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MONTHLY INVESTMENT STRATEGY. July 2011. Introduction.
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MONTHLY INVESTMENT STRATEGY July 2011
Introduction • The Fed’s most recent report on the state of the US economy struck a familiar note. Conditions in the most recent period have been subdued by “special factors” [the oil price, the tsunami in Japan] but looking further out the outlook is supposedly brighter. While there is no denying that there have been “special factors” the fact remains that in spite of negative real interest rates, QE2 and a very accommodative fiscal stance, growth is lacklustre and unemployment high. The environment for global businesses has been good [EMs had very brief recessions and have more than recovered their lost output] but, typically, developed world domestically orientated businesses have found the going tough. We have often discussed the underlying reasons. Integrating China into the world economy threatened rising unemployment [as manufacturing jobs migrated] and falling prices unless something intervened. Whether by accident or design that something was the bubble economy, the necessary consequence of policies which targeted inflation and relatively full employment. With the collapse of the credit bubble [and a wholesale rewriting of the economic history of the preceding years] the underlying trends have reasserted themselves. Baby boomers are getting older, have inadequate savings and are beginning to worry [with excellent reason] whether their governments will look after them. For governments, the financial crisis has brought long postponed budgetary problems knocking on their doors. International creditors, too, are beginning to worry that the large claims that they have accumulated over countries which run persistent external deficits may be difficult or impossible to enforce. • The situation in Greece is an extreme manifestation of these trends – something which politicians in other countries are beginning to acknowledge, if only verbally. While there is no doubt that EMU makes the situation very much worse it illustrates the way in which a debt crisis puts different interest groups at each others throats. Pensioners want their pension promises honoured, workers resent higher taxation, external creditors want domestic consumption suppressed to allow them their “rightful” share of output and low paid workers suspect the rich of tax evasion. While a debt bubble is growing these mutually irreconcilable claims can be pushed into the future. Once that process halts the hard reckoning begins. The result is political crisis. • For the moment the Greek crisis has been “solved” again. The government has agreed a new austerity programme and new loans will be made available. While a significant minority in both the ECB and German political circles now believes that Greece will never be viable within EMU no one wants to be the one to precipitate the next stage. The fault line therefore shifts to the ability of the government to implement more austerity measures and the willingness of the population to accept them. • Nick Carn July 2011
Global liquidity has picked up a little in recent months; the key influence in the future will be the end of QE2 and the prospect [the Fed is non committal] of QE3
Real interest rates One of the clearest illustrations that things are not “normal” in spite of protestations to the contrary is the fact of negative real policy rates almost everywhere. This creates a presumption against cash and an environment in which investors are actively encouraged into forays into one asset class or another sometimes irrespective of long term investment merits.
Fed assets vs equities and commodities The relationship between “QE” and asset prices is supposedly a commonsense one. The reality is different. Originally designed to lower bond yields and support real estate prices, the QE era has seen real estate prices fall and bond yields rise and then fall. Equities rose “because of liquidity” but then fell without the “liquidity” being withdrawn.
World trade volume World trade volume has been quite a good lead indicator of the business economy [the DM consumer has other issues]. The most recent numbers showed a loss of momentum.
OECD leading indicator In common with many other LIs the OECD version has turned down. Not surprisingly commodity prices enjoy a close relationship.
Fiscal tightening Whether smaller government really is the new big thing or not there is a lot of talk [and protest] about it. The US remains the outlier as it is still rowing in the opposite direction. This is likely to change next year.
Google searches for “double dip recession” In the search for reliable high frequency indicators Google is a natural choice even if there isn’t a long history.
US “Misery index” The Misery Index which attempts to combine inflation and unemployment had been on a long slide since the peak of the 1970s. It now suggests that the good times may be over.
Case Shiller To the “traditional” sources of happiness and woe needs to be added the balance sheet of the shortly to be retired baby boomer. Balance sheet effects have not been discernibly important in the past but evidence suggests that they are becoming more significant. June’s number showed a small uptick but this should be treated with caution as it is not seasonally adjusted and the spring typically sees higher activity. Nevertheless houses are now very affordable.
