Market Recap: Europe’s ‘Make-or-Break Moment’

Posted on October 24, 2014 by Gemmer Asset

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*As of 10/24/14 (before dividends)


Market Recap


The equity markets bounced back dramatically this week with gains pretty much across the board. The U.S. indexes were up between +3.4% and +4.1%, the best showing in a long time. As a matter of fact, on Tuesday the S&P notched its biggest gain in a year, and the largest single-session point advance since 2011.


The overseas markets were a bit more subdued. The developed EAFE added +2.6%, with Germany up +1.6% and France +2.4%. Japan was the standout performer in the developed world gaining +5.2%. It appears the pending VAT hike may be delayed and hopes are building for more support from the Bank of Japan at their upcoming meeting. Emerging equities lagged materially, largely due to the Brazilian market which lost -6.8% for the week. Stocks in Brazil struggled ahead of Sunday’s election.


The dollar renewed its rally this week, gaining +0.7% against the euro and +1.1% against the yen. This helped push commodities lower once again. Crude oil lost another -2.2% despite news that Saudi Arabia was considering modest production cuts. Precious metals also lost ground, with gold and silver dipping -0.5% while gold stocks lost -1.1%.


Finally, bond yields ticked higher, with the yield on the 10-year increasing 7bps. Intermediate-term bonds lost -0.5% for the week, but high yield roared back with a +1.1% gain.


Earnings Continue to Positively Surprise


So what lies behind this week’s rally? It’s as tricky identifying the catalyst for this rally as it was identifying the catalyst for the late September/early October swoon. Certainly there were a couple of modestly better economic reports both here and in Europe, but in reality they were not that significant. Rumors about a possible expansion of the European Central Bank’s (ECB) quantitative easing plan played probably as big a role as anything (more on this below).


In the U.S. earnings have been an important factor in stabilizing things. We’ve had some high profile problems such as Amazon, IBM, Coke, and McDonalds (rough week for Buffett – the last three are large holdings of Berkshire). However, in general the winners such as Apple, Caterpillar and 3M have outpaced the misses. So far 207 firms in the S&P 500 have reported (54% of market cap), and roughly 65% have beat earnings estimates (see chart below).




Matters are not as rosy when you look at sales.  On this measure just 49.3% of companies have beaten estimates, quite a bit below prior quarters.


But the sales numbers are pulled down to some extent by the energy sector. The recent fall in oil prices is hitting that sector hard. Earnings estimates for the energy sector in 2015 fell 8% this week alone, and are likely to push even lower next week when we see the bulk of energy company reports.


Remember that the above numbers show the percentage of companies beating estimates. On an absolute basis revenues are set to grow by roughly 5.5% year-over-year in the 3rd quarter while earnings grow 9%. This is solid performance considering GDP actually contracted in the first quarter. While valuations are rich on U.S. equities, continued earnings growth should underpin prices on any reasonable time horizon.


Europe’s ‘Make-or-Break Moment’


We remain of the opinion that the situation in Europe was the reason for much of the correction in late September and early October. This week the market shrugged off any bad news out of the region, but next week is going to be a big week. There are four key events in the region that could dictate what the European economy and markets do for quite some time.


1) Bank Stress Tests and Asset Quality Review. The ECB is slated to wrap up their review of 130 European banks on Sunday. They have been conducting stress tests of the banks to see how sound their balance sheets are and if they hold enough capital. This is a key step in the ECB’s plan towards stimulating bank lending in the region. If this part of the plan concludes successfully it sets the stage for more dramatic ECB action in November or December (see point #3 below).


2) Parliamentary Election in Ukraine. A victory for President Poroshenko’s moderate party should give him the mandate to negotiate with Russia in the months to come. It should also allow EU leaders to launch a credible peace process. This could lead to a rapprochement with Russia and possibly an early end to sanctions. This will be a shot in the arm for Germany and Italy, both of which have been hurt by confrontation with Russia.


3) The European commission rules on France’s 2015 budget. On Wednesday the commission is meant to reconcile France’s request (need?) to run a larger than allowed budget deficit with Germany’s insistence that targets be adhered to. France wants to cut taxes to stimulate growth. Germany thinks that only structural reforms will help. If the commission bends the rules it could set the stage for renewed fiscal stimulus in the region. However, such a move could provoke a backlash from Germany and possibly lead to a constitutional court challenge.


4) European Central Bank Meeting. Finally, the ECB meets on November 6th and this could be a very important meeting. Part of the reason the markets rallied this week were rumors that the ECB is considering buying corporate bonds on the secondary market as part of their quantitative easing plan. If the asset quality review noted above concludes without major problems investors will be sorely disappointed if the ECB doesn’t take another step in November, or at least indicate something for the December meeting.


Needless to say it is going to be an eventful couple weeks in Europe. So what are the odds of a favorable outcome on each point? To quote Anatole Kaletsky, chief economist at GaveKal:


“Putting these three events together, Europe has a decent chance of breaking out in the next few weeks from its vicious circle of policy failure and economic stagnation. Whether policymakers seize this chance is, of course, open to question given Europe’s long record of doing too little, too late. If Europe again disappoints expectations, the recession will deepen, with no serious hope of economic recovery next year. In that case, public opinion will veer onto a course of political nationalism and economic disintegration, not just in Greece and Italy but also in France and Germany. By next year it may be too late to reverse this. That’s what is meant by a make-or-break moment.”



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