What are the prospects for stock market indices?

- "In the short term, since 2008, stock market indices (we look at the S&P, the Eurostoxx and the CAC) have moved in line with risk aversion, which itself depends on economic news and concerns about some financial markets and some classes of borrowers."
- "In this Flash we look at a longer-term horizon, and we seek to ascertain what the economic environment implies for stock market indices."
- "It seems to us that:
• their stagnation in 2010 is consistent with the downward revision in growth prospects, and hence in PER levels, and investors are adopting a virtually deflationary equilibrium scenario, which is the most likely for the United States and the euro zone;
• subsequently (2011-2012), the indices can be expected to rise in line with earnings per share, which are rising rapidly because of the distortion of income sharing at the expense of wage earners."

Equity Issuance: Alka Seltzer, Anyone?

- The equity pipeline for this year is estimated to be US$116bn — "Add on what has already been done year to date and, at US$ 291bn, it will set a new record. Issuance will be heaviest in China, India and Singapore, and lightest in Taiwan, Thailand and the Philippines. By sector, financials, materials and energy lead."
- Relative to market cap, issuance will be 2.9%, slightly above average — "There is little relationship between markets and issuance: they are coincident at best. It the market’s down, issuance will be down and vice versa. Issuance does not cause the market to fall, it mere slows the ascent. Issuance is in excess of dividends paid and inflows, so we need to see a shift out of bank deposits or more interest from overseas investors."
- Best way to avoid the Alka Seltzer is stay away from the crowd — "With cash levels just at averages, investors may have to sell something in order to buy something. Consensus overweights are thus vulnerable to being sold down, since you can’t sell what you don’t own after all. Div financials, materials and consumers are vulnerable were this to happen."

Spain: near-term risky, medium-term more promising?

- "We see several near-term risks for the Spanish economy. GDP is likely to contract in the third quarter following the VAT hike, while the political environment remains difficult ahead of the 2011 budget vote."

- "We believe that the risks of a double-dip recession have receded, however, and that the economy is more likely to edge towards a protracted period of modest expansion in activity."

- "The main challenges are in the medium term as Spain has to switch to a more competitive growth model at the same time as the private sector succumbs to a drastic deleveraging process."

Public debt cannot be substituted for private debt

- "The argument used to defend the implementation of highly expansionary fiscal policies since the start of the crisis is that private debt must be replaced by public debt since private economic agents are deleveraging. But we saw that this substitution of public debt for private debt came to a halt very fast: as governments reduced their fiscal deficits while the private sector continued to deleverage, some countries found it impossible to finance their fiscal deficits under normal conditions."
- "Admittedly, the increase in the public debt has often gone far beyond the level that corresponded to a replacement of the private debt, but especially for investors, public debt cannot be substituted for private debt, and they therefore refuse to permanently accumulate public debt in their portfolios instead of private debt:
• investors (lenders) need a default risk-free asset; they accept the default risk on household and corporate debt, but not on public debt, which must play this role of default risk-free asset;
• investors (lenders) assess a debt’s solidity by looking at the counterpart of the debt in the borrower’s assets; for households, we are talking about a real estate asset (collateral), even if its valuation has often turned out to be abnormally high; for governments, the debts mainly finance current expenditure or tax cuts, not the accumulation of an asset, and this worsens their quality."

To what level can the savings rate of the Americans go?

- "If Americans’ (net) savings rate remains close to 6% - as it has for several months - the United States will not slide back into recession, but post slower growth for a long time to come."
- "But if we believe that there will be a new recession - i.e. a double dip - in the United States, we also have to believe that the savings rate among Americans will rise again and their consumption drop, which is possible given the changes in Americans’ wealth and the labour market situation, and despite
the low interest rates and the erratic stock market return."
- "In view of the trends in asset prices (real estate, equities), unemployment, problems encountered in the labour market, interest rates, etc., we seek to ascertain at what level Americans’ savings rate should normally be today, and whether there is a risk that it will continue to rise sharply. Our econometric analysis, which seems to be of good quality, shows that Americans’ current savings rate (6% for net savings) seems to correspond to the savings rate that is consistent with the trend in all determinants of household savings. So we do not believe in a further sharp rise in the savings rate or, accordingly, in a double dip scenario."

