Calamatta Cuschieri Market Review 17 May 2013

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1 Eurozone Yields on core European government bonds decline during the weak as economic data continued to disappoint. GDP data for Q1 came in on the weak side of expectations. Adverse weather conditions could have played a role, worsening the already sluggish underlying trend in domestic demand. The problem, however, is that the typically reliable leading indicators continue to point towards the same trend in Q2. The flash PMIs and the German Ifo for May next week are unlikely to change market consensus, with both indicators expected to be broadly in line with their April reading, consistent with a continued contraction in euro-area GDP. Negative data combined with lower-than-expected inflation continue to portray trends which will increase the pressure on the ECB to ease monetary conditions. The route of more unconventional monetary-policy measures hinted at by ECB s Mario Draghi at the last ECB press conference, may prove challenging. Direct purchases would leave the ECB s balance sheet susceptible to credit risk and probably face prohibitions by a number of influential members of the board. Other alternatives, like the direct involvement of the EIB, are more likely. Against this backdrop, leading market analysts expect another cut in the ECB s refinancing rate at the July meeting. A negative deposit rate also looks an increasing possibility. While such a course of action would have microeconomic disadvantages for many core countries, it may still be preferable to balance-sheet expansion as a macroeconomic tool. Ddevelopments on inflation hold the key to ECB policy. The sharp deceleration of inflation in April was instrumental in the decision to cut rates at the May meeting. Meanwhile, German Chancellor Angela Merkel noted in a panel discussion in Berlin earlier on this week that the "EU must remain open to Treaty change" and has to "move forward on banking union". She noted that coordination of national economic policies "on investment, labour costs and many other things" is essential for the euro's survival. On budgetary consolidation, she stressed the need for cuts in the size of state-controlled economies, but highlighted that the stability pact allowed for some deficit leeway. In a similar tone, German Finance Minister Wolfgang Schäuble called on France and Germany to cooperate closely, noting that it was "difficult for France to enforce economic reform". EU Commission President Jose Manuel Barroso commented that Germany must contribute to rebalancing the euro area and has scope for market liberalisation stressing that while Europe should tackle youth unemployment, it should also maintain its focus on budgetary consolidation. Elsewhere, in Italy, the Cabinet meeting scheduled for 17 May will decide on the budget bill. The suspension of the June instalment of the property tax on primary residences will likely be included in the new draft bill, according to several press reports, as requested by the centre-right coalition party PdL. The suspension will leave more time for a re-assessment of the much-hated property tax later in the year, government officials said. PM Enrico Letta re-affirmed yesterday Italy is not going to give up on its fiscal targets and that Italy does not intend to finance growth by issuing additional debt. US In the US, economic data releases too were nothing to ride home about as manufacturing indicators indicated that the manufacturing sector is currently in modest contraction, while inflation continues to slow; inflation in April fell to 1.1% y-o-y from 1.5%. In this context, concerns over an imminent narrowing of bond purchases by the Fed are overdone, with the market expecting that a slowdown in the pace of bond purchases will be announced only in December, to start next year. Despite this, the market reaction to an article over last weekend in the Wall Street Journal over the weekend, which focused on the Fed s need to keep flexibility to alter its monthly pace of purchases as it sees fit, highlights how tricky it will be for the Fed to manage the exit and how important an effective communications strategy will be in this phase. Next week will see Fed communications in action, with a Tuesday speech from New York Fed President William Dudley, testimony before the Congressional Joint Economic Committee on the economic outlook from

2 Fed Chairman Ben Bernanke on Wednesday, along with the minutes of the May FOMC meeting. All three are expected to emphasise that an eventual cutback is not a tightening of policy but rather easing. The FOMC remains committed to defending its 2% inflation objective on both sides that is, against either too high or too low inflation. The recent decline in core inflation has been pronounced. At the very least, the slowdown appears to contradict any near-term concerns that inflation is accelerating. Instead, it appears to signal that consumer demand for goods and services remains weak, limiting the ability of businesses to raise prices. Forex Following a small correction in late April, the USD is rallying and seems to have rebounded considerably. This rally might lose steam in the short term, but recent moves confirm the outlook; dollar gains will be far bigger in H2, as the Fed exit debate heats up. Risk conditions overall are still positive; however, there is a great degree of differentiation among asset classes. Despite this, the FX seems to have become disconnected from the pure risk-on/risk-off conditions, as the dollar is now doing well in a risk-on environment, and that is mostly because investors can perceive the divergence of monetary policies that is coming up. Overall, central banks have been instrumental in keeping risk sentiment up, especially as far as equities and credit are concerned. The main driver has been the improvement in US data, starting with the Non-Farm Payrolls report on 3 May, following a poor run. The Fed seems to have concluded that the low yields offered a good opportunity to test the market It is too early to position for an aggressive change of tone from the Fed. It seems that the Fed has just checked the market and seen that managing a smooth exit will not be as easy as expected. Still, the market will be eagerly waiting for the June FOMC and that should keep the dollar supported. The Fed is then expected to trim QE in the autumn, before ending the programme by late 2013, with the dollar expected to remain well supported by the end of the year Corporate Credit The rally in credit markets seems to have stalled somewhat this week, with credit spreads correcting moderately wider as primary markets re-opened. European markets also had to digest the sharp price falls in Co-Operative Bank s debt following a six-notch downgrade by Moody s towards the end of the previous week. Moody s downgrade Co-Op Bank s rating late last week, cutting the bank by six notches on the basis of a large capital hole and limited options to raise equity. Combined with the resignation of Co-Op Bank s CEO, sub bonds prices fell sharply. Lower Tier 2 bonds fell by points, while senior debt dropped by a more modest 7 points. The extremely volatile price action around Co-Op Bank and the lack of spill over into other names coupled with the contained reaction to the three-notch downgrade of Banca Monte Dei Paschi, ties in line with the view that credit selection will be a significant generator of alpha this year, more than ever before. Meanwhile, this quarter s earnings have been mixed in Europe, with underlying growth weak but not significantly worse than analysts expectations. Overall, only ca. 5% of companies missed consensus on both sales and EBITDA, with almost all companies posting numbers in line with or better than analyst forecasts as results have been mixed among non-financials. While some companies came in ahead of consensus expectations and management s previous guidance, several others failed to make progress towards executing their disposals targets and generating positive cash flows. This is not surprising given the depressed economic backdrop in Europe, which has now been in recession for six consecutive quarters. In contrast, financials earnings were generally stronger than analysts' expectations, with several peripherals banks returning to profitability as they posted significant improvements versus Q (a quarter in which several made particularly large Non Performing Loans provisions). In fact, 79% of financials beat earnings estimates with only 21% missing estimates.

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