US ISM The latest ISM numbers were better than expected but the weakness in new orders confirms the underlying problem – chronically weak demand growth. The supply disruptions due to the Japanese earthquake have affected output but this is not the source of the underlying malaise. The US is not at immediate risk of slipping back into recession but a self sustaining “normal” recovery remains elusive.
Growth in US and Euroland net worth Net worth attempts to fill the explanatory gap left by employment and incomes. Net worth has had an unsteady decade – also a decade during which economic growth has been persistently over estimated.
US Conference Board consumer confidence index The latest consumer confidence index showed confidence falling; doubtless rising gas prices and falling equity prices played a part. The larger message, though, is that confidence has been stuck in a range well below the 90% or so that has been normal for the last twenty years.
US NFIB Index It is large companies that have been most upbeat during the recovery. Small businesses which are typically more exposed to the domestic and service sectors have had a harder time of it. Optimism dropped back sharply in June.
Chinese GDP Chinese activity has been slowing and inflationary pressures will soon be ebbing. The “local” view is that as soon as this happens conditions will improve, the stock market will rally and so on. My view is that the rise in inflation is only a cyclical phenomenon and that China’s real issue is overcapacity. According to this view the greater risks lie around a bigger than expected slowdown.
HSBC China flash PMI June’s flash PMI index for China indicated no expansion [although the level is still compatible with 13% IP growth]. The good news is that inflationary pressures [the main worry for most people] are ebbing.
HK property prices relative to incomes Relative to incomes HK property prices are approaching the highs of the mid 1990s [a level that preceded a long and severe fall in prices] an eloquent testimony to how out of cycle EM/DM conditions are.
How young is the US cycle? The previous chart speaks to how different conditions are in DM and EM. By some measures [as above] the cycle is young but include the very long expansion in China – a big part of global growth – and you come to a different conclusion.
Japan Frequently updated rates of change can be confusing. This chart of Japan’s real GDP is eloquent.
Euroland PMI Even ‘though Germany is still going strong the Euroland economy [assuming such a thing exists] is losing momentum. As recent scenes in Greece attest the “average” has no political relevance.
German “Early bird” German activity is falling from extreme levels to something more normal. What hasn’t happened, even during the boom, is a stimulus to other European countries through growth in domestic consumer demand.
German retail sales German retail sales fell sharply in May, further confirmation that there is effectively no chance that Germany will take over as the locomotive of final demand as the peripheral economies retrench.
UK average earnings and inflation In common with much of the developed world the UK is seeing a fierce squeeze on real incomes. By some measures this is the fiercest since the late 1970s. In spite of high inflation there is no sign at the moment of a wage price spiral.
Asset class returns Due to a rally in the last three days of the quarter both DM equities and commodities managed a positive return for H1. Treasuries also managed a positive return while the real outlier was the huge increase in peripheral sovereign spreads.
Cyclically adjusted US P/E It is hard to argue that stocks are cheap compared to their history.
USD and US exports as % GDP The USD has been weak and it has been having an effect on US exports. If fiscal tightening constrains the growth of domestic demand there is scope for the external accounts to improve a lot. Good news for the US and the USD - bad news for most everybody else.
US competitiveness Apart from the big improvement compared to the majors the US has seen competitiveness improve very markedly compared to EMs – including China.
EM yield curves suggest lower growth ahead EM yield curves suggest that a slowdown is now very probable. Even so, more tightening is likely
Global versus local A comparison of a “Global trade” asset eg LVMH with “Local” assets says a lot about where profit opportunities have been.
Peripheral bonds – probability of default The main bond story remains peripheral sovereigns. Generally credit has had a good year [credit and equities has very much been the fable of the Hare and the tortoise]. OIS spreads have shown some signs of strain but nothing alarming as yet.