The role of the Chinese cycle in the global cycle

- "We seek to ascertain the role played by the Chinese cycle in the global cycle."
- "This poses two types of questions:
• to measure the weight of the Chinese cycle, we can use an accounting approach (China’s weight in global GDP, in global trade); but it overlooks the multiplier effects of the Chinese cycle: growth motor of other Asian economies, effects of the sharing of the production between China and other Asian countries. Effectively, we find an elasticity of output (GDP and manufacturing output) to output in China of 0.4 and not from 0.1 to 0.2 according to the accounting approach;
• we also have to look at the direction of causality between the Chinese cycle and the cycle of the rest of the world; in certain periods (after Lehmans’ bankruptcy), the freezing of the global economy has weakened the Chinese economy; in other periods (late 2009, early 2010 for instance), Chinese growth has driven upwards the global economy. However, overall, statistical tests show that causality definitely heads from China to OECD countries."

US and China export monetary easing

- "Slower growth in US and China producing easier global monetary stance"
- "Fed to signal leaning toward additional QE in meeting statement"
- "Euro area core inflation still trending downward excluding tax hikes"
- "Turkish vote raises odds of political stability and fiscal prudence"

Still Some Way To Travel

- "Federal Reserve officials next week are expected to inch closer to the view that a new, more active phase of accommodation is warranted. Although the FOMC may fall short of a consensus for imminent action, the policy statement likely will attempt to keep alive sentiment that renewed expansion of the balance sheet is approaching."
- "Incoming data have prompted a widening consensus that recovery is anemic at a time when financial supports remain uneven at best. We expect second half growth near 1¾% with final demand too slow to spur rising resource use, a key focus of policy concern. The latest small business survey showed that an important segment of the economy continues to lag recovery amid unusually tight credit conditions and a lack of confidence in the outlook."
- "The bond market's favorable reaction to the August Fed announcement should dispel concerns that there would be limited benefit to a new easing effort. Term premiums fell noticeably in the days following the decision to maintain large holdings of longer duration assets. Coupled with an ongoing commitment to low overnight rates, the renewed openness to quantitative measures has for now arrested an untimely deterioration in financial conditions."

Yield: Not the place to be

- "By December, most of Asia’s central banks will be hiking rates again and we expect their ranks will, by then, include China and Indonesia, Asia’s two key holdouts so far. Trouble in the US and Europe isn’t going to kill Asia’s recovery. In the two years since Lehman Brothers imploded, consumption in the US has gone absolutely nowhere – it still has not returned to precrisis levels. Ditto for Europe. Ditto for Japan. But compared to precrisis (3Q08) levels, consumption in Asia is up by 18%. That’s why Asia’s central banks will be back in tightening mode soon – because Asia’s recovery is not about the US. It’s about Asia. Asia is no longer too small to matter. Among other things, this means Asia can and will consume whether the G3 does or not. And it means Asia’s monetary policies will depend more on what happens here in Asia and less on what happens elsewhere in the world."
- "The market environment is likely to get more unfriendly and challenging for bond investors in 4Q10 and 2011. Yes, US real GDP growth will be slow in the coming quarters, but slow growth is a far cry from recession and USD yields need to be a lot higher, if recession fears drop out of the picture. USD yield curves will steepen to discount an earlier and more rapid rise in short-term interest rates. If that happens, the bond market is not the place to be. Yield curves will steepen not only in the US, but also in Asia. Improvements in the macro outlook will oblige many Asian central banks to tighten monetary policy further in 2011 and expectations of that will put upward pressure on yields well be before actual rate hikes push shortterm rates higher."
- "Unless economic conditions deteriorate to an outright recession, which would force investment portfolios to reduce allocation of riskier assets, we do not see much downside for equities. We think Asia equities will continue to be well supported, underpinned by attractive valuations and resilient domestic and regional growth."

