London Session: The Calm Before the Storm?

The markets have been remarkable calm after yesterday’s major moves to the downside. It‘s not often that you see the stocks end the day down 5 per cent, however it has been more frequent this year which is likely to go down as one of the most volatile years in recent memory.

However, the bears are taking a breather today. A mixture of profit taking, a little bit more clarity on Greece, some positive noises from China and market expectation for the conclusion of the Fed meeting and Ben Bernanke’s press conference afterwards has seen risk stabilise this morning and European stock markets are fairly flat. However, there hasn’t been any major shifts regarding events in Greece and the Eurozone debt crisis is still at a critical stage, thus today’s price action is more of a normal pull-back rather than a shift in sentiment.

Ben Bernanke will address the media at 1815GMT this evening; however he is still playing second fiddle to Greece. We don’t expect Bernanke to announce anything drastic like QE3, although he may lay the ground work for more stimuli if the Eurozone crisis does not get resolved quickly. More likely would be an announcement from Bernanke that the future path for interest rates depend on the unemployment rate and rates will remain low until it falls to a more acceptable level. After all, the Fed has a joint mandate: to boost growth and ensure full employment. It is failing on the latter point, so it has to do something. Whether it does something as drastic as more QE depends on Europe, so Bernanke is left in the same position as us: waiting for Greece to implode and Merkel and Sarkozy to try and piece together a solution.

We said after Thursday’s “debt deal” that we probably weren’t done with emergency summits out of the Eurozone. Here we are less than a week later and the EU’s high command is having an emergency meeting with Greek PM Papandreou. His cabinet has approved the referendum and since each member state has its sovereignty it’s hard to see what France and Germany can do stop Greece from holding the vote or to persuade the people to vote yes to the bailout terms. After all, Germany and France have a bad rep in Greece since they are the ones enforcing all of the austerity that the people don’t like…

To those outside of Europe this de-centralisation of political and fiscal power makes the whole Eurozone untenable, indeed Greece may well end up being the straw that broke the camel’s back.

Greece tends to cause a domino effect in Europe. Its actions in the last 48 hours have increased the chance of a disorderly default and a breakdown of the Eurozone and it has reversed most of the good work done last week. Greek 2-year bond yields hit 90% today! It makes a mockery of the 50% haircut “agreed” by the banks last week that would avoid default, and it seriously dents the chances of the EFSF attracting foreign funds for its Special Purpose Investment Vehicle.

Remarkably, reports suggest that China may still be interested in investing EUR700mn in the EFSF SPIV; however Beijing is likely to want more clarity on the state of Greece before it signs on the dotted line. The EFSF decided to hold off on selling a EUR3 billion bond today to help fund its bailout loans to Greece, Ireland and Portugal due to volatile market conditions. This is another reason for Merkel and Sarkozy to let rip at Papandreou, his actions are threatening contagion not only to other bailed out nations but also to Italy and even Spain. One thing is for sure, the latest debt deal has not ringed fenced Greece.

Italy is now the bellwether for European health and it is hurtling towards bailout territory. Its bond yield has surged to fresh daily highs of 6.24%, and not even rumours that the ECB is a huge buyer of Italian debt is enough to attract buyers. Italy has a major debt issuance in the middle of this month. Rome and the EU high command will hope that the markets have calmed down by then otherwise Italy could be on its way to the IMF.

Economic data is taking a back seat today, but it is unlikely to help improve sentiment. The German unemployment rate rose to 7% today from 6.9%, the first increase since June 2009. The manufacturing PMI for the currency bloc was weak at 47.1 for October. This survey is deep in contraction territory and suggests weak or even negative growth at the start of the fourth quarter. The one bright spot is corporate earnings, which have been fairly good for Q3. However, weak growth and continued problems in Europe may weigh on profits later this year, which could keep a lid on stock prices for now.

In the UK, construction PMI data was stronger than expected last month at 53.9 vs. 50.0 expected. This was boosted by stronger household construction; however the forward looking components of the survey were still weak, and suggest that this sector will remain a drag on growth as we head into the end of the year. US ADP payrolls were slightly stronger at 110k, vs 100k expected. This survey doesn’t have a great correlation with NFP, so we will still need to wait for Friday’s figures to get a clear picture of the US labour market. However, risk assets had an initial jump on the news.

Overall, bearish sentiment is still rife in the markets; however prices tend to mean revert when they get overstretched – as we have seen to the downside in the last couple of days. So we could be in a range-bound environment for the rest of the week or until the markets digest the Fed, the ECB meeting, payrolls, the G20 and the confidence vote in the Greek government scheduled for Friday.