MarketView for October 21

Summary

The S&P 500 index chalked up its third straight week of gains on Friday, lifted by optimism before this weekend's summit of European leaders and strong earnings from the blue-chips. However, it is important to keep in mind that important differences still separate the major players, France and Germany, in solving Europe's debt crisis.

However, with two summits scheduled for next week, Wall Street is taking a bullish attitude with the idea that a resolution will soon be reached. Buying was also motivated by fear of missing a sharp move if basic agreements are reached over the weekend.

Recent gains have pushed the S&P 500 to the top of its trading range between 1,230 and 1,250, where it has struggled to advance. Now the thought is that we need to see progress in Europe before earnings can push equities much higher. For the week, the Dow was up 1.3 percent and the S&P rose 1.1 percent. However, the Nasdaq was down 1.1 percent on the week.

Consumer discretionary stocks were the best performing among S&P sectors after McDonald's reported higher-than-expected quarterly profit. Shares of the fast-food restaurant chain hit a new high of $92.45 earlier. The stock ended up 3.7 percent at $92.32.

Light volume suggests investors aren't entirely convinced of the move; just 7.91 billion shares traded on the New York Stock Exchange, NYSE Amex and Nasdaq on Friday, below this year's daily average of about 8 billion.

Equity markets have been susceptible to rapid and violent swings in recent weeks as traders latch on to varying headlines on Europe's debt crisis, leaving markets prone to volatility heading into the weekend.

Among industrial companies, Honeywell rose 5.8 percent to $51.28 after it reported better-than-expected results and lifted its earnings outlook. The commercial aerospace company rose as much as 5.7 percent, its largest gain since May 2010.

General Electric's third-quarter earnings met Street estimates, driven by strong demand from Brazil, Russia and China. But its shares fell 1.9 percent to $16.31 as investors worried about declining profit margins at GE's energy equipment division.

According to Thomson Reuter’s data, of the 133 companies in the S&P 500 that have reported earnings through Friday, 68 percent have topped analysts' expectations.

Germany and Greece Cannot Seem to Agree on Steps Going Forward

 Private holders of Greek debt may need to accept losses of up to 60 percent on their investments if Greece's debt mountain is to be made more sustainable in the long-term, a downbeat analysis by the EU and IMF indicated on Friday. Euro zone finance ministers threw Greece a lifeline on Friday by agreeing to approve an 8 billion euro loan tranche that Athens needs next month to pay its bills. However, the European Commission, European Central Bank and International Monetary Fund -- the so-called troika -- issued a gloomy report on Greece's ability to pay its debts.

Among three scenarios it examined, the only one that would reduce Greece's debt pile to 110 percent of GDP -- a level still regarded as high -- was one in which private bond holders agreed to a 60 percent haircut.

"To reduce debt below 110 percent of GDP by 2020 would require a face value reduction of at least 60 percent and/or more concessional official sector financing terms," the debt sustainability report, obtained by Reuters, showed. A footnote explained that the ECB disagreed with including the scenarios in the report, concerned that private sector lenders would refuse to agree to such a steep write down voluntarily, effectively leading to a full scale Greek default. The report also said Greece's debt pile could peak at 186 percent of GDP, from around 160 percent currently.

The euro zone finance ministers said the 8 billion euro tranche, the sixth installment of 110 billion euros of EU/IMF loans agreed last year, would be paid in the first half of November, pending the IMF's sign-off. That should allow Greece to avoid defaulting on its debt this year.

Meeting ahead of a summit of EU leaders on Sunday, finance ministers also indicated that deep divisions between France and Germany over how best to scale up the euro zone's bailout facility to give it more firepower may have been overcome.

France believes the most efficient leverage method would be to turn the European Financial Stability Facility (EFSF) into a bank, allowing it to access ECB liquidity. Germany and others opposed this, and France's finance minister said he was not going to be unnecessarily confrontational over the issue.

"We will not make it a point for definitive confrontation," he told reporters as he left the meeting late on Friday. "What matters is what will work. And what will work is something that is dissuasive and an effective firewall."

Austria's finance minister, Maria Fekter, who arrived at the meeting saying there were seven options on the table for leveraging the EFSF, left the meeting saying there were now two, indicating that some progress had been made.

If France does ultimately drop its insistence on the EFSF being turned into a bank, then the most likely method for scaling up the EFSF is expected to be some form of insurance program aimed at restoring confidence in euro zone debt. Moreover, by guaranteeing only a portion, perhaps a third or a fifth, of each debt issue, the available EFSF funds could stretch 3-5 times further, increasing it to around 1 trillion euros.

However, analysts are concerned that such a plan could create a two-tier bond market, with bonds that have guarantees trading at a premium to the secondary market -- an outcome that could exacerbate market turmoil. Some analysts believe choosing such an option would be the worst outcome of the summit.

In a related set of discussions, EU finance ministers will on Saturday meet to discuss the requirements for recapitalizing the European banking system, with the aim of making it more resilient to the possibility of a default in Greece and any wider contagion across the continent.

EU leaders will then meet on Sunday to see if they can agree a comprehensive plan to resolve the two-year-old debt crisis, with another summit scheduled for Wednesday, October 26, because no breakthrough is expected on Sunday.

German Chancellor Angela Merkel, French President Nicolas Sarkozy and Europe's top two officials, European Council President Herman Van Rompuy and European Commission President Jose Manuel Barroso, will also meet late on Saturday to try to break the deadlock before Sunday's summit.

Sarkozy appeared isolated after an acrimonious meeting in Frankfurt on Wednesday, when he pushed the idea of turning the EFSF, a 440-billion-euro ($600 billion) fund, into a bank.

Germany, the ECB and the European Commission all argued that the move would violate an EU treaty prohibition on monetary financing of governments.

"The path is closed for using the ECB to ease liquidity problems," Merkel told conservative lawmakers in Berlin, according to participants at the private meeting.

The outcome of the Sunday and Wednesday summits will determine whether investor confidence in the euro area can be restored. It will also influence whether an expected Greek debt write-down triggers a chain reaction of financial turmoil across Europe, hitting French, German and other banks -- and potentially pushing Italy and Spain deeper into the mire.

EU officials say the total amount required to shore up the region's banking system is just short of 100 billion euros. Those banks that cannot raise money on the markets will have to turn to national governments, and finally to the EFSF. European banks will be required to increase their core tier one capital ratio to 9 percent to help them withstand losses on sovereign debt, banking sources said.

France fears its credit rating could come under threat if the wrong method is chosen to scale up the bailout fund to prevent contagion spreading to Italy and Spain, the euro zone's third and fourth largest economies. Standard & Poor's said on Friday it was likely to downgrade France and four other states if Europe slips into recession. It was the second agency this week to cast doubt on France's rating after Moody's on Tuesday.

Underlining the threat the euro zone crisis poses to the global economy, U.S. President Barack Obama held a video conference with Merkel and Sarkozy on Thursday, reiterating that he hopes a solution will be in place in time for a summit of G20 leaders in Cannes, France on November 3 -November 4.