EDRG: The problems are so large and entangled

US retail sales in September rose 1.1% and industrial production was up 0.2% with manufacturing rising 0.4%. This still suggests that the second half of the year should be better than the first. It is the same story with the Philly Fed which was at 8.7 in October after -17.5 in September and -30.7 in August. New orders were up sharply (+7.8 vs. -11.3).
All Chinese data over the past two weeks has pointed to continued growth (GDP rose 9.1%) while restrictive monetary policy is still weighing on new lending. Inflation edged down to 6.1% compared to 6.2% in the previous month but food prices are keeping it high and it is unlikely that the Pock will change tack over the short term.

EUROPE
European markets paused for breath after the rebound at the beginning of October. Even so, political and economic uncertainty persists, each feeding off the other. Germany and France made a big fuss about the October 23 summit which got hopes up of a big move. There then followed the usual government denials and the outcome of the meeting is now in doubt.

Such a climate hardly encourages rating agencies to be understanding. Consequently, Moody’s downgraded Spain by two notches and put France under watch. This means a sword of Damocles is hanging over any banking recapitalisation plans or moves to leverage the EFSF. S&P, meanwhile, said it would downgrade peripheral countries and France in the event of a recession in the euro zone. This seems likely to occur given the macroeconomic data. The only good news for Europe’s leaders ir that initial estimates of the capital shortfall in the banking sector are around EUR 70-90bn and not the 200bn mentioned previously.

In company news, the first Q3 results were upbeat but came with profit warnings. Temenos has sharply reduced guidance on sales and margins and Infineon signalled a slowdown in growth resulting in a lacklustre quarter and expectations of a drop in the 4th quarter. Sampo also disappointed due to its 21% stake in Nordea and a provision in its insurance business.

The slowdown is starting to have an effect and taking some companies by surprise. Schneider says growth is slowing in Western Europe and has lowered its operating margin target from 15% to 14% due to a negative mix (weakness in Europe and the growing contribution of its Solutions division which has lower margins), inflationary pressure in the emerging zone and higher restructuring charges. Safran (plane equipment) disappointed the market due to spare parts sales only rising 4%. Advertising agency Publicis posted solid results but the company is cautious for the 4th quarter.

BIC’s sales of lighters and razors are still robust but the company is seeing more competition in stationery in the US and in its Advertising and Promotional products divisions. Gemalto reaffirmed its 2011 targets but lower sales in mobile phones still disappointed the market. In hotels, investors were reassured when Accor said it saw no slowdown.

Many other companies are also seeing no slowdown. Diageo and Pernod Ricard saw organic growth of 9% and 11% respectively in Q3, a sign of strong growth in Asia (+15%) Remy Cointreau also posted 15% in organic growth due mainly to a 26.5% jump in Cognac sales with sterling performance in China. Danone’s mineral water division was up 8% due to Asia which largely compensated for poor weather in Europe and dairy product sales that were viewed as disappointing.

Nestlé beat expectations and has slightly revised up guidance for the full year even if the excessively high Swiss franc is a problem. Lastly, Edenred benefited from a 22% rise in Latin American sales.
In technology, SAP posted strong growth and high margins and guided analysts towards the top of the earnings range for 2011. In telecom equipment, Ericsson and Nokia had good results. Nokia in particular rallied on markets -after months of stock market misery- due to its upbeat performance in the terminals division and the impact of dual SIM phones.

US
US equity markets edged higher over the week on encouraging macroeconomic data and the sentiment that euro zone concerns were already factored into share prices, particularly in the financial sector. The Philly Fed index was much higher than expected while leading indicators were in line and up for the 5th time in a row. Elsewhere, confidence levels among US property developers returned to March 2010 highs.

The third quarter earnings seasons continued with results from Intel and Microsoft in line with expectations. But elsewhere in the tech sector, some semiconductor companies disappointed due to inventory adjustments and the impact of flooding in Thailand which hit hard disk drives in particular. Financials like Goldman Sachs and Bank of America posted relatively lacklustre figures but the market had largely discounted the drop. In healthcare, United Health andJohnson & Johnson beat expectations and revised up guidance for the full year.

Over the last 5 days, energy and financials led advances. Technology and materials fell back slightly.

JAPAN
Mostly mirroring day-to-day US stock moves, the Topix fell 0.3% in JPY and 1.3% in EUR. TSE1 daily average trade volume was the thinnest to date at JPY 949bn and would have been even lighter but for very heavy trading in Olympus.

Very narrow ranges between daily highs and lows might also mean investors preferred to stay on the sidelines. The JPY/USD edged up 0.2% while the JPY/EUR strengthened by 1.1%.

