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Equity markets correlate to sovereign crisis

Euromoney Skew takes a look at the equity markets and finds out that the market is not out of sync with the government bond crisis, as it first appears to be.

Credit analysts don’t get the stock market.

Yesterday (Monday November 28), the S&P 500 closed 2.92% higher, the Eurostoxx 50 was up an impressive 5.23%, and the FTSE 100 index rose 2.87%. Meanwhile the Nikkei 225 was up 2.30% on Tuesday morning.

These stock market rises came even as the OECD issued a bleak outlook for the euro area, projecting two quarters of GDP decline. Its forecast for 0.2% growth in 2012 still looks too optimistic to many bank economists who were busily revising down their forecasts for the European economy in 2012 even further. Deutsche Bank, for example, cut its 2012 euro area GDP forecast from +0.4% to -0.5%.

Moody’s Investor service warned yesterday that the continued rapid escalation of the euro area sovereign and banking credit crisis is threatening the credit standing of all European sovereigns.

Even the ratings agency’s positive case for Europe, which envisages a resolution of the crisis before serial and disorderly sovereign defaults, sounds painful. 

“The rating agency notes that the political impetus to implement an effective resolution plan may only emerge after a series of shocks, which may lead to more countries losing access to market funding for a sustained period and requiring a support programme. This would very likely cause those countries' ratings to be moved into speculative grade.”

And the likelihood of a far worse outcome is increasing by the day. 

“The probability of multiple defaults (in addition to Greece's private sector involvement programme) by euro area countries is no longer negligible. In Moody's view, the longer the liquidity crisis continues, the more rapidly the probability of defaults will continue to rise.”

That would likely lead to one or more countries leaving the euro. So, a strange day for a stock market rally, then? 

“It’s just surreal,” one of the market’s leading credit strategists says. “On one side of the room you hear the government traders saying the third biggest government bond market in the world is now trading on risk of default and some of the European government bond markets are closing down. On the other side of the room, equity markets rally. Certainly equity investors can take some comfort from the strength of corporate balance sheets and they have money to put to work, but you have to wonder if equity investors just caught in the headlights.”

But maybe the equity markets are not so disengaged from the awful reality unfolding in the government bond markets.

While equity markets did not fall in absolute price terms over the summer, even as government bond markets collapsed, they failed to rise on strong earnings, especially in the US but also in Europe, and on record margins.

European PE multiple is driven by sovereign risk (Sov-X) 
Source: UBS, Reuters 

Day-to-day equity market volatility no doubt reflects hopes and fears over whether Europe comes so close to disaster that politicians finally come up with a resolute response. The equity market is trying to price in a small-to-moderate risk of a catastrophic outcome and not managing that task very well.

Daily volatility may not exactly mimic the ups and downs of government bonds but the correlation is closer than first appears.

Nick Nelson, equity strategist at UBS points to the rise in yields of the SovX index since October 2009, with the fall in the 12-month forward price earnings ratio on the DJ Stoxx 600. 

“The correlation is quite high at around 0.85.” He says: “Margins have been at 30 year highs; corporates are benefiting from flexible labour markets and working arrangements; and even with a recession next year in Europe we don’t expect earnings to fall because more than half their revenues come form outside Europe.”

When equity P/E ratios fell from around 15 to 10 as yields on the Western Europe SovX rose from around 80bp to over 300bp, even as margins and earnings did so well, that was equity markets panicking. Absolute equity prices held steady and barely moved...but that didn’t tell the story.

- Euromoney Skew Blog

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