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Overnight, European and US equity markets managed to hold onto Friday’s large gains which is an important sign that we may have reached a significant turning point. The “risk off” trade is clearly unwinding with the VIX falling below 17 for the first since the onset of the correction in early May. I have highlighted “correction” because whilst many a few weeks ago were acting like we were in the midst of a new bear market, many stock market indices such as Australia, the US, and the S&P500 have fallen by less than 10% from the peak highs that were set back in April. 

Technically a stock market index has to fall by at least 20% to be labelled a bear market. And to place this in context following the onset of the GFC in 2008, stock markets did enter brief bear market phases in 2010 and 2011 (which corresponded with the VIX reaching 50 on both occasions). And then there was the major bear market that occurred in 2008 when most stock market indices lost up to 50% to 60% and the VIX maxed out at around 90 – which was an historical record. 

The falls this year have been very subdued by comparison, but the sentiment and pessimism in my opinion, have been on a par, perhaps even worse than that witnessed in previous years. We are of the opinion that the corrective phases that have occurred each year since the GFC, are the equivalent of aftershocks occurring after the main “earthquake”. Not to discount present day issues in Europe, the US and China, but I see markets continuing to climb a wall of worry for the next few years, but with the indices moving higher. 

The rogue wave or secondary crash that many experts and economists are forecasting will occur in the future may well prove to be an ‘illusive mirage’. Markets have been conditioned to expect a pessimistic, bearish scenario playing out and this has lead to stocks becoming extremely cheap and bonds overvalued.For the value investor, today’s environment is robust in that the quality companies with top line revenue growth, sound business models are easier find – and cheaper to buy. These are challenging times but therein lies the opportunity for those prepared to face the widely pervasive fear.

 Monday’s pause was constructive in my view as investors continued to reflect on the positive action taken in Europe. Whilst not delivering everything that Europe needs, the summit was definitely a step in the right direction and provided the first evidence of a Germany now willing to compromise. Self preservation is a powerful motivation and Germany has but few options in my view but to shoulder more responsibility and take the necessary steps if the euro is to be preserved. 

Key bourses in Europe were all up by at least 1.25% on Monday with many pushing up towards two month highs. The Euro Stoxx index has rallied sharply since early July, and remains well above the lows seen in 2009 and 2011 – and this is yet again more evidence that Europe and the global economy are not about to fall into the abyss. 

Tensions in the euro bond market are also dissipating, with Italian 2 year bonds firming in price again as two year yields fell to a 7 week low of 3.26%. It was also telling that the cost of insuring against default on European corporate and sovereign debt fell to the lowest in two months. 

The US indices recovered back to par after losing ground intraday on weaker than expected manufacturing data. However the pervading optimism that EU leaders remain on the right track would appear to be dominating sentiment currently. 

The conflicting data on the state of the US economy was in evidence again today with the Institute for Supply Management’s manufacturing index falling to 49.7 in June, showing contraction for the first time in almost three years and trailing the median economist estimate of 52. Again if anything providing further evidence that the Fed will need to provide a bias towards loosening. Perhaps this is what the chart below is telling us… 

The Dow appears ready to test key resistance at the 12,900 level, but probably after a mild short term corrective sell off. Support is at 12,600 and I expect this level to be heavily defended on the downside. A break through the upper resistance band could see further gains towards 13,200 over the following six months. 

Although America’s latest manufacturing data was disappointing, factory output in Europe topped initial forecasts as did that in China where the PMI fell to 50.2 in June from 50.4 in May, however that exceeded a 49.9 median estimate. Japan’s Tankan index of large manufacturers’ sentiment also surpassed forecasts – which was surprising given this year’s strength in the yen. 

After being the butt of negativity of late however it is no surprise that optimism is being underpinned by developments in Europe. With the EU Summit done and dusted, attention will now turn to the meeting of the European Central Bank this Thursday. EU leaders will certainly be looking for some follow through on the rescue measures agreed last week and I would not be surprised to see the ECB cut rates this week. Historically the central bank action has tended to respond in lockstep following any progress at the political level. 

Certainly there remains cause for immediate action following recent data. The jobless rate in Europe has ticked up to 11.1 percent in May from 11 percent in April, according to the European Union’s statistics office. Unemployment climbed to 17.561 million people in May, an increase of 88,000 from the previous month. Spain’s unemployment rate, the steepest in the EU, increased to 24.6 percent from 24.3 percent a month earlier. 

And employment statistics will also be the focus across the Atlantic. Friday’s employment release will be keenly watched to see whether the US can muster material job additions. The previous two months additions have come in at less than 100,000, and a number above this level is needed to boost confidence in the recovery. A minor increase will no doubt boost the prospects for action on the QE front, and the FOMC meeting in late July will increasingly be focal point for markets over the next few weeks.. 

Talking Turkey 

The financial world is full of acronyms. Having coined the term ‘BRIC’ Goldman Sachs’ Jim O’Neil has more recently identified Mexico, Indonesia, South Korea, and Turkey as the MIST economies – the rising stars and next generation of high growth economies. 

However today Turkey – the fastest growing economy in Europe last year, the second fastest globally – showed signs that it may be approaching ‘soft landing’ territory. GDP for this year’s first quarter came in at 3.2%, a far cry from the 11% of last year’s first quarter.

One swallow does not make a summer though and Turkey’s plight is not unexpected. In fact it topped analyst expectations and the nation’s decade long economic boom remains firmly intact… for now at least. 

The Istanbul 100 index 

In a climate of downgrades, it makes a refreshing change to see Moody’s recently raise Turkey’s national credit rating to Ba1, strengthening the country’s position as an emerging financial power. In addition, the country has improved it public debt position which now sits at around 40% of GDP, significantly lower than the 70% of 2002. 

What’s more, Turkey’s population is young and growing; currently 75 million, the United Nations estimates that it will reach 92 million by 2050. And although income per head has tripled in less than a decade – to around US$10,000 – the Turkish are still playing catch up with the Western world. 

Having said all that, risk is never far away from high growth. 

The nation’s dependence on Europe meant that they joined Spain and Italy in cheering the outcome of last week’s summit. Nearly half of Turkey’s exports go to the EU, three quarters of Foreign Direct Investment comes from Europe and three quarters of the country’s tourists come from Europe. 

Turkey’s current account deficit has also attracted unwanted attention. In 2011 it averaged 10% of GDP, second only to America’s. Given that much of this is due to a significant energy bill, our bullish view on commodities prices places a great deal of importance on the country’s exports going forward. 

With inflation higher than most of its emerging-market peers, Turkey is facing a pivotal year. Our preference from the MIST group is South Korea, however we will be watching how Turkey overcomes it prevailing challenges with great interest.

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