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MONTHLY INVESTMENT STRATEGY. January 2012. Introduction.
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MONTHLY INVESTMENT STRATEGY January 2012
Introduction Euroland will start 2012 in recession, how long and how deep this proves to be will depend on the ability to stabilise the financial system which remains in a very weak state. The ECB’s three year LTROs certainly ease funding concerns but do nothing to address solvency. While it is possible that this will provide support for peripheral sovereign bond markets this is not in any way certain. Banks have been reducing their exposure so far and unlimited one year funding, which was already available, has not prevented the crisis getting to this point. In any case the outlook for the peripheral economies in Euroland remains very grim. Amidst a slew of macroeconomic releases from Spain, many of which are hard to square with other data, car sales were reported at a level last seen in Q2 1986. The new version of the “Growth and Stability Pact” differs from that already enshrined in the Maastricht treaty in that it will be enforced by the legal systems of the member states. Although an agreement exists that this will be done there are in practise quite a number of hurdles. The position of Greece remains awkward. The budget deficit in 2011will far overshoot its target once again and for Greece to remain in the union sets a very poor example. The alternative, for Greece to leave and redenominate its currency, threatens to set off a chain of events similar to that following the decision to let Greece default. Depositors all over Euroland would have been told that they, too, were not necessarily safe. US economic data has been better than expected over the last few weeks but there is good reason for caution. The budget deficit is still huge – 8.7% of GDP and final demand has been helped by a fall in the savings ratio back towards 3%. Neither looks sustainable even in an election year. In addition the tax break on business spending [which has probably been supporting the sales of cars and light trucks as well] comes to an end shortly. China is not analysable in the way that developed economies are but it is clear that exports are losing altitude while the long planned transition to a more domestic demand oriented economy is still more talk than reality. Past episodes of capex on the scale of China’s over the last several years have never ended well. While the authorities will plan to keep the economy on an even keel in the run up to the leadership change in October there is no guarantee they will be successful. How the Chinese banking system works and, in particular, the links between it and the “unofficial” banking system seems to be a topic of hot debate between those best informed on the subject. I claim no special expertise but the banking system in China has to be a hot candidate for “you don’t know who’s swimming naked until the tide goes out”. Markets in 2011 confounded conventional wisdom. In bond markets the “European convergence trade” [where investors have enjoyed 20 plus years of being overcompensated for peripheral risk] came spectacularly unstuck. Equity investors had an equivalent experience as emerging markets the “safe haven” of the consensus were by far the worst. The best performing major asset class was UK inflation linked gilts with a return of 20% [tax free for UK taxpayers] but all “fully sovereign” bond markets did well. UK inflation linked bonds now guarantee a loss in real terms – together with the ongoing compression of equity valuations markets are increasingly discounting a future less prosperous than the present. The Euroland bear market is now quite advanced by historical standards [it has fallen 60% from its high] but investors willing to take a long view need to be able to weather the arithmetic – since halving it has already fallen another 20%. In line with tradition and in the interests of full disclosure the commentary from December last year is on the next page Nick Carn December 30th 2011
Introduction from December 2010 A month is a long time in markets. October’s market action had been so dominated by anticipating the effects of the Fed’s QE programme [in particular the run up in commodity prices that is so very unwelcome in the BRICS] that to discuss in last month’s introduction the ongoing shambles that is Euroland felt rather like the intellectual equivalent of a dog returning to its vomit. I am not claiming any special foresight, the Irish crisis could have precipitated at any time, but as it happens, rivets popping in Euroland were the main attraction in November. It did make me think, however, that some comment on the progress of the other member of the “Big Three*” the Chinese State Sponsored Overproduction Project [and the one mostly below the markets’ radar - for the moment] should at least be included this month alongside an update on El Dolor. In traditional financial panic fashion the Irish instalment of the Euroland crisis was “solved” then unsolved and, at the time of writing, solved again - all within the space of three weeks. The proximate cause was the