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MONTHLY INVESTMENT STRATEGY. September 2011. Introduction.
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MONTHLY INVESTMENT STRATEGY September 2011
Introduction It is increasingly clear to markets that the business sector which has led this sub par recovery is now itself losing altitude. Global PMIs have turned down while there is still little sign of a recovery in the domestic economies of DMs. The revision of US growth showed that the recovery was weaker than at first believed while August payrolls [plus downward revisions for June and July] confirm that job growth has stalled. Nor do lower interest rates appear to be stimulating housing or consumption -possibly because collateral is lacking or possibly because the personal sector has lost its appetite. Either way debt to income ratios are now falling for the household sector – a break with the experience of the last several decades. Meanwhile, in case anyone might have missed it, the global move towards fiscal consolidation has now been joined [via a cliff hanger over raising the debt ceiling] by the US. With administered interest rates at zero and fiscal expansion off the agenda further economic weakness as it comes will have to be addressed by a further round of LSAPs. The latest Fed minutes prepared the way. For a while at the beginning of the month it appeared that the Euroland sovereign debt crisis [in reality a foreign exchange crisis pursued by other means] had stabilised. As a result of effective intervention by the ECB in a disorderly market Italian and Spanish yields fell. Of course this is not the same as transforming their perceived credit worthiness. The halcyon episode proved short lived. The economic news flow has continued to be poor with the recovery in Germany and France stuttering to a halt and Italy, Greece and Spain all drifting further from their deficit reduction targets. Once again it seems as if everyone in Euroland is at each others throats . The “market” frequently expresses impatience with the speed of “official” reaction to the Euroland crisis by which, in one form or another, is usually meant the speed at which Euroland proceeds to the supposed final destination of a full transfer union whether by increased contributions to a “bailout” fund, the issue of “Eurobonds” or increased sovereign bond purchases by the ECB. From a perspective heavily conditioned by recent history [the European “convergence” trade has been a winner for so long that it has encompassed most people’s careers] this is reasonable but there is another possible outcome. This involves a fight back by national democracies. During the upswing the malign consequences of EMU were not apparent; indeed it appeared that there were none, quite the opposite in fact. This illusion has now shattered in Portugal, Greece and Ireland [which are in depression with more to come] while Spain and Italy are not far behind. In Germany the economy was strong until very recently and whatever the long term consequences of EMU they were clearly not apparent in the here and now. That is why the most recent figures showing that the French economy did not grow at all in the second quarter and that Germany hardly expanded are so important. Weaker economies will focus attention on France’s role in the drama as well as Germany’s willingness and ability to suffer the consequences of a debt union. France’s budget arithmetic was particularly dependent on quite rosy growth assumptions which now look as if they are unlikely to be achieved. With France likely to be downgraded at some point it is increasingly clear that Germany stands to lose her AAA rating as well. With German inflation already above target her two great economic fears are just about to be realised. The perception that Euroland poses an existential threat to Germany [and not just Germany] as a AAA rated, self determining democracy governed by the rule of law is growing. Nick Carn September 2011
CSFB risk appetite Risk appetite has rebounded from a very distressed level. As we discussed last time the use of this as a contrary indicator needs to be conditioned by the fact that “panic” episodes seem to be becoming more frequent and during financial crisis part one it remained in the panic zone for some time.
Global PMIs Whereas the domestic economies in the developed world have struggled since the credit crunch business sentiment enjoyed a V shaped recovery which is now starting to fade. In the past this has tended to lead global growth. It’s not yet indicating recession but is moving in that direction.
Headline PMIs NJA The global downturn seems to be spreading. Not only has China cooled but PMIs in Taiwan Australia and Singapore are all now contracting.
New fiscal realities Source IMF Fiscal consolidation is the new fashion whether at foreign gunpoint as in Greece or as part of a new set of political realities as in America. The US had previously been the outlier but now looks to be moving quickly to catch up. For the moment it looks as if fiscal expansion is not an option if faced with a weak economy – nor are lower interest rates an option since they are close to zero in most DMs already.
China Although China is cooling down inflation remains stubbornly high. With a change in administration coming next year it will be tempting to postpone the hard decisions. Either which way there is going to be a lot to be learned about the Chinese economy in the next few months.
China PMI China’s PMI was a little better than expected post revisions sitting just on the 50 boom/bust line.
US ISM – could have been worse? The market reaction to the latest set of ISM numbers suggests that it is starting to “get with the programme”. Initially they were greeted as good but further consideration of the detail revealed that the picture continues to deteriorate.
US Payrolls Augusts' payrolls confirmed the weak progress of US employment. Even adjusting for the Verizon strike the number was poor. Added to this were downward revisions for the two previous months.
US retail sales US retail sales rose in July - apparently confirming that although weak the recovery is not on its knees. The underlying reality was a bit different; postponed auto sales and higher gas prices both flattered the headline figure. Michigan consumer confidence painted a different picture with confidence falling to a multi decade low. This was a level last seen under the Carter administration. The poor outlook for jobs and incomes will determine the outcome - whatever the short term fluctuations in the reported numbers.
