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MONTHLY INVESTMENT STRATEGY. May 2011. Introduction.
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MONTHLY INVESTMENT STRATEGY May 2011
Introduction The bull case for the economy and for equity markets is simply stated. The extraordinary measures taken in response to the financial crisis have been successful, business confidence and company earnings are growing and employment and wages will soon follow. Growth in the developing world, which was largely bypassed by the crisis continues unabated. Moreover, using current measures of the P/E ratio, stock markets are not expensive by historical standards and, compared to the low levels of interest rates, are cheap. We have dealt with the valuation part of this equation many times but, to reiterate, earnings and margins have been mean reverting in the past and are currently high while there has, historically, been no information in the relationship between interest rates and equity valuations. This leaves one with the link between the stock market and “headline” macro momentum. This is much more interesting and we discuss it further in the chart pack. With the world economy plunging into a deflationary abyss nothing could have been more logical than to take comfort from any and all signs that momentum was turning to the upside and this, of course, was what markets did. The link was then “formalised” by regressing stock market returns to some sort of leading indicator for the economy – PMI surveys, for example. Not only does this neatly capture a positive feedback loop [stock prices are important to business confidence] but it also recruits two other powerful constituencies. One of these is the mainstream economic forecasting community whose mean variance models were validated by a recovery [the crash, of course, had every economy operating well below trend]. The other important group is the believers in “stocks for the long run” who are typically bullish on stock markets either because they have gone up or because they have gone down. Whereas economic momentum, [proxied by leading indicators, IFO or whatever] has been the way to play the equity rally it’s important not to mistake it for something it is not. It does not represent an eternal truth about how the stock market behaves. Instead, it’s simply the current way of looking at things and in that respect is fundamentally no different from looking at “hidden assets” in Tokyo in the late 1980s or “clicks” in the dotcom boom. What is an eternal verity, however, is that no market is ever egregiously cheap [or expensive] by the criteria generally applied at the time. Markets are most certainly “efficient” in that limited sense. In the past economic growth has had almost nothing to do with stock market performance – in fact the relationship is, if anything, inverse – the better the economy the poorer the returns have been from investing in the stock market. There’s evidence that the relationship has been improving recently the reasons for which, crashing economy crashing stock market and then the reverse, are pretty obvious. Were this to persist it would be a “new era” relationship. I think it probably is. The Japanese stock market became very closely connected to the business cycle after 1990. Nick Carn May 2011
Euroland It’s no secret that monetary policy is now too loose for Germany – and by construction for Euroland as a whole. The problem is further complicated by the fact that the crisis largely makes a nonsense out of conventional analysis. There are now numerous “risk free” rates in the Euro area, Greek two year rates are 20%. Government bonds are also “risk free” from the point of view of a banking regulation but Greek bonds trade at 55. Nor are there really any signs of it getting better.
Global money growth has stabilised in the middle of its historic range – still growing but not as rapidly. The end of QE2 is eagerly anticipated.
CSFB risk appetite Overall, risk appetite is average to high; the equity component continues to reflect lacklustre relative performance by emerging markets.
OECD leading indicator As we discussed in the introduction most indicators, particularly those focussed on the business sector [and par excellence those which include the stock market among their components] point to continued expansion. While the linkage between top level macro data and the financial markets holds this is “positive for risk assets” or “supportive of confidence” as a previous generation would have put it.
US growth The US economy is still expanding albeit at a slower rate and capex is rising – a source of encouragement to “normal cyclists”. Further out the end of QE and fiscal consolidation loom. Lack of fiscal discipline will upset the bond and currency markets while tightening will hit corporate cash flow – as a matter of pure arithmetic.
US budget balance as % GDP The US has been bucking the global trend towards budget consolidation [at least at the federal level].The figures from the CBO tell a misleading story because they assume that the temporary extension of the Bush tax cuts is er, temporary. The projections in the chart above assume that they will be extended . The difference is substantial under the CBO scenario debt/gdp stabilises at about 75% in the other it reaches 100% by the end of the decade and continues to climb. The announcement by S&P that the US is on credit watch shouldn’t tell anyone anything they didn’t know already – the demographic and debt clock ticks away.
US housing starts Nothing new, but housing and consumer don’t share the ebullience of the business sector. Maybe they are just slow to the punch.
US median income This is a major reason why the rank and file are feeling less upbeat than the equity owning class.
US real private consumption Not entirely surprisingly, given the income situation, consumption is limping along particularly after adjusting for higher gasoline prices. Meanwhile savings rates would like to rise but “need” to be kept down
Euroland Manufacturing PMI The story in Euroland continues to be that things are very hot in Germany where unemployment is now low and more and more dismal the further you get from the core. A year ago Greece went for a bailout. Twelve months later bond rates are 600bp higher.
