward fiscal union. Such steps support optimistic claims that the European situation better reflects the circumstance that led to the formation of the United States of America than the events that led to the dissolution of the Soviet Union. At its own outset, the USA attracted concerns of inconsistencies and unsustainable dynamics. But, the sheer force of political will kept the project alive long enough to achieve sufficient integration to overcome the multiple crises that have occurred since.

In the last two years, Europe has repeatedly failed to overcome doubts about levels of commitment. But, at the same time it has been slowly adjusting and advancing toward a more sustainable solution. Now we are getting closer to seeing what that solution looks like, what are the market implications?

Despite their recent bounce, European equities are at depressed levels. Cyclical stocks will remain exposed to economic stress, and are best bought on corrections. Dividend stocks should continue to pay well, with lower downside risk, and the euro ought to resume its decline if the ECB goes ahead with the rate cut that many now expect.

Russia too stands to benefit, as market stress eases. The Russian equity market has shown an excessively high correlation with Europe. As such, it is severely discounted, even whilst the more flexible FX policy means that ruble earnings are stable. Over the summer, investors should understand that the Russian economy has weathered the recent crisis quantitatively better than previous events. Its discount to global markets should begin to close. Buying Russian funds and blue chips looks increasingly wise.

Best regards,

James