CAP AM REPORT

The success so far of this US earnings season (Apple yesterday and Morgan Stanley and Wells Fargo last night) gave a boost to European equities, with the major indices up 0.4 to 1.5%. The same can’t be said for the US though, highlighting the widening chasm between the real economy and financial market sentiment. A perfect example of this disparity came from three large US manufacturers who not only revealed better-than-expected Q2 results, but showed order books that dispel the idea of a double dip. One company stating that “the worst is behind us”.

At its height though, the S&P could only manage a 0.5% lift and actually finished 1.3% lower (1069). Most of the damage was done after Bernanke’s testimony to the US Senate Banking Committee (the S&P fell 1% immediately after). Now realistically there was nothing new in what he said.

We only got the FOMC minutes about a week ago and there wasn’t much of a departure from that. “Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth”. This is why the Fed is forecasting growth, healthy growth of 3-3.5% in 2010 and 3.5-4.5% in 2011 and 2012. These are upbeat growth forecasts there is no question of that and the Fed remains optimistic on the recovery.

The major difference between forecasts now and a few months ago concerns the assessment of risks - with most Fed participants seeing the more risks to the downside. Now the reason for that is due to deteriorating financial conditions and in particular “concerns about the ability of Greece and number of other euro-area countries to manage blah blah blah…” Again we are faced with this circularity. Notice what the Fed isn’t saying though.

The Fed isn’t saying that the withdrawal of fiscal stimulus is the key threat to growth. Notice that the Fed isn’t intrinsically worried, or more worried by the outlook. Basically what the Fed, and our own RBA are saying (and a point I have made repeatedly) is that biggest threat to growth is financial market sentiment. This is why they are more worried about growth now and this is the circularity. It is for this reason they were talking about having a plan to provide further stimulus if necessary. Not because a handful of growth indictors have been volatile or failed to beat expectations etc. But because financial markets are panicky – sentiment erratic. If they could take financial markets out of the equation, I suspect the Fed’s growth assessment would be much more upbeat. The longer this goes on though, the greater the chance of even more regulation.

Now the damage on the S&P was broad-based, all sectors were down although consumer services, financials and healthcare were the key underperformers. The Dow was otherwise off 131pts to 10120, the Nasdaq fell 1.6% (2187) and the SPI fell 1.2% (4347).

Somehow euro lost its safe haven status last night and greenbacks rallied, despite growth fears over the US. I love FX. We saw some sizeable moves in Europe with eur and sterling down over a big figure to 1.2761 and 1.5166 (as BoE minutes showed the MPC discussed further QE). AUD fell 33pips to 0.8786 and Yen sits at 87.05 (virtually unchanged). Under that scenario the bounce in copper was remarkable (+2.3% in New York and on higher-than-expected copper sales from Freeport) although that didn’t really extend to other commodities – crude down 1.5% ($76.4) and gold down $7 to $1185.

Needless to say, US treasuries rallied, although on light volumes and trading ranges again were comparatively narrow. At the close the 2yr yield was down 2bp to 0.56%, the 5yr was down 5bp to 1.64% and the 10yr fell 7bp to 2.88%. Aussie futures ended about 3 ticks higher (on a 8-9tick range) - 95.31 on the 3s and 94.84 on the 10s.

So the next big test for market sentiment is the European stress tests on Friday. Now clearly no one rally knows the situation here, how bad banks nor how the market will respond. Unfortunately some commentary is already trying to set these tests up for failure. If ‘not enough’ banks fail the tests they will be deemed implausible supposedly. But that’s obviously a catch 22. Because if ‘enough’ banks fail, that will of course be used as proof that the European financial system is insolvent at worst, or extremely fragile at best and the tests will be discredited anyway. Very Faustian apparently. Except that it isn’t. You see no matter how hard pessimists try, the idea that regulators must fail a certain number of banks to satisfy some credibility criteria is ludicrous.

To do so would merely justify some of the more extreme arguments regarding European financial solvency (or the lack thereof). For some, there simply can never be enough banks that fail the test. To try and appease these people would achieve little, given the proponents simply will not accept anything other than Armageddon. The conceit is palpable. The European financial system is insolvent and anything else will lack credibility in their eyes.

My guess is, and I don’t think I’m being controversial here, is that at worst we’re going to see some capital raising. But as we also know, this won’t be an issue for an economy that as a whole, is in a much better financial position than the US. Whatever the arguments, these tests are in fact credible. The Europeans enjoy very high rates of private saving generally, a much better fiscal position than the US, and a much better current account position. What won’t be credible is if some commentators turn against Europe’s results having embraced the US stress tests. On that score we got a further detail last night. Apparently the Europeans will assume three scenarios – benchmark growth, an adverse scenario and sovereign shock. Although note that the sovereign shock scenario doesn’t include default. Give the situation with Greece etc I think this assumption is more than credible. The Europeans demonstrated their commitment to the euro zone, Greece hasn’t defaulted and so there is no reason to assume this as a scenario. It would be unrealistic to do so given the consequence of any default would be the disintegration of the euro zone.

Bits and pieces otherwise. US mortgage applications rose 7.6% in the week to July 16 with refis up 8.6% and purchases up 3.4% and Obama signed the US financial reform bill into law.

Nothing much in Australia today and in NZ we only get ANZ’s consumer confidence measure at 1pm (oz time). Tonight check out (but don’t panic over) the EC PMIs. UK retail sales are out as US jobless claims and existing home sales.

Finally, don’t forget Market Rock tonight.

This is the seventh year in row the Australian money markets will gather together at The Basement in Circular Quay. It’s a battle of the bands financial market style and includes aspiring rockers from institutions such as ICAP, CBA, ANZ, CITIBANK, ABERDEEN ASSET MANAGEMENT, MF GLOBAL,BANK OF SCOTLAND etc etc.

ICAP organiser and seasoned rocker Victor Gugger, says” it is easily the most fun and best attended night on the financial markets social calendar. Market participants love to come along and let their hair down (if they have any left) and listen to their mates deliver classic covers from the 70's and 80's. Every now and then something special happens - such as an explosive tin whistle solo by the ANZ Head of global markets during a version of the classic rock track “Wild Thing" a few years back...”

A guaranteed good time for all.....

Have a great day…