US household debt Household debt ratios have come down but as can be seen from recent mortgage applications data lower interest rates no longer seem to spur new borrowing but rather help in reducing debt. This change is a powerful headwind for an economic model which has relied on increasing leverage to offset stagnant real wage growth and high unemployment.
US consumer sentiment Measured on the University of Michigan survey, consumers in the first week of August were more depressed than at any time since the Carter administration. What they say and what they do is frequently quite different but, nor surprisingly, extreme readings like this tend to be associated with a weak economy.
Euroland PMI To some extent the pattern in the US of upbeat business and downbeat consumers has been repeated in Euroland. Much of the recovery has come from the business sector, proxied here by PMIs. Most recently the “good bit” has started to deteriorate.
Real GDP quarterly % change For a while the story in “Euroland” was that growth [dominated by Germany and France] was quite good albeit held back by weakness in the periphery. 2Q numbers from France and Germany showing that their economies hardly grew at all have changed that and made the various other Euroland issues more pressing as the readiness and willingness of the [so far] AAA countries to help out is reduced.
“Progress” in fiscal consolidation Everyone is now behind their targets for fiscal consolidation something which will make the next bailout even more unpopular unless it is recognised that the policy mix is self defeating. However if that recognition is permitted where does it lead? To tolerance of large deficits? Or to recognising that devaluation has to be part of the solution?
Euroland housing markets Euroland house prices reflect the very different conditions across the region. The bubble economies are seeing steep falls [the Spanish numbers seem implausibly mild] while Germany never saw them rise in the first place and Switzerland has seen a 60% rise in Euro terms over the last 5 years purely through appreciation of the currency – there are gains in local terms as well.
Euroland house prices The mixed fortunes of the housing markets in Euroland tell an eloquent version of the EMU tale.
UK PMI In common with most of the DMs the UK economy has disappointed over recent quarters. Unlike, most obviously, the Europiigs the UK recovery plan has involved a currency devaluation as well as fiscal tightening to contain some of the inflationary effects. Unfortunately the external environment on which the switch to export lead growth depends is now deteriorating.
Asset Class returns August was a bleak month. 2011 returns have shown a certain logic however; senior debt has outperformed sub, sub has outperformed equity. Even financial sub has outperformed equity. Ems bring up the rear – in spite of their different fundamentals. As Japan demonstrated it takes an awful lot to break established correlations.
Correlation of risk assets increasing It is the nature of efficient markets that they constantly shift the decision frontier. One of the arguments for emerging markets 15 years ago was that the “asset class” was internally diversified, Chile danced to a different tune to Malaysia. This changed when the asset class became popular and gradually the markets became more and more highly correlated. The same has been happening across “risk assets” as the fashion has become one for “absolute” returns.
Risk assets vs Treasuries correlation increasingly negative The “other side of the trade” is the correlation of risk assets with Treasuries. Here the correlation has become increasingly negative and as a result Treasuries have become a way to either cancel out some of the other portfolio bets or [if short]to double them up.
From backwardation to contango Another asset class to enter the arena in the last few years has been commodities and already the nature of the beast has started to change. Not only have commodity prices become correlated with equities [oil was once a good diversifier] but where once one was paid to roll positions [the source of all of the return from the strategy in many periods] now you have to pay to play.
Stockmarkets Stock markets [this is Europe] have reflected the differing fortunes of the “international” and “domestic” economies [a difference intensified in Euroland by EMU]. Global PMIs are now rolling over so the bloom is off the rose – the big unanswered question is China.
Bank exposure to peripheral Euroland as % GDP As we have discussed before, each of the Euroland endgames seems individually implausible but, presumably, one must be correct. It’s easy to see why France has such a stake in holding the project together – not least the exposure of her banks.
Dax and German bonds An often discussed metric is the relationship between equity valuations and bond yields – the so called “Fed model”. The fact that it doesn’t work has diminished its popularity. In Euroland there’s another conceptual difficulty to overcome – the choice of bond yield which encompasses Greece at 15% and Germany at 2%. The yield on the DAX is currently higher than on 10yr Bunds but whether this is encouraging or not is debatable. Throughout the bull market it was the other way round. A persistent yield gap has been a characteristic of the Japanese market during its long malaise
Monetary sovereignty and CDS The key to sovereign default risk is monetary sovereignty. If you have the ability to print your own currency there is no reason to default unless you choose to. In some circumstances that might be the more attractive option – angry bondholders might be less inclined to sack the parliament building than angry welfare recipients – so the risk is not non existent. However it’s clear that the UK [or the US] needs to choose to default whereas someone in EMU may have no such choice.
Corporate spreads Although it has risen recently the BBB bond spread is close to its average for the last decade.
Corporate bonds Spreads are one thing - yields another. The yield on investment grade bonds has gone relentlessly down
Probability of default based on CDS spreads Euroland is once again a lot of cats fighting in a sack.
Dec 2011 Euribor It’s increasingly clear that the ECB’s rate hike earlier this year was a “mistake” - or at least incompatible with peace in Euroland financial markets. “Normalisation” [just as in the US and increasingly everywhere in the developed world] looks a distant prospect.