imminent collapse of Allied Irish Bank [a bank so small, it should be remembered that it didn’t even feature on the “top thirty” list of banks which passed their special Euroland solvency tests in the summer]. The ingredients are the same as ever. Trapped in monetary union Ireland is supposed to restore competitiveness [and the ability to service and repay its foreign debt] by deflating domestic demand. Unfortunately government finances do not seem to be improving [as we have discussed before it’s not really government finances which matter so much as the external account but that is where the official focus is] and the underlying deficit is still some 12% of GDP even after several austerity programmes. Just as in Greece’s case as soon as it looks like “can’t pay won’t pay” then the market looks around to see who guarantees the EMU project and finds – destructive ambiguity. Is EMU a “sworn confraternity or not? Are there limits to ECB support for distressed banks or sovereigns? These crucial questions never get a straight answer - and can’t get a straight answer because it depends on who you talk to. Instead the response from Merkel was to start discussing a Permanent Crisis Resolution Mechanism. Whereas this might be a good idea in the long run in the short run it replaced a situation in which default risk was supposedly low due to the EFSF to one in which the probability of restructuring was perceived to be high. It involved trying to on the one hand stabilize near term debt funding costs through moral hazard while at the same time trying to limit future moral hazard through imposing bond holder losses in future crises – a near impossible task. In the event markets were calmed by some notion [undisclosed] that the ECB is on their side. The fact remains that there are losses to be taken by somebody and the ECB is on its own side. Until next time then. Nick Carn December 2010 *Big Three; Pathological EMU, Governments Renege, The Chinese Overcapacity Project
World money growth is mildly expansive. The monetary argument for a “risk on” market in 2012 is that the ECB and China’s Central Bank who for different reasons have been somewhat restrained in 2011 “get religion” this year. Whether this happens or not, the background remains one of CBs battling pronounced deflationary tendencies.
CSFB risk appetite Risk appetite has recovered from very depressed levels. Bond spreads remain wide and EMs have underperformed DMs – two big influences on this model. Equity sentiment based measures are mildly bullish.
US real disposable income growth Source; US Bureau of Economic Analysis Growth in disposable incomes is very sluggish. The biggest short term effect is from inflation hence the slump and recovery as the “QE” oil price spike came and went. Debt has been a big part of the overall dynamic for the economy. The private sector has already begun to retrench and the government sector will soon – even if it’s postponed until after the election.
US economic surprises Economic data from the US has been better than expected. There are several reasons not to extrapolate the trend. Firstly, as can be seen from the above, this is close to as good as it gets. Secondly demand has been supported by a fall in the savings ratio, a large budget deficit and tax driven accelerated spending on capex.
US personal savings rate Source; US Bureau of Economic Analysis Whereas for many economies bubbleconomics is a distant memory, the US still demonstrates some bubble characteristics – notably demand sustained by a falling savings ratio.
US debt Source; Federal Reserve Notwithstanding the recent fall in the savings ratio the deleveraging trend looks well established – demographics certainly supports it.
China Source: CEinet The good news for investors in China [and they need some] is that inflation is moderating. How good this is depends on whether you think that inflation was the main issue or not. Our view is that it was only ever a cyclical problem and that overinvestment will prove to be the main story. The BRIC’s story isn’t quite what it used to be – the role of increased labour force participation [in hindsight a big part of the “Asian miracle” of the 1990s] is being revised up. For further information see Goldman’s recent piece in which they disown the BRIC’s theme [although that’s not quite how they chose to put it].
Chinese foreign exchange reserves China is not an easy place to analyse – it is safe to say that there is at least a measure of economic news management. For this reason really “hard” data is very interesting. Something is clearly happening to net capital inflows – possibly an increase in exports of capital.
China property prices The slowdown in China and the associated fall in property prices has been deliberate so far and if the authorities execute according to plan this process will level out. Given the starting point the risks are very high that it now takes on a life of its own. There is a good chance that the rise in commodity prices which was partly the consequence of QE1 then initiated a tightening cycle in China which in its turn has led to an economic downturn – another longer term consequence of the financial crisis.
