The Overnight Report: Merkozy Underwhelms

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By Greg Peel

The Dow closed down 77 points or 0.7% while the S&P lost 1.0% to 1192 and the Nasdaq fell 1.2%.

America had its AAA rating confirmed last night. And its outlook was deemed to be “stable”. The announcement came from Fitch, however, and not S&P. Moody's had previously confirmed its AAA rating as well.

All eyes were on Europe last night and the meeting between German chancellor Angela Merkel and French president Nicholas Sarkozy (now dubbed “Merkozy”), who had joined forces in Paris to try to nut out an even more substantial and effective solution to Europe's debt woes than those previously implemented. Wall Street, and the world, was hopeful.

It was not expected to be a brief affair, so prior to any announcement markets had to deal with the first estimate of the eurozone's June quarter GDP. It came out as 0.2% growth when 0.3% growth was expected, and worryingly that “miss” was due to only 0.1% growth from European powerhouse Germany when 0.5% was expected. It must be remembered, of course, that while it's easy to think of Germany as the “China of Europe”, being another US creditor, it still runs a budget deficit, that deficit has exceeded ECB restrictions like everywhere else in the eurozone, and budget cut measures are in place.

I will also throw in my long held view that backward-looking technical definitions of a recession are useless, misleading and even dangerous, and that in reality recessions are a state of mind. If you think things are getting worse then they will, because you will facilitate the slowdown by being cautious. In the June quarter, the eurozone debt issue blew up once more with a particular focus on the touch-and-go Greek parliamentary vote on tougher budget cuts. Is that a climate in which all Europeans feel keen to borrow, spend and invest?

The disappointing eurozone GDP number had Wall Street off to a weaker start, although stocks recovered early losses on some local economic releases.

US industrial production in July rose 0.9% following 0.4% growth in June and against expectations of only 0.6%. Capacity utilisation grew to 77.5% from 76.9% in June against expectations of 77.0%. This is the economy which is supposed to be heading into double-dip. But the problem is, July production preceded the market mayhem in August, and hence economists expect the August numbers to be weaker given the fear that mayhem generated.

See? Recessions are a state of mind.

US housing starts fell 1.5% in July to mark 9.8% growth year on year. That's the lowest growth rate since records were first kept in 1959. The only silver lining here is that economists had expected a slightly bigger fall.

Then just as Wall Street was weighing all this up, Merkozy appeared on television screens. Markets went suddenly quiet.

To preface, the two major elements the more hopeful in the world were looking for was a big increase in the EFSF (European financial stability fund), and talk has been of an increase to E2 trillion from the existing E400bn, and the introduction of a pan-eurozone bond which would allow the ECB to manage the debt crisis in a blanket rather than piecemeal fashion, mimicking the manipulation the Fed is able to achieve with US bonds. Those with a less rosy tint in their glasses have nevertheless been more pragmatic.

In the case of the EFSF, the parliaments of all EU member nations would have to agree and those with the means would have to chip in. The bulk of the responsibility would fall to Germany, and German taxpayers are already fed up with bailing out Club Med. In the case of the eurobond, it would require sixteen member nations to overcome thousands of years of hatred and agree to let an appointed, representative super-committee to unilaterally control their sovereignty. 

Yeah right. Think of it this way: What if say Australia, New Zealand, Indonesia and PNG got together to form a trading bloc, a common currency and current accounts controlled by one appointed body, the presidency of which one presumes would rotate? Can't see it? There will never be a eurobond.

At least there will never be a eurobond until the eurozone is actually homogenous. Merkozy took one small step towards homogeneity last night when they declared a desire to coordinate the fiscal policies (corporate tax rates etc) of Germany and France. The leadership group seemed to be potentially throwing down the gauntlet to the rest of the zone – get on board or get out of the way.

But this was peripheral. What Merkozy more importantly announced was that there would be no eurobond, and what's more that the EFSF was “sufficient” for now. And just to top things off they threw in a desire to introduce a European financial transactions tax.

The Dow fell 190 points on this news. The EFSF is sufficient? It's never going to cover Spain and Italy!

Yet those with less a rosy tint again saw an opportunity. Right now, the yields on Spanish and Italian debt are much lower than they were before the ECB stepped in to buy. A eurobond was never an option, and an increase in the EFSF to E2trn always seemed beyond the realms. And there is a growing mantra on Wall Street now (mirrored in Australia): value is on offer; dividend yields are very attractive compared to Treasury yields; ignore the noise of short-term panic and look at the long-term picture.

The Dow then wobbled its way up to its closing level.

As we go into tonight's session in Europe, which missed Merkozy's announcement, there is a fear on Wall Street that the bond vigilantes will be back hitting Spanish and Italian debt. We know that nothing ever happens quickly in Europe, politically, so we may yet be in for a rough ride for a while. On the flipside, Friday night sees an option expiry in the US and there are very big positions at 1200 in the S&P 500 which market-makers would like to protect.

On the matter of a financial transactions tax, it was considered in the US as one of the post-GFC suggestions and was quickly dismissed. For one, it would kill off high frequency trading. Like it or loathe it, HFT is currently providing the bulk of market liquidity (and probably a lot of unnecessary volatility). And in today's world of dual listings and global electronic markets, a financial transactions tax would need to be implemented world-wide, not just in one region. It didn't stop shares in NYSE Euronext falling 11% last night.

The main recipient of the disappointment generated by Merkozy was once again gold, which jumped US20.50 to US$1786.70/oz. Next came US bonds, and the ten-year yield fell 10bps to 2.22%. But it appears that the latest fad of using the Swiss franc as a safe haven is now over, given staunch threats of intervention from Swiss officials. The US dollar index ticked up slightly to 73.98.

Commodities were generally weaker on the European news (which included the weaker GDP), with metals other than nickel falling 1-2% in London. Brent crude was down US44c to US$109.47/bbl and West Texas was down US73c to US$87.15/bbl.

The Aussie is 0.2% lower in 24 hours at US$1.0484 and the SPI Overnight fell 4 points, having already ignored Wall Street yesterday, and not much liked Westpac's ((WBC)) result.

With the S&P falling 1.0% last night, one can honestly suggest it could have been a lot worse. We will need to see how eurozone bond markets react tonight but perhaps the world is starting to feel that last week's action was all a bit overdone.

The big names reporting earnings today in Australia include Boral ((BLD)), Brambles ((BXB)), CSL ((CSL)) and Woodside ((WPL)). 

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