Introducing the Year-End 2011 S&P 500 Target

- Another year of gains but it is likely to be uneven. "After calibrating several methods to arrive at probable stock market levels, it appears that 2011 should provide solid gains for equity investors with a newly established year-end S&P 500 target of 1,300, which argues for further 10% appreciation off of the 2010 yearend objective of 1,175. Overall, our analysis contends that stock market investors could enjoy an aggregate total return of roughly 20% in the next 15 months or so."
- Sentiment readings strongly support impressive upside opportunity. "The unique Panic/Euphoria Model remains mired in panic territory yielding a 97% chance that stock prices are higher in a year’s time. Moreover, the average gain over the past 20 years when this tracker was registering panic readings has been better than 17%. Continued and consistent equity mutual fund outflows only further emphasizes the disdain for the asset class, bolstering the case that investors may find a need to chase returns, providing added impetus for higher stock indices."
- Valuation models sustain the bullish case. "The P/E Bulls-Eye approach has shifted with the sweet spot having moved to less than 8x trailing EPS, but the current 14-16x P/E range still augurs well for share prices given an 85% probability of gains in the subsequent 12 months with an average near 14% move. Furthermore, our most highly correlated valuation metric suggests that share prices could be as much as 30% under-valued. Thus, the projected index level could prove conservative."
- Earnings expectations are depressed with investors having no conviction in estimates. "Despite consensus bottom-up estimates calling for almost 16% EPS growth next year and buy-side surveys showing only 9% forecasts, the market is implying declines in future earnings which historically has generated highly respectable 20%+ strength. While margins challenges in the middle of next year could argue for a repeat of 2010’s summer weakness, equities should provide very adequate returns for informed and nimble investors who understand the implications of a trading environment."
- Risks to the outlook include policy errors and growing debt burdens. "Government policy decisions could have enormous influence on the 2011 market direction as deficit financing requires a responsible path given possible contagion effects from debt-laden countries. In addition, labor woes in most developed economies could drive increased trade friction as politicians scramble to placate dissatisfied voters. Debt rollover is a particularly onerous difficulty as was seen for the REITs two years ago and the average duration of government debt may need lengthening, but bond market vigilantes may not be all that tolerant if reasonable and credible longterm deficit reduction plans are not instituted."

China: A soft landing underway

- Global Letter   
• Japan’s intervention: a sterile debate
- Feature Articles  
• China: A soft landing underway  
• ASEAN: Fiscal exit by stealth
- Data Preview  
• The week ahead
- Chart Alerts  
• Leading economic indexes for China and India  
• Australia: Consumer sentiment moderates in September
- Outlook 2010-2012  
• Australia: Growth momentum building  
• China: Reform platform for sustainable growth  
• Hong Kong: Moderating, but solid growth 
• India: RBI to stay on hold  
• Indonesia: Monetary and fiscal normalisation begins  
• Malaysia: Rate hikes are over for now  
• New Zealand: Earthquake reconstruction to boost growth  
• Philippines: Going for growth  
• Singapore: More property market measures  
• South Korea: When doves cry  
• Taiwan: Robust economic expansion continues 
• Thailand: Still on track to normalisation  
• Vietnam: Some encouraging fiscal numbers

The yen remains strong even after intervention

- Unexpected FX intervention unlikely to change the recent trend in the FX markets — "The Ministry of Finance intervened in the foreign exchange market this week. The unexpected action pushed the yen down by about 3-4 yen to both the US dollar and euro. Yet, compared with the second-quarter average, the yen is still 4-7% stronger. Moreover, the yen-selling intervention is unlikely to change the recent trend in the FX markets given that the ongoing yen strength against both currencies stems from external factors, including the slowing U.S. economy, expectations for additional easing measures from the U.S. Fed and a sovereign crisis in the Euro area."
- A higher yen’s short term impact: Corporate profits are influenced — "In this backdrop, there is a persistent concern that the yen’s strength will affect the Japanese economy in the short term through a negative impact on corporate profits. The higher yen has a negative impact on corporate profits in the exportoriented sectors including production machinery, electrical machinery, information and communication electronics equipment, transportation equipment and general-purpose machinery. In contrast, sectors in which crude oil and natural gas take up a high percentage in total raw materials, namely, petroleum and coal products, electricity, and gas, heat supply and water, should benefit from the rising yen."
- A higher yen’s medium term impact (1): An accelerating ascent of the overseas production ratio in manufacturing — "As yen appreciation continues, the attention is also shifting gradually to a medium term impact on the Japanese economy. In the past, a sharp yen appreciation has hastened manufacturers to shift their production overseas with roughly a 2-year time lag. In fiscal 2010-2012, the overseas production ratio may rise at a pace about 2.4 times as fast as the average in the past (a 0.7ppt rise per annum)."
- A higher yen’s medium term impact (2): Domestic capex as well as domestic employment in manufacturing will likely stagnate — "In the past, a rise in the overseas production ratio in manufacturing has pushed down manufacturing domestic business investment and employment by around 1.9ppt and 1.0ppt per annum, respectively. The downward pressure may increase 2.4 times as large as before."

European periphery: think relative

- "At a time when economic data in the euro area has been surprising on the positive side, negative headlines in the European periphery last week pushed spreads to Bunds above the pre-stability package highs in early May. Despite a subsequent recovery, the scale of accumulated potential losses on peripheral assets remains highly sensitive given the central role played by banks in particular in the supply absorption process. While most of the focus in this respect is on domestic banking sectors, the latest BIS statistics on foreign claims add another piece to the jigsaw in assessing the overall burden. It reveals evidence of cross-border sharing of losses, making the digestion process more manageable. In this article, we take a deeper look at the BIS data in an attempt to quantify the extent of this dynamic. On the whole, we believe it adds to the contention that pessimism regarding the periphery is overdone even though there is still a long way to go in the remedial process."

