IG Markets Afternoon thoughts

IG Markets Afternoon thoughts

Across Asia, regional markets are stronger on growing optimism around the latest attempt by leaders to solve the European debt crisis. European leaders are now reportedly working on a plan that could double the size of the bailout fund. The latest development has superseded S&P’s move to put 15 eurozone nations on ratings watch. The plan involves allowing the eurozone’s existing EUR 440 billion bail-out fund to continue running when a new EUR 500 billion facility comes into force in mid-2012, almost doubling the rescue system’s firepower. The ASX 200 is outperforming the region with a 1% rise, while the Nikkei and Hang Seng are not far behind with gains of around 0.9% each. The Shanghai is lagging the region with a 0.2% increase. In light of the strength we are seeing in the Asian region, both US and European markets are pointing towards gains at the open.

Australia's S&P/ASX 200 is up 1% at 4303, fading after an early rise to 4316.3 in response to Wall Street's resilience to S&P's warning on eurozone sovereign credit ratings, and the credit risks to the EFSF. Materials names are leading broad-based gains on light volume, with BHP Billiton up 1.3%, although Newcrest Mining is lower 1.3% after Deutsche Bank downgraded it Tuesday. Australia's economy grew solidly in 3Q with GDP expanding 1.0% from 2Q, beating expected growth of 0.8%. Strong business investment and company profits fuelled the growth, while an inventory rundown, weaker government spending and substantial net exports detraction held back activity.

The big four banks are facing a lot of pressure to pass on the full rate cut delivered by the RBA yesterday. Many analysts feel the big banks will not pass on the full rate cut as they say funding costs remain at elevated levels. However, that argument falls on deaf ears in Australia as the big four continue to post record profits. We are seeing many of the interest rate sensitive stocks like the retailers underperform today. Myer is down 0.6% and David Jones is around 1% lower. Consumers only get some relief when their banks pass on these rate cuts and therefore investors are exercising some caution.

Friday’s EU summit has captured the attention of investors across all asset markets. With so much riding on the summit, we are likely to start seeing some cautious trading after the recent gains we have experienced. When expectations are so high, there is bound to be some disappointment. The proposed changes to the EU treaty are likely to face challenges from the weaker nations with some leaders opposing the changes. British PM David Cameron has reportedly threatened to block EU treaty changes if London’s demands are not met. Implementing any treaty changes might also turn out to be more complicated than what it seems. With all the upcoming meetings, particularly on the European front, the headline risk has never been greater.

EUR/USD has managed to regain the 1.34 level during Asian trade, but continues to look vulnerable as headline-driven price action continues to be the dominant theme. It was pretty obvious that ratings agency S&P would put the EFSF on review for a possible downgrade, given 15 of the nations that guarantee the fund may be downgraded themselves. So, in theory, this should not have come as much of a surprise. The real talking point overnight was an article reported in the Financial Times that we could now see the ESM (European Stability Mechanism) brought forward a year to run in conjunction with the EFSF, while winning increased support from the IMF, suggesting the market could see the ‘bazooka’ effect it had been looking for. Importantly, it seems the EU is contemplating turning the ESM, the permanent bailout fund originally designed to supersede the EFSF, into a ‘credit institution’, which in theory would allow it to access ECB funding. With the ESM operating under very different treaties and funding mechanisms from the EFSF, what the ESM can and can’t do seems a lot more flexible. Whether this piece of speculation actually plays out is debatable, but it is clear that the market is pricing in some sort of ‘game changing’ outcome from the Friday summit. Tomorrow night however, we get to hear from the ECB, so this will be a more short-term catalyst. Everyone is expecting a 25 basis-point cut from the ECB, however there is a chance we could even get 50 basis points, which would put downside pressure on the single currency. As always, the press conference will be closely watched to see Mario Draghi’s view on downside risks to price stability. It is also worth pointing out that the euro’s 60-day correlation with the S&P is near record highs, and given the S&P is approaching July downtrend resistance and the elusive 200-day moving average, this may play into price action on the single currency.

ENDS

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