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Markets update

Lothar Mentel - 17 January 2011

Wednesday’s auction of Portuguese debt gave us further indications that the sovereign debt crisis, although not going away any time soon, will continue to be managed in order to prevent a Europe-wide collapse. Not only was it important for Portugal’s bond auction to be well subscribed, it was vital that the interest rate to be paid on the debt was kept below the 7% level. 

If the auction went badly, and the interest rate was forced above that level, then Portugal could find itself in a debt spiral similar to that experienced by Greece and Ireland, making an emergency bailout unavoidable. Bond market investors would then be able to make a killing by short-selling Portuguese debt, before turning their attention towards Spain and attempting to do something similar. Spain has become the piece on the international chessboard that needs to be protected at all costs. It is the EU member considered both too big to be allowed to fail and potentially too expensive to rescue. 

Fortunately, the auction ended relatively successfully, with Portugal able to sell more than €1.2 billion in longer term debt, whilst keeping the interest rate to be paid at a slightly more manageable 6.71%, “not only acceptable but, in the current climate, favourable”, according to Portugal’s finance minister.

Portugal is not out of the woods, of course. Its borrowing costs are still worryingly high and for many analysts it is still a case of ‘when’ rather than ‘if’ Portugal will have to resort to asking for bailout funds. What made this auction successful, along with further bond auctions held later in the week by Spain and Italy, was the support of overseas investors. Roughly 80% of the demand for Portuguese debt is believed to have been from foreign buyers. Last week China waded in with its support for Eurozone debt (particularly Spain’s), and earlier this week we heard encouraging noises from Japan that it would be willing to purchase more than a fifth of the bonds due to be issued by the European Financial Stability Facility next week. International support is clearly positive for the Eurozone countries, but it doesn’t come without ulterior motives. It also points towards a desire by the Japanese to establish international funding support structures between itself and other sovereign debt-issuing nations. Given that Japan has quite a debt mountain of its own (its debt to GDP ratio is 200 percent), one can understand why they might consider this a priority.

Once Europe’s bond auctions were out of the way attention could be turned towards the beginnings of the US results season. Aluminium industry leader Alcoa traditionally kicks off, and sentiment was lifted by its results, which beat Wall Street estimates. Good numbers from Alcoa have, in the past, been seen as a positive signal for the entire earnings season.  We were more interested in Intel’s results, however, which came as a pleasant surprise. Intel has recently been suffering from weaker consumer spending and also losing market share in the mobile devices (smartphones and tablets) markets, but it was able to report strong consensus-beating growth almost entirely from increased sales in the business end of the market. This was just the sort of signal we had hoped for, since it demonstrates that the economic recovery is now more broadly based, and that corporate spending cycles have turned the corner.

Just two weeks into the year and already the themes likely to preoccupy markets throughout the rest of the year are emerging. On the one hand, inflation worries and sovereign debt concerns are still putting a damper on market sentiment, although it appears that with each mini crisis averted, the shock value (and market reaction) is less and less. On the other, there are clear signs that many companies are doing well, generating good profits and increasing market share. Importantly for us, we are seeing greater differentiation, so from a stockpicking perspective it is getting easier to make a distinction between the good companies and the not so good.  If you believe, as we do, that the macro worries are not insurmountable, then this is a good time to invest.

Lothar Mentel, 14 January 2011

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