Q&A on QE

- QE-II Not a Done Deal — "We do not expect any QE to be announced in September. Beyond that, QE-II would be triggered if the Fed downgrades growth projections to forecast rising unemployment and/or financial conditions worsen significantly."
- Unlikely That TIPS Will be Added to Aggregate Bond Indices — "Although the market has priced in up to a 33% probability that TIPS will be added to benchmark indices, we anticipate that this will not happen. However, expect extremely high demand for TIPS if it does."
- Lower Rates, Longer MBS Durations? — "Prepay models are lengthening mortgage durations to reflect the new prepay dynamics experienced in the last two years. We do not expect these model changes to stimulate duration flows."
- Agency Debt — "2-year agency spreads to Treasuries are very tight historically. Thus, we recommend extending from 2-year agencies to 3-year agencies on the front end of the curve."
- US Rate Strategy Model Portfolio — "The portfolio is down 0.1% month-to-date"

Core Ranking Reversal

- "The ranking in terms of economic growth between the two biggest euro area member countries has changed. While France has outperformed Germany on GDP growth for most of the time since the introduction of the EUR, we expect Germany to show higher GDP growth than France in coming years."
- "With less cyclical support, France faces a more difficult environment than Germany in which to reduce its general government deficit to 3% by 2013. In addition, after the likely implementation of the unpopular pension reform, the government is unlikely to introduce far-reaching austerity measures. Hence, the gap between the government debt-to-GDP ratio in France and Germany is likely to widen, creating pressure on sovereign bond spreads."
- "However, we are quite confident that France will meet its target to reduce the deficit-to-GDP ratio to 6% in 2011. Furthermore, France faces a less adverse impact from demographic changes than Germany, suggesting a less threatening outlook for public balances long term (Jürgen Michels, see page 2)."

September 2010: Economic slowdown confirmed, event risks ahead

- "We expect EUR/USD to trade in limbo in the absence of a clear trend in relative rates over the next half year year. Beyond this, we continue to find more dollar negative factors and expect EUR/USD to head moderately higher."
- "We see only limited downside potential for USD/JPY after BoJ's intervention. USD/JPY can stay subdued for a while though with China buying JGBs. USD/JPY belongs in the 90-100 though."
- "The pound is in our view overbought according to short-term financial factors and we forecast EUR/GBP slightly higher on 3-6 months. Sterling weakness will, however, be limited by the stronger dollar. GBP is undervalued from long-term estimates though and EUR/GBP can eventually break below 0.80."
- "We expect the CHF to stay strong over the next half year, backed by sound Swiss data and the outlook of higher rates. EUR/CHF will rise when ECB sharpens rhetoric and EUR risks gradually diminishes."
- "We maintain our positive views on the Scandies and foresee lower levels in both EUR/SEK and EUR/NOK over the coming quarters. Risk-reward has been better though and both can be subject to a sell-off if risk appetite disappears from markets again."
- "We expect to see EUR/DKK trading in a narrow range and the Danish Central Bank to actively monitor the krone. Normalisation of rates can occur in the latter part of our forecast horizon."
- "We like AUD and NZD for now but acknowledge that both are trading at overvalued levels."