China finance The suspicion is that Chinese finance is a riddle wrapped within an enigma but even on “official” figures there has clearly been a big growth in leverage and especially in off balance sheet borrowing.
China Industrial expectations index December’s PMI rose to 50.3 above the boom/bust line and ahead of expectations. The main contributors to the improvement were food related so this should not be extrapolated – forward looking surveys suggest that there is still a struggle ahead.
Private debt/gdp It’s not just the “Anglo Saxon” economies which have levered up. The outliers on this measure are Germany and Japan both of whom have seen their debt ratios fall since 1995 – and both of whom recently celebrated 50 years of government bonds outperforming equities.
Euroland sovereign financing needs The “Euroland economy” [there is really no such thing] is now in recession and leading indicators suggest that there is more to come. Government finances will surely deteriorate further particularly in the “periphery”. Even before this happens, however, there is an enormous financing calendar.
External vulnerability indices This shows the current account deficit plus external debt refinancing needs as a share of foreign exchange reserves. The countries on the receiving end of the Asian crisis have managed their affairs very differently this time around. It is in Euroland and its neighbours that this bit of history is repeating itself. A disorderly collapse in Greece spreading through the region is a key tail risk. Highly dependent on western European banks [no “Vienna Accord” this time] and with precarious external positions there is scope for a generalised economic collapse in south eastern Europe. Turkey, too, is vulnerable and, of course, Cyprus is an unresolved issue.
Banking liabilities and fx reserves Not surprisingly this weakness is repeated when comparing fx reserves to banking claims. Eastern Europe has by far the biggest “mismatch”.
S&P valuation We have often featured versions of this chart before. By the standards of recent years stocks are cheap – by longer term standards they are merely average. Euroland stocks often look “cheaper” because there is no long term data.
US profits as % of GDP The other issue for stock markets is that corporate margins are very high and, like profits as a share of GDP, have historically been strongly mean reverting. One of the puzzles is why in what appears to be such a competitive global environment margins are so high. Incidentally, this chart allows one to pinpoint the beginning of the great equity bull market at the beginning of the 1980s as well as the peak of the 1960s bull market.
Growth versus value in Euroland Since the financial crisis “quality” has been outperforming worldwide – particularly in Euroland.
Bear markets compared This chart, from Absolute Strategy Research, compares bear markets in history. The current European bear stands comparison with some of the most severe.
European stockmarkets One might wonder what they were ever doing up there in the first place but European stock markets have had huge falls since 2007.
Asset class returns 2011 A 12% S&P rally in Q4 saved world equities from the doghouse; they ended down 6.9% in USD – poor but not life threatening. This masked very weak “peripheral” Euroland returns e.g. Italy - 22% and Greece -50%. Emerging markets were also weak -18.2%. Bonds outperformed. “Sovereign” sovereigns were the best overall category with inflation linked debt returning over +10%. Even the worst - Euroland subordinated financial [-8.7%] outperformed the equity market. Currencies were fairly quiet [JPY the best] while commodities were generally weak – the CRB fell -8.3%.
Government bond yields The European convergence trade came spectacularly unstuck in 2011.After Greece was allowed to “default” many European sovereign bond markets completely changed their nature. Rather than being “rates” markets, trading on the expected path of official interest rates, they became like emerging market bond markets - trading on perceived restructuring risk and subject to sudden halts in capital inflows.
Credit Most credit is cheap by historical standards based on the implied default rate. It has, however, been very volatile which is off putting in a VAR dominated world.
Progress on fiscal consolidation November’s numbers showed a deterioration over October in spite of some “special accounting” by Portugal. Spain’s 2011 deficit looks like 8% against the “plan” of 6%.
Cumulative purchases of government bonds by ECB The ECB will continue to be a battleground between believers in sound money and those who think that the “Union” should trump all. It has already stepped up purchases [while giving the impression of being reluctant] and there is no real obstacle to another rate cut. The expectation that it will publicly “stand behind” the government bond markets, however, will be disappointed. Moreover, if it did go down that route, there is also the risk that it would be behaving in a way that made impossible Germany’s continued membership of EMU.