Olympus suddenly emerged into the limelight. It lost nearly half of its value in 4 days after firing CEO Michael C. Woodford who was only 6 months into the job. This triggered a slew of downgrades and even rating suspensions from analysts with high expectations he would make the endoscope giant into a truly global player. Mobile phone operators Softbank, DoCoMo and KDDI plunged 5% as the successful launches of the iPhone 4S ironically raised concerns that smartphone battles would intensify further. Nikon dropped by another 4% on worries the Thai flood was worsening and spreading damage to more than 400 Japanese local firms, namely auto, camera, and HDD-related makers. It may take at least a couple of months before they can resume production.

Murata Mfg (micro capacitors) supplies essential parts to Apple and surged 9% when sales of the new iPhone beat expectations. The property sector rose most with Sumitomo, Mitsui and Mitsubishi all gaining about 5% as the worst news in office rents and condo sales appeared behind them. Komatsu and Fanuc continued to rally, rising more than 4% despite increasing signs of slowing growth in China.

ASIA
It was a relatively stable week on Asian markets. China’s macroeconomic data was unsurprising and inflation really does seem to have peaked in August.

But tension is still mounting between China and the US. China’s ripostes have take various forms: 1) China Eastern Airlines and China Southern Airlines, two of the top three airlines in the country, have cancelled or postponed orders for Boeing planes 2) Several of Apple’s suppliers in China have suddenly been singled out and accused of pollution. A large Catcher factory making casings for phones and iPods has been forced to close. 3) Wal-Mart’s CEO in China has been abruptly sacked for the official reason that several of its supermarkets in the country had incorrectly labelled meat as organic produce. This is the sort of minor fraud that is common when a country is going through a retailing boom and does not warrant removing the CEO. But in the current climate, China’s authorities are sticking strictly to the rules as far as US companies are concerned.

Panasonic’s decision to stop producing televisions cheered rival stocks in Korea and Taiwan. Panasonic represents 32% of the global plasma flat screen market and this will now go mainly to SAMSUNG and LG in Korea. Note that this is a niche market and only represents 2.5% of the LCD TV market. Panasonic is also leaving this segment and closing two factories but the impact as more limited as it has less than 2.5% of the global LCD market. This will now be split between Korean and Taiwanese manufacturers.

This is another example of Japanese industry being beaten by South Korea on quality, costs and distribution networks.

Above it, it reflects the handicap of the very high JPY, up more than 7% against the won year to date.

A key trend in 2012 will be low cost smartphones. There is more and more talk of models priced at less than EUR 120.

The segment will see high growth in both mature and emerging countries. Top-end makers like Apple and Samsun should maintain market share due to brand strength and innovation but the rest of the market will see price competition and companies like Nokia, HTC and Motorola will have to adapt. Production chains will also need companies offering cheaper components. Mediatek, a large Taiwanese company with a EUR 10bn market cap which makes processors for cheap phones, looks well positioned to benefit from this. Investors know MEDIATEK well because of very strong growth in 2G a few years ago. It is now making the smartphone more democratic with clients like Lenovo and Motorola who are banking on cheaper chips which are just as good as those used by Apple and Samsung. The stock has performed very well over the last 2 months and we expect the trend to continue.

The economic impact of Thailand’s floods is still being underestimated in our view. Some key export sectors are starting to release forecasts and production volumes are seen falling as much as 50% in Q4 vs. Q3. Heading the list is autos, mainly Japanese makers, and technology. About 40% of some key components for laptops are made in Thailand. Sales will suffer in both segments.

OTHER EMERGING MARKETS
Around one third of Indian banks have announced results. They are satisfactory overall and the cost of credit is under control and only up a little. The big news of the week was National Housing Bank’s offer to standardise mortgage rates between existing and future loans while scrapping penalties over early reimbursements. As most banks already apply these principles, the impact should be limited if the suggestion is adopted.

Reliance Industries, India’s largest market cap, posted results in line with expectations despite refining margins that came in a little below consensus. On the other hand, margins in petrochemicals rose. Gas production continued downwards, falling to 45 MMSCD vs. 55 initially expected. This means higher imports of liquefied gas, good news for Petronet LNG which has doubled its profits.

So far, earnings growth is running at a satisfactory 17%. However, the main risk for the Indian market is still global contraction of bank liquidity. However, the domestic economy generates 88% of GDP. After tight monetary policy over the last 2 years, India has significant growth potential. We remain fundamentally optimistic on the market over the medium term.

The market went fell 2.56% in USD and Brazil’s currency depreciated by 1.70%. In the US we had mixed economic figures. Brazil’s central bank cut rates by 50bp to 11.50%. Furthermore, consumer price inflation (IPCA-15) moderated to 0.42% in October from 0.53% in September (below consensus). The yoy inflation measure fell for the first time in 14 month to a still high 7.12% from 7.33% in September. This week’s highlight was in the commodity market. Vale said iron ore prices would fall in Q4 due to weaker demand in Europe, which represents 20% of Vale’s volumes and a seasonal demand slowdown in China in Q4 2011 and Q1 2012. Vale believes iron ore prices will recover from the second quarter onwards. Its stock prices lost 12% on that news.