The Top Tens

- "MSFT takes over the top spot. After reviewing the top holdings of the largest-50 actively managed US mutual funds by asset size, Microsoft took over as the most held stock at 18 of the top-50 funds in 2Q10, up from the number two spot in 1Q10. Wells Fargo moved to the number two spot, the position it held in 4Q09. Meanwhile, JP Morgan fell out of the top-3 to the fourth most held stock while Merck replaced it in the third position. The poor performance for all sectors in 2Q10 is the likely reason why 25 of the top-30 most held stocks were flat to down from their number of holdings in 1Q10."
- "Financials and Tech names continue to represent 60% of the 15 most held positions in the top-tens lists of the top-50 mutual funds. Despite negative performance for every sector and industry group in the second quarter and Financials performing second to worst while Tech performed fifth to worst of the sectors, these groups continue to represent a significant proportion of holdings for the top-50 mutual funds. Financials and Tech names represent 40% of the top-30 positions held in the top-tens lists for the top-50 mutual funds. These trends have been in place each quarter since 4Q09, which we find interesting considering the disparity of performance of each sector over the past three quarters."
- "Merck and Wells Fargo continue to seem the most over-owned. We calculate the ratio of the top-ten listings to market value as a basic technique to scan whether a large-cap name is over- or under-represented among mutual fund portfolios. From this perspective, Merck and Wells Fargo continue to rank as over-owned, while Goldman Sachs has also spiked in the screen as over-represented. Meanwhile, Apple, General Electric and Coca-Cola seem most under-represented."
- "Google and Apple remain the most owned among growth funds while JP Morgan, Merck and AT&T are the most heavily owned by value funds. Additionally, Microsoft declined in holdings for growth funds in the quarter. Meanwhile, among value funds the holdings of Wells Fargo fell from the most well represented name to the fourth most liked."
- "Domestic mutual fund flows continue to suffer significant outflows through the first seven-months of 2010. Domestic equity mutual funds suffered a cumulative outflow of $236.45 billion from 2007 through 2009 and have continued to struggle through July 2010, having shed an additional $27.10 billion. Meanwhile, international equity funds garnered $28.68 billion through July 2010 after taking in $30.28 billion in 2009. Bond funds have attracted $184.32 billion thus far in 2010, greater than the $177.78 billion inflow of the comparable period of 2009, during which year bond funds took in a record $375.48 billion."

Bank of Canada cannot go it alone much longer

- "The Bank of Canada (BoC) has just raised its key rate a third time while the central banks of most of the other advanced countries look on from the sidelines."
- "The BoC’s actions are in response to the more vigorous recovery in Canada, which is benefitting from a strong rebound in economic growth in the emerging countries. Moreover, in terms of domestic demand growth, Canada stands in sharp contrast with the United States, where the housing crisis has caused household balance sheets to deteriorate considerably."
- "In light of the respective shocks suffered and present inflation levels, while the BoC proceeds to normalize rates, the Fed should stay put for yet another year."
- "Although exports as a percentage of GDP have fallen drastically since 2000, the fact is that the Canadian economy remains a small open economy whose monetary policy cannot diverge outrageously from that of its principal trade partner."
- "In 2003, the central bank had to backtrack after learning this lesson the hard way. In the period when the yield spread on 2-year government bonds reached 200 bps, the loonie gained US$0.10."
- "In our opinion, the BoC will go ahead with only two more 25-bp hikes seeing how both international trade and residential investment are expected to detract from economic growth in the coming months. Canadian monetary authorities should then mark time before raising rates further until the U.S. economy gets up and running again."

Is there really a decorrelation between Asia on the one hand and the United States and Europe on the other?

- "It can reasonably be imagined that Asia will experience high growth (due to technological catch-up, internal migration, the capacity for increasing indebtedness, rising education levels, demand for durable goods, etc.), while the United States and Europe will have only moderate growth (due to deleveraging, deindustrialisation, the distortion of income sharing to the detriment of wage-earners, wealth loss, the need to reduce fiscal deficits at a time when household savings are increasing, and in Europe low productivity gains)."
- "However, the sluggishness of growth in the United States and Europe will affect Asia. We seek to ascertain whether Asian growth will be greatly reduced by the economic problems of the United States and Europe, or whether Asia, thanks to its domestic market, can become decorrelated from the United States and Europe. In 2008, Asia's renewed correlation to the situation of the OECD countries took place via finance and bank credit. At present, we note that, even though Asia's exports to the United States and Europe account for 50% of Asian exports (taken as a whole, excluding intraregional trade), the elasticity of Asia's GDP to exports is only 0.09, while it is 0.54 in relation to domestic demand: Asia is very largely decorrelated from the United States and Europe."

What developments could cause a double dip in the United States and Europe?

- "Our main scenario does absolutely not include a double dip (return to recession) in the United States and the euro zone. It predicts only slow growth, due to the ongoing private sector deleveraging, the distortion of income sharing at the expense of wage earners, the slowdown in global trade, the reduction in fiscal deficits, deindustrialisation, the persistent weakness of residential property, the deterioration in the labour market situation, etc."
- "However, we have to look at the developments that could cause a double dip:
• a far sharper rise in the US household savings rate, due to the deterioration in the labour market situation and the wealth loss;
• a higher fiscal multiplier (effect of the reduction in fiscal deficits on growth) than what is normally expected, due to the fact that the fall in the fiscal deficit is not offset by a rise in private demand. In Greece and Ireland, the fiscal multiplier seems to be higher than 1;
• a far sharper fall in wages in Europe (excluding Germany), in order to rebuild corporate profitability;
• a far more pronounced slowdown than expected in China and other Asian countries, and therefore in global trade."