10 October 2011

Macro Strategy Update

Short Term Positive, Long Term still Negative

We see three signs that tell us a bear market rally is in the making. The first sign is that European financial stocks are showing signs of a reversal (Fig 1). Charts show that a reverse head and shoulders has been established by the European financial index. Technically, this indicates a reversal in the previous down trend as a series of lower highs and lower lows is broken. The threat of a systemic risk to the European banking sector is now lower.

Figure 1: European financial index with reverse head and shoulders formation.

The second sign is that European financials, relative to the market, is beginning to outperform. As shown in Fig 2, as the index rises, it shows financial stocks rising faster than the overall equity market. This is the result of aggressive bidding of financial stocks by investors. Which seems to be signaling that either financial stocks are oversold and trading below their fair value, or that European policy makers are finally getting their act together.

Figure 2: European financials outperforming the market.

The third and last signal is that a bank failure typically accelerates a policy response. Last week, Dexia Group, a Belgian-French financial institution required state assistance after posting losses of 4 billion euro in the second quarter (its largest in history). The French and Belgian governments are now in the process of buying up the bad assets of the banking group and guaranteeing its future financing needs. Over the weekend, Germany and France pledged to recapitalise the European banking system in three weeks time1. We had previously highlighted that policy makers need to act aggressively on bank recapitalisation, so this new development is indeed welcome news.

These three signals are enough to trigger a rise in risk taking as they have reduced the odds of a macro shock emanating from Europe. Nonetheless, we have not changed our long term negative outlook. Economies continue to slow while investors’ preference for defensive sectors remains unchanged. In the high yield bond sector, investors continue to seek out the safest junk bonds over the highest yielding but riskiest ones (Fig 3). As in most bear markets, when the selling is overdone and positive factors appear, a counter trend rally can occur. These bear market rallies provide opportunities for the nimble investor to trade and for long term investors to lighten risk positions.

Figure 3: Relative chart of CCC-rated bonds to BB-rated bonds. As the index rise, preference for BB-rated over CCC-rated increases.

Conclusion & Portfolio Positions

The fall in risk aversion is likely to continue as the Europeans get their act together. However storm clouds remain on the horizon, meaning that the longer term trend remains negative and it is still too early to call for the end of the bear market.

We continue to remind all our clients to approve the recommendation for rebalancing their portfolios (if not yet done so) as this bear market rally provides us with a good opportunity to lighten our equity exposure. Please talk to your advisers if you have further questions.

1. Merkel, Sarkozy pledge bank recapitalisation. 10 October 2011. Bloomberg News

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