We also met Petrobras’s CEO this week. We estimate Petrobras could almost double its production in the long term. Over the short term, however, operating costs could rise more than expected due to higher refinery costs. All attention is now focused on Europe.

CONVERTIBLES
The Galp share and the exchangeable Parpublica Galp 5.25% 2017 bond jumped on news of an oil discovery off the coast of Mozambique by a consortium in which Galp owns 10%. The field should be producing 300,000 b/d by 2020. Alcatel was down on less optimistic analysts’ estimations of network infrastructure spending in the US. We nevertheless think Alcatel will meet is margin targets of at least 5% in 2011. The company is also in talks with Permira over the sale of Genesys which could fetch USD 1.5bn. Even if this only represents EUR 0.3 per share, it will help consolidate Alcatel’s balance sheet and allow it to deploy its pricing strategy. Sacyr’s CEO has been dismissed after a disagreement with the board. His departure should trigger the sale of 5-10% of the company’s stake in Repsol, probably to Pemex. That should help pay back a EUR 4.9bn loan and get better refinancing conditions. STMicroelectronics’ results beat its own targets. But the STEricsson joint venture is still loss-making. The company no longer gives guidance on the breakeven point but its statements suggest it could continue to supply components to Nokia and its future Microsoft smartphone. Despite the difficulties between Germany and France, convertibles have held up well. That is perhaps due to some new fixed maturity funds which have bolstered prices despite market turbulence. That is good news for us and we are taking advantage of it.

COMMODITIES
Each week brings its own surprises. Commodities fall sharply this week amid extreme risk aversion. Base metals (i.e. the most cyclical commodities) were particularly badly hit, losing close to 7%. And yet China’s economic data was not all that bad: growth is still high (9.1% in Q3), as is industrial production (+13.8%) and electricity production even accelerated to +10.7%, an indication that the economy is still on an upward trend. The market preferred to focus on the negatives like Angang (Steel, China) temporarily shutting down a blast furnace due to soft demand. Iron ore prices also fell sharply; BHP Billiton attributes this to lacklustre demand from European steel makers. ArcelorMittal is in fact thinking about idling a Polish blast furnace after stopping production for good in two facilities in Liège. Demand for commodities does seem to have entered a turbulent zone but we should remember that supply is still struggling to meet even reduced demand.

Freeport, for example, has halted operations in its Grasberg mine in Indonesia due to a very violent strike involving sabotage and even deaths during demonstrations. This is the world’s second largest copper mine producing 4% of global output and with every idle week, the shortfall is 8,000 tonnes of copper and 1 tonne of gold. Gold shed around 4% as the dollar rallied 1% against the EUR and investors sought liquidity. As in September, it would appear that this fall is due more to traders closing futures positions than to supply and demand fundamentals which are still upbeat. Agnico Eagle is to close its Goldex mine in Quebec (160,000 oz each year) due to an unstable load-bearing wall. This shows that markets may be focusing on precarious demand but supply is hardly stable either.

Oil also lost ground but is still rooted above USD 100 for Brent crude. PetroChina has confirmed that the country’s refining capacity should rise to 12.45 million b/d by 2015 to 14.5 million b/d by 2020. Current Chinese consumption is 10 million b/d so consumption is expected to rise by an annual 5% over the medium term.

Takeovers are still in vogue in natural resources: Norway’s oil company Statoil has acquired Brigham Exploration for USD 4.4bn or a 36% premium, New Gold has bought the junior company Silver Quest for USD 124m (a 52% premium), Rio Tinto has countered Cameco with a bid on the junior uranium producer Hathor and Poland’s KGHM Polska (copper and silver) says it is preparing to bid for a rival Canadian company in the very near future.

ASSET ALLOCATION
Markets are still in thrall to uncertainties over Europe, growth and sovereign debt. Between October 13 and 20, the major indices performed as follows in local currency:

– Standard&Poor’s 500 +1%
– Euro Stoxx 50 -2.6%
– TOPIX -1.7%
– MSCI Emerging markets -2.2% (in EUR)

Bond markets traded in narrow bands with yields losing a little over the period, 2.19% for US treasuries and 2.01% for the German Bund. In contrast, yields rose sharply in Spain to 5.5% and even 6% in Italy which is close to its August peak Forex markets were stable: the USD quoted 1.37 vs. the EUR, the JPY hovered around 77 and the RMB stabilised at about 6.38.

Ahead of the European summit, equity positions were largely unchanged in our portfolios. We focused on managing option expiry dates in our hedging strategies. They have made a significant contribution to performance in October due to low equity volatility. We traded currency hedges and dollar and sterling hedging in particular, within recent trading ranges.

Elsewhere, rising bond markets have benefited our sensitivity to interest rate risk on German bonds. EdR Europe Flexible: exposure fluctuated between 43% and 47%. Hedging through October options is still adding value to our hedging. Recent market consolidation has helped us to focus again on the DAX as a relative value play.

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