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One Minute to Midnight: Central Bankers to the Rescue
July 30, 2012

The circle of investor negativity was broken in dramatic fashion late last week as despondency gave way to euphoria, as investors scrambled to cover their shorts after comments by Mario Draghi, the President of the European Central Bank in strong support of the euro. With a few well-chosen words by both Draghi and Bernanke, the financial world’s two most important policy makers, markets surged giving the Standard & Poor’s 500 Index the longest rally since March, amid optimism that Europe’s leaders will act to ease the region’s debt crisis.

With the clock ticking down to one minute to midnight, Draghi acted to avoid further panic selling of European debt in this ever-widening crisis. Draghi appears to have come to the conclusion that low policy rates by themselves won't stimulate the market, if risk-averse investors demand a hefty premium to buy the bonds of Europe’s indebted periphery, keeping borrowing costs elevated.

And as a reminder that any ECB action could meet resistance from the Eurozone’s richest member, Germany’s central bank said Friday that it remained opposed to huge purchases of government bonds by the ECB.

Meanwhile, European stocks registered little reaction to economic data released Friday in Washington showing that the U.S. economy grew at an annual pace of only 1.5 percent in the second quarter, the slowest rate of growth since the third quarter of last year. In late trading Friday in Europe saw the Euro Stoxx 50, a measure of Eurozone blue chip stocks, was up 1.7 percent and the FTSE 100 Index in London was up 0.8 percent.

Spanish and Italian bond yields were lower, stemming a week of rises, as investors registered less nervousness about the potential need for bailouts. The yield, or interest rate, on the 10-year Spanish bond was at 6.659 percent, down 0.169 percentage points. The Italian 10-year yield finished the week, down 0.092 percentage point to 5.917 percent.

But despite these optimistic signs, Germany remains staunchly opposed to full-scale bond purchases, a tool which could help relieve pressure on Italian and Spanish yields, could weaken the euro and introduce a measure of inflation into the region. To date the German central bank the Bundesbank is sticking by its position that bond purchases by the ECB are an unacceptable blurring on the line between government fiscal policy and monetary policy. This means that the ECB’s most potent weapon for combating this crisis is likely to remain sitting on the shelf.

In an effort to break the logjam, ECB President Mario Draghi will hold talks with Bundesbank President Hens Weidmann in the coming days. And while the President of the Bundesbank, has only one vote on the ECB’s 23-member governing council, which meets Thursday. But his dissent could undercut the effectiveness of attempts to influence the bond market. If the ECB appears divided, investors might question its resolve.

The most likely path forward after a session of arm-twisting with a reluctant Bundesbank, is for the ECB to resume its sterilized bond purchases through its Securities Market Program with possible assistance from the EFSF. This in turn may offer some short-term relief, in the form of cheaper borrowing costs for the weaker peripheral nations in Europe. But the fact that these programs are limited and temporary in nature will eventually see the resumption of short interest in the bonds of the weaker sovereigns.

Still, this past week has made it clear that when the ECB’s back is against a wall, they will do the minimum to avert a full-blown banking crisis or a European-wide depression.

With correlations between stocks waning, there appears to be ample room for stock pickers to add value. The CBOE's S&P 500 Implied Correlation Index, measures investors expectations’ of the degree of co-movement between equities. While still high by historical terms at around 65, this degree of anticipated co-movement is down from its mid-December record of 85—suggesting that stock picking is becoming more profitable.

Investors have been seeking stability lately flocking to the traditional safe havens of consumer staples, utilities and healthcare. The one exception is S&P 500 companies with extensive Eurozone operations. Key U.S. automakers and computer companies have blamed Europe's woes in recent days for their high profile misses.

Large capitalization dividend stocks are still the mainstay of investor portfolios. One area that I like is in the pharmaceutical industry where worries over the so-called patent cliff have depressed the multiples quite substantially for the group. The stocks currently trade at 12.5 times 2013 estimated EPS versus a historical multiple of about 18 times. The sector offers a reasonably compelling dividend yield of 3.9 percent for the big four with the average free cash flow payout less than 50 percent, suggesting plenty of room to upsize the dividend over time.

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