Industrial production s/a Markets have slightly lost interest in the debacle since it has seemed possible to defend the Spanish frontier. The fact remains, however, that Germany’s performance is diverging from that of the other “core” countries as well. Many on the ECB council now accept that the piglets are not viable within Euroland. Comments about capital controls like those recently made by the Belgium deputy PM [technically he’s not because Belgium has no government] should be very scary.
German IFO components Germany itself is slowing [from breakneck rates] and although the current assessment component rose to a new high other components are rolling over – ‘though still consistent with strong growth. This remains an export story; a rise in domestic consumption is still more hope than reality.
German HICP Unemployment at the lowest since reunification rising inflation and interest rates at emergency [low] levels – the next wave of malign consequences of EMU are washing over Germany.
Fiscal consolidation – or lack of it. The plan is for the troubled economies in Euroland to deflate themselves back to health. “Is it the 1930s?” is a question I was asked on CNBC last week. For some countries in Euroland the answer is yes; gold standard [EMU] = mass unemployment + deflation + rising political extremism [coming soon]. Elsewhere the story is different.
Trade weighted USD The US is still out of step with the global trend towards fiscal consolidation – at least at the Federal level. The dollar has been quite weak, flirting with all time lows on a TWI basis – quite an achievement if one considers the mess that is Euroland and Japan. Against the yuan it just [28th April] broke its 1993 low. Action in many assets has partly been a function of the dollar; fiscal and monetary laxity combined. The next stage is to see how serious moves to address either [both?] really are.
Dr Copper “Dr” Copper [so called because of his prescience in calling the industrial cycle] had been put out to grass but that was before China started industrialising. China is at an important inflection point as it tries to transition to a lower growth rate and an economy less dependent on exports and capex. In spite of “cash is trash” sentiment and new cycle highs in stocks and all time highs in precious metals, copper is struggling to maintain altitude.
Silver Silver has gone parabolic. It occupies an ambiguous place between industrial and precious metals but is joining the precious metal group for the moment and playing catch up with gold. As you can see from the chart it is the current cycle investment par excellence recovering from the 2008 sell off and making one new high after another. Love China, love metals, love silver. Hate the dollar, love precious metals. Fear QE - embrace bimetallism. There’s something for everyone. Or was until last week.
Equity returns and economic growth Not everything that should be the case is the case and this “commonsense” relationship fails empirically.
GDP and returns Even approaches based on perfect foresight have underperformed value based approaches. Both GDP based tests provided negative results.
Earnings and ISM There has historically been a poor relationship between earnings and the ISM but it seems to have been getting better recently. One aspect of the paradigm shift in Japan [which had “surpassed capitalism” but not in the way that the authors of the eponymous book meant] was that the stock market became highly correlated to the economic cycle rising in expansions and falling in contractions. There was money to be made trading equities but they ceased to be a “fire and forget” asset class.
Europe realised volatility There’s a lot of verbal angst around in Euroland – fanned by different factions pursuing their various agendas vis a vis the peripheral debt disaster but actualised equity market volatility has been steadily falling as the market has rallied. This is the normal relationship – low volatility is typical of rising markets, gently lulling investors into thinking that the risks they are running are small ones. Of course, the risk they should care about, permanent loss of capital, is a function of fundamentals. Both the Tokyo bubble and the dotcom bubble were characterised by low vol.
Purchases of Treasuries by Fed Following the Bank of England’s example the Fed has been buying over 100% of the net treasury bond issuance
Treasury yields and QE In point of fact treasury yields declined as QE1 came to an end. Of course this wasn’t the only thing going on but it seems that the lack of traction in the credit multiplier overwhelmed the supply/demand shift. There’s a good chance that this will happen again.
Commercial banks holdings of Treasuries The answer to the question “Who will buy the Treasuries?” is answered by “The banks”. It’s easy to see from the chart why analogies are drawn with the early 1990s - also a hangover from a real estate bust. What began with Silverado S & L [an organisation so speculative that in its home State of Colorado it was known as “Desperado”] ended with Robert Citron bankrupting Orange County when the Fed eventually raised rates. Hard to make up.
Implied probability default from CDs The dark blue line is the important one. The market has given up on Greece and to a lesser extent on the other piglets. While large the numbers are not big enough to overwhelm the system. Spain is also making halting attempts to address its budget deficit – not that that’s really the issue; budget deficits are the consequence not the cause of the problem. When the banking system comes “on balance sheet” then the cost really rockets – the Irish can tell that tale. This, however, is one of the few problem areas [it appears] in the world of credit. Even European bank sun debt is close to its tightest levels.
