We remain dependant on European statements but what a difference a year makes. This time last year we saw softening economic data and increasingly poor news coming out of Europe. But then we had a diffident ECB president who had just finished a round of rate increases as Europe slumped. This time we have combative words from Mario Draghi to support the euro, apparently at all costs. There's some bluster in the remarks but what was interesting was admission that the transmission mechanism has broken. We have a two speed Europe: slow and reverse. And it doesn't matter whether markets embrace austerity (UK) or recessionary austerity (Italy and Spain); the results are the same with all three showing a 2% contraction in GDP.

Rates in Europe are also divided by the super low, deflationary yields on German bonds and the +7% rates in Spain, with Italy close behind. The other peripheral bond markets (Greece, Ireland and Portugal) are temporarily immunized through support packages. Liquidity within Europe is manageable. Bank lending is made grudgingly with much tighter credit standards. That's not making it easy for SMEs to access capital. Lending is way down.

So what does this mean? Some possible buying of peripheral debt by the ECB and other looser actions. But remember, as things stand, the ECB can not flat out buy and monetize debt (which means the bonds remain on the bank's balance sheet indefinitely). That leaves the ESM, which does not yet have the funding or leverage. But Draghi's comments may keep things in check and stop the routs. Signs are not healthy in Europe. Spain's housing market is down 20%, with more to follow, labor costs are down and unemployment at 25%, a new high. These are classic problems that QE solves. And to cap it, we saw a big dividend cut from Telefonica in Spain. Expect the market to remain very wary.

The markets are down 6% to 7% but there's nothing obvious to buy. The Bunds trade remains vulnerable both to a break-up and Germany supporting more rescue packages.

US: Still Mixed, Still Just OK
Clearer signals that the Fed will lean towards easing. The recent reports are mixed with some weaker regional Fed reports...Richmond Fed new orders were particularly slow...but slightly better claims numbers and encouraging housing signs. So the "will they, won't they" debate breaks down like this:

And what will they do? This gets interesting as one of the lines from the last FOMC meeting was a concern about disrupting the Treasury market. So the tools this time could be i) MBS purchases ii) extending the language beyond 2014 iii) changing the way the forecast are communicated, so there's less apparent board dissension iv) changes to IOER v) making access to cheaper funding conditional upon loan activity and vi) assigning outcomes to policy actions, which we have written about before and makes a lot of sense as it would stop the on/off reactions to QE measures.

There's also more open support for NGDP-type targets and for more inflation. While the 2% target is not about to disappear, the 10-year yield and the TIPS market are pointing unambiguously towards much lower inflation fears. And, deflation probably remains one of the Fed's greatest fears.

US Economic Data
Nearly all data show how rapidly we have lost momentum but we are not at the point where there's a negative feedback loop, which would mean lower spending, leading to lower employment, lower confidence and so on. GDP is still in positive territory and we have seen the pattern of a summer slowdown in both 2010 and 2011. The Q2 GDP numbers were in line with expectations. Business investment picked up over 7%, which was good to see after the expiration of last year's accelerated depreciation allowances, and inventories were a net contributor again after a Q1 run down. Government continued its downward path, cutting 0.3% from growth. Federal and state government has now been a net drag on the economy for nine out of the last ten quarters. Corporate profits remain high. Here they are against GDP:

Source: Federal Reserve Bank of St. Louis, Economic Research

Our concern is that this can not be much improved without more final demand.

We also had some very welcome comments from two regional Fed presidents suggesting that i) inflation was not a concern but ii) employment definitely was. John Williams of the San Francisco Fed may have had this in mind, which shows the natural, or non-accelerating rate of unemployment or, more prosaically, where unemployment can fall without raising inflation.

Source: Federal Reserve Bank of St. Louis, Economic Research

The answer? About another 3% from today's 8% level. Williams mentioned that there's "a lot more [the Fed] can buy without interfering in the market function" which was a forceful thumb bite to the school that believes that a quiet withdrawal of QE would be just fine. And his final word was that it was "essential [to] provide sufficient monetary accommodation to keep our economy moving forward." He gets it! I'm hopeful this is a stalking horse for more QE and hopefully the open ended kind which ties policy to an outcome.

Claims were also a brighter spot this week at about 30,000 better, which took down the four week moving average. The GDP revisions played a role here. Q4 2011 grew from an initial report of 2.8% to a final of 4.0%, which explains both why we saw better employment numbers in the first three months of the year and the GDP catch up with the GDI numbers.

Source: Federal Reserve Bank of St. Louis, Economic Research

Bonds
A very tactical market and we're seeing a new, lower yield range given the auctions, the focus on Europe and domestic data. Curves are flattening. That's a typical softening message. The range is now around 1.50% with a swing of 25bps either way.

What could send it lower? Any and all the usual grinds, so that's Greece, slower growth in Europe, lower inflation, a really bad NFP report and a possible unwind of the credit trade if the earnings season reveals much weakness.

So a very skeptical view of the market and treasuries remain our favorite "hot potato" investment...short holding periods on the super long duration treasuries of 8.9 for GT10 and 20.1 for GT30.

Equities
Earnings are not that great; about 60% of companies are beating on earnings but the same number are missing on sales, which is far more important. We have had pre-announcements, which cleared the way for some positive news and generally the market seems to have discounted the warnings about the remainder of the year. Some multinationals are missing bottom lines because FX. One thing to note is that we're at about the same levels as this time last year but sitting on top of higher earnings and thus lower valuations. That creates a solid underpin.

Bottom Line: The core story is the S&P[1] yielding 2.1% and with major pockets of large caps trading on 13x with increasing payouts. We've seen much more stability in large cap than mid and small this year: mid cap is + 5% and small cap +4%. The US remains one of the strongest equity markets YTD and they're gradually getting cheaper given steady earnings increases and an S&P level which is mostly unchanged from March 2011.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.

Sources: Bloomberg, Federal Reserve Bank of San Francisco, Bureau of Economic Analysis, High Frequency Economics, ISI, Federal Reserve Bank of Richmond, Federal Reserve Bank of Chicago, US Census Bureau, US Dept of Commerce, Capital Economics, European Central Bank, Federal Reserve Bank of St. Louis, Sentinel Asset Management, Inc.

(c) Sentinel Investments

www.sentinelinvestments.com

             
 

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