Market Implications of Growth Deceleration

- "Concern about a slowdown in global economic growth in the second half of 2010 has been one of the distinguishing features of the recent weakness in global markets. These concerns have been sparked by a softer patch of macro data, most notably from the US, but also a moderation in survey data across the world."
- "A 2010H2 slowdown is embedded in our economic forecasts, but it is important to be clear: in several parts of the world, such as China, and indeed globally, economic growth in the first half was running at above-trend levels, so a degree of slowing is both likely and desirable. We estimate that on a qoq annualised basis global growth will slow from an average of about 4.8% in the first half of 2010 to about 3.8% in the second half."
- "Even if one were confident about the better growth prospects ahead, this deceleration in growth momentum is likely to involve a fairly choppy period in asset markets. We find that currently both equity returns and bond yields are tracking at the lower end of the historical distribution of outcomes from previous instances of growth deceleration (that do not end in recessions)."
- "Given the scars from the acute financial and housing crash that preceded this recovery, and that policy is likely to be much more constrained if growth slows much further, it is possible to explain such a performance. And, although we find that a wide range of outcomes are consistent with the kind of growth deceleration that we have in our forecast, this poor starting point suggests that—absent a serious valuation overhang—a move to worse economic outcomes would normally be required for markets to deteriorate significantly."
GoldmanSachs Global Economics Weekly 20100714

European bank stress tests: A preview

- "We view the upcoming release of the European banks stress test results as a potentially important inflection point for the market. The experience in the US last year suggests that properly executed stress tests can greatly improve confidence in the stability of the financial system. In Europe, they may ease concerns by ensuring that the sovereign crisis and a likely slowdown in euro area growth will not result in widespread bank failures."
- "We have a bias to be long risk as the results of the stress tests are released. First, the capital needs we estimate are not insurmountable, particularly given the programs already in place to address them: FROB in Spain, the SoFFin in Germany, and the Financial Stability Fund in Greece. In each case, the total needs are within the potential scope of the programs. Even if some programs have difficulty funding, it is possible that the European Financial Stability Facility (EFSF) would provide a backstop, given the relatively small size of the needs. Second, although pessimism has retreated somewhat as markets have rallied over the past two weeks, many investors are still very sceptical of the stress tests, suggesting room for upside surprises. Finally, for the majority of banks, transparency alone may succeed in restoring confidence. Any market stabilization due to the stress tests would be beneficial to banks, particularly if it allowed them to issue term debt at lower spreads and move away from covered bonds and ECB funding that they have been forced to use recently."
- "To achieve this, the tests must: create transparency and/or stress balance sheets with respect to loans to corporates and individuals, as well as sovereigns; differentiate
between strong and weak banks using a sufficiently high minimum core T1 capital
hurdle; and force recapitalization of failing banks, with governments positioned to
backstop institutions that are unlisted/unable to raise capital privately."
- "In our view, the institutions most likely to “fail” the stress tests – meaning be forced to raise new capital – are Spanish cajas, German Landesbanks, and Greek banks. Based on some simple assumptions using the information available from the European regulatory authorities, supplemented with the methodology used in the US stress tests, we estimate capital needs of EUR36bn for Spanish cajas, EUR34bn for German Landesbanks, and EUR8.6bn for Greek banks. Importantly, these estimates are based on a number of assumptions and are designed more to compare the potential capital needs with the programs in place to address them than to predict the exact results of the tests."
- "There are admittedly a number of risks to a long bias going into the release of the
results. According to our estimates, FROB may have to issue EUR34bn. Although this
could be spread out over time, difficulties in issuing cannot be ruled out while Spain
itself remains under scrutiny. Regulators may fail to create the transparency needed or
to set sufficiently aggressive loss assumptions. Capital hurdles may be set too low by
looking at T1 capital instead of core T1 capital. Bank books may be treated too lightly.
Finally, spreads have rallied over the past two weeks, suggesting the bar is no longer set so low that any disclosure whatsoever will cause a rally."
Barclays Credit Research 20100714

The 5 best things about the Flash Crash

- "On May 6 2010, major U.S. market indices dropped by over 9%, with a 7% decline within one 15-minute span, temporarily evaporating $1 trillion in market capitalization, before recovering. The SEC has not yet determined what caused this event. In their examinations, the SEC is dealing with a world that has changed a lot from the traditional floor-based outcry model; the percentage of total volumes executed by floor brokers and specialists fell from 52% in 1999 to 7.5% as of 2007."
- "That’s why the Flash Crash discussion includes a focus on high-frequency trading. Market research estimates that HFT has grown in the U.S. to 70% of all trades (50%-60% of shares traded). In Japan, HFT is roughly 30% of all trading, and in Europe, 40%. The broad category of HFT includes funds that employ algorithms to arbitrage away market variances (e.g., between exchange traded funds and their component stocks), a benign and helpful function for markets. Other HFTs track the order flow of other participants to both influence and benefit from it, which engenders a lot more debate."
JPMorgan Eye on the Market 20100713

Where do stock market prices not follow earnings per share over a long period, and why?

- "We look at the situations of the United States, the euro zone, the United Kingdom and Japan and we compare trends in share prices and EPS (earnings per share). A significant difference in these developments can result from:
marked changes in the determinants of PER (and therefore of long-term interest rates and growth);
"parasitic" influences on stock market prices; for example sluggish growth in consumption can depress demand for stocks and stock market prices, even if EPS are on the rise."
- "The elasticity of stock market indices to EPS is too low, and above all in Japan where it is virtually zero. We show that in all likelihood:
the changes in the determinants of PER do not explain the bias between stock market indices and PER;
the trend in household consumption explains stock market indices better than EPS, and the slowdown in consumption plays a part in the weakness of the elasticity of indices to EPS, especially in Japan."
Natixis Special Report 20100709