The “bearish consensus” was in deep trouble on Friday night with stock markets having the best month end rally for some months. Going into the European summit on Thursday, markets were extremely nervous and sceptical that a break through could be made on the Eurozone debt crisis. The bears believe that Friday’s upward dynamic will prove to be a short run event, and that the rally will quickly run out of steam.
We do need to see further follow through this week in both equity markets and gold, but I’m encouraged by the price action and in my view there is now a high probability of a further upward extension. Bonds are paying the lowest returns in history, and in response to the pervasive fear, market participants have moved to the sidelines and are sitting on substantial cash and liquidity. I think we will now see this liquidity begin to re-enter stock markets as those investors underweight equities rush to ‘up weight’ their equity portfolio settings.
With views very much polarised at extreme ends of the spectrum, the investor relief at the compromises reached at the Summit and Germany’s reversal on key policies caught many by surprise. Key European indices all rallied, with the broad EURO STOXX 50 up 4.96%. US markets followed suit with the DOW, S&P, and NASDAQ up 2.2%, 2.49% and 3% respectively. Commodities rose the most in 3 years with oil up nearly 10%. Gold was back above $1600.
The S&P 500 closed on its highs on Friday
As I highlighted on Friday the first major move coming from the Summit was agreement on a 120 billion-euro plan to stimulate growth. That was certainly a positive, but the stickier point to come was what decisions would be made on the bailouts of peripheral economies.
And the decision to ease loan terms for Spanish and Italian banks was a decisive clear signal here. Germany dropped the critical requirement that governments receive preferred-creditor status on crisis loans to Spain’s banks. This is key and paves the way to recapitalise lenders directly with bailout funds.
Also highly significant was the decision to set up a single banking supervisor, which means that the institutions can go direct rather than apply for aid through their (in some cases already debt laden) governments. The support of Germany was integral to this – so it was a relief to see the German parliament approve the creation of a permanent bailout fund on Friday.
Unsurprisingly, the upward dynamics in stock markets were mirrored in the bond markets with Spanish and Italian bonds yields falling sharply, whilst the euro had its biggest upward move this year, hitting 1.2667.
Yields on Italian bonds dropped sharply to finish at 5.79%.
Spanish 10 year debt closed at 6.25%, well below the critical 7% level .
A few days ago, many were forecasting that a Eurodollar test of the 1.20 level was imminent. The latest price action may now call into question that scenario.
Many will certainly have slept better over the weekend with European Union President Herman Van Rompuy calling the accord a “breakthrough”, having “addressed the issues on the seniority of Spanish loans”.
I certainly think the Summit answered many questions, but it is still clear that we are not out of the woods, and that many challenges remain in the European rescue plan.
However, when have equity markets not climbed the “wall of worry”?
The ASX200 still has some way to go to reclaim the losses sustained in May and June, but we can expect a big rally today. The futures are indicating gains of around 50 points, but I think we will see at least 80 today.
The ASX200 should test upper resistance at 4140 today.
The overwhelming positive is that heads are firmly out of the sand on the issues being faced, and that consultation is occurring, and compromises being made. The key now is how effective the plan is, and what happens at the next stumbling block.
With all the attention focussed on Europe it was easy to miss that there was some positivity coming out of the US as well. The Institute for Supply Management-Chicago Inc. showed business activity expanded in June at a faster pace than expected. Together with last week’s better than expected rise in durable goods orders in May, this will alleviate some concerns on the US manufacturing recovery.
Also boosting the price of oil was the ongoing deadlock in negotiations over Iran’s uranium enrichment program. EU sanctions against Iran come into full force today, and no doubt will maintain tension on the oil price in the coming months, but I continue to believe that an oil price spike this year before the US election is remote.
Gold had a good upward dynamic, closing at $1600 but we will need further follow through price action before a line can be ruled under the correction that began back in March last year. In terms of price action, gold is trading within a converging triangle range and we can expect a breakout in the next few weeks. The bounce of the lower boundary on Friday was encouraging.
Lastly, the VIX declined by 13 percent on Friday, which is another clear sign in my opinion, that markets had become too extreme. In 2010 and 2011, volatility increased to around 50 on both occasions. This year, the highest level we have seen so far is 28. The breakout that occurred a few months ago is now in danger and the VIX is breaking down, indicating that fear and tensions are beginning to subside.
This will be supportive of our bullish case scenario that equity markets will finish sharply higher running into the end of the year.
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