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Daily Agenda: International Bond Market Plays Musical Chairs

Chinese government bond auction sees limited demand; Fed releases Beige Book; Royal Bank of Canada reports earnings.

Investor sentiment is shifting today from commodity markets, particularly oil, to fixed income. How much more room there is to rally? In a note to clients yesterday, Gluskin Sheff market strategist David Rosenberg hit the nail on the head: “One does have to wonder what the scope is for a further rally with ten-year Japanese government bond yields at 0.7 percent; France at 1 percent; Spain at 1.8 percent and Italy at 2 percent,” adding, “European Central Bank bond buying and renewed recession in Japan has already been priced in...and then some.” Of course, saying that bonds have little room to rise is a very different thing than saying they will sell off and, with inflation still nowhere to be seen, few investors appear willing to bet on a near-term swoon. In the game of musical chairs that is the process of guessing when yields will eventually rise, the music seems destined to continue playing for some time yet.

Europe continues to post sluggish numbers. Final nonmanufacturing purchasing managers’ index (PMI) data for the euro zone released by Markit this morning registered at levels softer than the initial flash reading with a significant contraction individually for France. In the lead-up to the ECB announcement tomorrow, the fact that the new order subindex, a primary indicator of forward demand, fell for the period adding ammunition to the argument for action by the central bank.

Yields rise in China. A Ministry of Finance auction for seven-year sovereign debt resulted in significantly higher yields than forecast, at 3.6 percent. Recent pressure in domestic Chinese debt markets has been ascribed by analysts to a lower likelihood of further market intervention by the People’s Bank of China as economic data firms. Separately, final nonmanufacturing PMI data issued by the National Bureau of Statistics today improved over the flash reading, as did the HSBC index, which focuses on managers at smaller companies.

U.S. data on deck. A number of economic data points are coming out in the U.S. today, including the ADP employment report, third-quarter nonfarm productivity and November ISM nonmanufacturing levels. The critical ISM employment subindex for the service sector and ADP data will be carefully parsed by investors in the run-up to Department of Labor employment situation release on Friday. The Federal Reserve is scheduled to release its Beige Book at 2 pm.

RBC posts earnings. This morning Royal Bank of Canada was the first of the major Canadian financial institutions to report earnings for the fourth fiscal quarter, with a slight miss on gains in commercial banking and wealth management that were offset partially by underperformance in capital markets. The bank reported net income of C$1.57 ($1.38) per share versus $1.40 during the same period last year and analysts’ consensus forecasts of $1.58.

Portfolio Perspective: European Energy Sector Stocks Poised to Sink FurtherPieter Taselaar and Thijs Hovers, Lucerne Capital

Our pessimistic view of the energy sector, specifically oil services, has been rewarded this month as we continue to see a deteriorating operating environment resulting in numerous profit warnings.

We have written about our concerns in the oil services sector. The decline in oil prices has been well documented, but there are other factors at play here as well. In a deteriorating operating environment, we remain concerned with businesses that have both a high fixed-cost base component, such as seismic boats, rigs and subsea installation vessels, and too much leverage on their balance sheets. As the oil majors focus on their own returns and the capital expenditure budgets of their suppliers are reined in, we believe that the services companies remain very poorly positioned for this shifting dynamic. This month we have seen profit warnings from Petrofac and Seadrill. We continue to believe that market participants are underestimating the toxicity of a low-quality fixed asset base burdened with high financial leverage.

As a region, Europe is still delivering anemic growth rates and therefore, we believe our fundamental stock selection process is crucial to generating double-digit annualized net returns. Within this backdrop, we look to uncover solid businesses run by exceptional management teams that benefit from a discounted European valuation but sell their products abroad into faster-growing end markets. We are not buying Europe per se; we are investing in various pockets of excellence headquartered in that region.

Lucerne Capital Management is a Greenwich, Connecticut–based long-short equity investment firm with a focus on Continental Europe. Portfolio managers Pieter Taselaar and Thijs Hovers have overseen the firm’s flagship Lucerne Capital Fund since its inception in 2002.

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