Oct. 25 (MF Global) -- This market comment was written at 8:50 a.m. on October 24th, US east coast time...
In an incredible reversal, copper rallied strongly on Friday, rising almost 6% on the day and practically making up all of Thursday's 7% plunge. Many of the other metals rallied in sympathy as well, although most did not do as well as copper did in erasing their losses. There was no particular news behind Friday's about-face, but we suspect that a round of bargain hunting set in after Thursday's steep plunge, as many may have viewed the decline as excessive and an unusual aberration given that most other markets were reasonably steady that day. The net result of the past two very volatile sessions was roughly unchanged for metals -- a rather appropriate result given that we were heading into a very uncertain weekend as far as Europe was concerned.
As it now stands, most markets seem to be relieved by the progress made over the weekend by European leaders. Metals are building on Friday’s decent gains and there are modest advances in many other complexes as well, including energy and some of the ags. However, the advance in metals is outpacing the gains we are seeing elsewhere, since the group is also teeing off somewhat disproportionately on news that China’s PMI expanded moderately in October to break three months of declines. In this regard, the flash PMI -- designed to give an early snapshot of the month's factory activity -- rose to 51.1 in October from September's final reading of 49.9, and came in well above the 49.9 estimate. The data also showed Chinese factory pricing pressures easing in October, with the input price sub-index falling to 54.3 from 58.8 in September. Offsetting the Chinese news somewhat, was data released out of Germany showing that the country’s manufacturing sector contracted in October for the first time in two years. Markit's composite output index, which combines service activity with manufacturing output, rose marginally to a reading of 51.2 from 50.5 in September, but in our view, the deterioration in the country’s manufacturing sector overrides the gains in services.
With regard to weekend European developments, although no "grand bargain" was formally announced, there was a working agreement on some key issues, with the loose ends expected to be tied up by Wednesday, which is when another summit meeting will be held. Among the issues tentatively agreed on is that holders of Greek bonds will likely have to take much bigger losses than the 21% originally agreed to in July, with discounts of between 50%-60% now being proposed. (This is a far more realistic haircut anyway given where Greek paper is trading on the secondary market). Since many banks, particularly French ones, will take a bigger capital hit in light of these steeper write-offs, a parallel plan for boosting their capital was also agreed to. In this regard, around 108 billion Euros would be used to recapitalize banks, somewhat on the low side of estimates given the IMF's recent projection that at least 200 billion Euros would be needed. However, this was in line with what the European Banking Authority told ministers that its emergency tests showed were needed. Banks in bailout countries account for almost half the capital shortfall, but German, French, Italian, and Spanish banks will also be required to find new capital. UK banks were spared for the time being. Banks were told to raise funds from private investors, their governments, or as a last resort, tap the EFSF rescue fund.
The ministers made more limited progress on a third issue, namely, how to increase the firepower of the EFSF rescue fund. German Chancellor Angela Merkel is firmly opposed to French suggestions that the fund should get a banking license that would enable it to borrow from the ECB. The Germans are instead proposing that more money be put into the fund, but this would mean a greater French commitment and a likely downgrade of France's coveted AAA credit rating. Plans to increase the fund’s firepower through an insurance scheme, which would use the EFSF to guarantee bond losses, runs into a similar problem in that it saddles France with too many liabilities. A second option is to set up an EFSF-insured fund that would seek outside investment for troubled bonds, with China likely being asked to be one of the investors.
Greece’s deteriorating economic outlook was also apparently the subject of intense discussions. In this regard, the ministers agreed to release the majority of loans worth 8 billion Euros to prevent the country from defaulting, but much time was spent discussing what debt levels the Greeks could comfortably service given their rapidly deteriorating economic outlook. In sum, the Irish Prime Minister summed it up well when he said "There was clearly an understanding that the world is watching Europe and that there isn't any point in doing this in a half-hearted fashion." The markets apparently agree, which is why we are slightly higher right now, although the Euro is not doing much of anything, now trading at $1.3850 and pretty much unchanged from Friday.
We expect the markets to work higher perhaps through to Wednesday, but we think that most of this "expectation rally" will likely be fully priced in after that. Investors will then look to the credit markets to see if various European bonds are indeed holding up in light of the new plans and if they are, focus will gradually revert towards the more worrying global macro outlook. Although the Chinese numbers are offering some relief, as least judging from today’s PMI reading, we doubt the country will be able to escape its own version of a “slow growth patch” given that a number of its export markets are slowing.
With respect to US macro numbers, nothing will be released on Monday, but on Tuesday, we get the Case-Shiller 20-city price index for August (expected at -3.5%), as well as October consumer confidence readings (expected at 46). On Wednesday, we get September durable goods (expected at -1%) and September new home sales (expected at 300,000). Weekly initial claims data comes out Thursday (expected at 403,000), followed by the most important release of the week, which is third-quarter GDP (now expected at 2.2%, almost double the previous quarter). August pending home sales also comes out Thursday (expected at -1%), while personal income and spending for September comes out Friday (expected at .3% and .6%, respectively). Finally, we get Michigan consumer sentiment readings (expected at 57.5)