Cazenove European specialist Chris Rice explains why the EU stress tests and relaxation of the Basel III proposals has reduced the risk of a second credit crunch in 2011.
July saw a huge shift away from defensives towards financials and cyclicals.
This was triggered by anticipation of the passing by all (bar seven) banks of the EU stress tests, followed by the relaxation of the Basel III proposals on the bank sector.
This has two important consequences: firstly, the banks themselves now have the potential to earn a decent RoE in the coming years; secondly, it reduces the risk of a second credit crunch in 2011, which in turn means the economy has a better chance of a self-sustaining recovery.
The main trigger for the rally in cyclicals was the unexpected turn back up in several European indicators of economic activity. This was a surprise to the consensus and us, as both the bellweather Belgian courbe synthetique and German IFO rose in July.
Indeed the IFO index hit a three year high with the biggest monthly jump since German reunification in 1990! This presented another reason for global investors who had abandoned Europe in April/May to return to the region, which was reflected in the strong bounce in the euro at the expense of the dollar.
European earnings revisions had begun to fall in July as the euro and sterling strengthened again. Earnings expectations had been beaten in the last month’s quarterly reports, but this is the best quarter of the year in terms of earnings momentum, and when earnings momentum turns down, so does sector performance.
We are beginning to observe some clustering of correlations reminiscent of 1999. Pharmaceuticals, largecap oil, defence, telecoms, and some utilities are behaving as if they are the same security. Even cyclicals such as steel and cement look like pharma now.
Could we blame it on fears of government austerity? The flipside is also true. engineering, chemicals, luxury goods, global consumer, small/mid cap, and resources are behaving the same. Could we ascribe that to China?
It means there is a rising tension in markets, which spells danger. In a world dominated by near-zero interest rates, equity investors have almost no appetite for yield or value generally.
Many commentators have proffered rational explanations for why this may be the case. Maybe it needs no explanation - perhaps value stocks are just that – good value.
Are we digging ourselves a hole? Value-oriented investors are always asked such a question in markets dominated by momentum. I have always sought to have a pragmatic approach to investing – recognising that value can remain a long way from trend for some time.
I do entertain alternative outcomes to my central view but allowing a poor month to force a change in strategy for its own sake can be an equally, if not more, dangerous route to take.
Chris Rice is manager of the Cazenove European fund
