December 2009
Mixed Grill at Christmas
After what has been another, ahem, interesting year we lead up to the Christmas break with a flurry of last minute data. As this may help set the scene for the New Year a brief overview is probably appropriate.
UK
GDP data for the third quarter (Q3) was revised up to -0.2%, having been officially measured at -0.4%. It would not have been surprising to see this figure flat or even slightly positive and in light of news this quarter it seems likely that the UK economy will have emerged from recession in Q4.
After years of increasing debt and reducing savings the UK consumers savings rate jumped up to 8.6% in Q3, indicating the consumer is sensibly trying to repair balance sheets. This is good news and hopefully points to a more stable economic environment in at least one area.
Inflation has started to tick up and as the latest Bank of England minutes (released this morning) discuss this will have much to do with fuel prices. Combined with the VAT hike on January 1st inflation may be a big cause for concern early next year, although at the moment we anticipate these fears will prove misplaced as growth remains subdued.
Internationally
In the US the strong Q3 figures have been revised down further, starting at 3.5% the figure now stands at 2.2%, annualised. Breaking down the figures as we did before it looks like 2.3% of this growth came from areas supported by government spending and stimulus.
Chicago Fed figures indicate that some sectors of the US economy have been mired at recessionary levels over Q4 and the possibility that the worlds largest economy’s rebound may be grinding to a halt seems to be growing.
On the positive side there are indications that the US housing market may have stabilised and affordability levels are now good (particularly compared to the UK where prices still stand at a frightening 6 times average wage) while there are indications that unemployment may not be getting any worse. We do however need to see several months’ worth of data to fully buy into this latter story.
Thankfully Emerging Market growth remains robust and it appears that the Chinese stimulus package is still working well. While there continue to be fears about market distortions and bubbles as a result the Chinese government has proved remarkably adept at tweaking things and there seems to be no obvious reason why this growth will grind to a halt. In the short term we do remain wary about individual equity markets but the longer term growth potential remains intact.
Indicators
The Dollar is showing some signs of recovery, particularly against the Euro, with the DXY index (discussed last time) breaking out of its downtrend. On a macro level this makes sense because despite doubts about the speed of its recovery the US recession has been shallower than Europe and the long term growth prospects are better.
The big question is, will the strengthening dollar break the carry trade and send markets backwards? So far this has not happened and the hope is we will see an orderly unwinding of the trade if the dollar gets stronger but with stock market volumes incredibly light for the end of year holidays it is difficult to read anything into this at the moment.
Yesterday the VIX volatility index briefly dropped to its lowest point for the year, indeed its lowest point since pre-Lehman’s. This reflects a more relaxed mood in the markets, although to many commentators this is now seen as a high level of complacency. Without trying to spoil Christmas this is perhaps the most worrying indicator because with the macro outlook still so unclear and therefore corporate earnings so uncertain, we would think there should be more caution in the market.
Conclusion
Never before have we experienced a time like the last 16 months and the legacy of this period, and the boom that led us here, will linger for many years.
As a consequence of this remarkable period we have encountered so many divergent views on markets and economies from so many accomplished people, extrapolating out all different kinds of outcome but one thing has remained constant, those that most accurately predicted the fall have remained steadfastly measured in their outlook.
Morgan Stanley’s expectations of a BBB recovery among the larger nations: Bumpy, Below-par and Boring may be as good as we should expect.
One conclusion however remains clear. Now is not a time to be too clever or brave but to gather around yourself what is truly important at this time of year and count your blessings as we look towards a New Year, with optimism and hope but also a strong sense of caution.
Merry Christmas and a Happy New Year
And finally (having tried very hard to find a decent Christmas joke, and failed miserably, after such a year our politicians deserve a brief mention)………
It’s tough being a politician. Half your reputation is ruined by lies the other half is ruined by the truth.
About the Dollar, not Darling
With so much commentary having been already written about Alistair Darling’s disappointing Pre Budget Report lets look at something which may have a real impact on the global economy and markets.
In recent issues we have looked at the dichotomy between positive market behaviour and the problems in key economies. Put simply markets seem to be discounting an outcome that seems improbable.
So if the market is not reflecting the economic reality what is it doing? We are increasingly of the view that in addition to the massive liquidity that has been injected into financial markets there has been one key story behind stock market strength and that is the dollar carry trade.
This is selling (effectively borrowing in) the dollar, which is cheap as the US base rate is basically at zero, while buying higher yielding riskier assets with the proceeds. This trade has enjoyed an additional benefit in that the selling pressure forces the dollar lower while the buying drives risk assets higher. This enhances the profit on both sides of the trade. The net effect of this can be shown on the chart below which compares the DXY index (which reflects the dollars level against a basket of six currencies, dominated by the Euro) with the S&P 500 US share index over the last two years.
The top line shows the strength of the dollar and you can see a significant inverse correlation to the strength of the stock market shown below. The weaker the dollar the stronger the stock market and vice versa.
Odd isn’t it, the weaker dollar should signify worries about economic disappointment, while the strong equity markets should indicate belief in recovery. So it seems that stock markets may have been going up, not because investors truly believe the economic environment has improved, but because it is the trade that has had all the momentum. But what happens when reality reasserts itself? Well that may be happening now.
Over recent days we have seen the Dubai crisis blow up, we have seen Greek government debt downgraded, while the Irish government has passed an unprecedented austerity budget to maintain confidence among bond investors. Furthermore Moody’s is now the second credit rating agency to suggest that UK debt will be downgraded, while Japan’s stellar third quarter growth recovery of 4.8% was adjusted to just 1.3% (annualised). In this environment the US doesn’t look so bad, the dollar is looking oversold and the chart below shows how it appears to be breaking out of its trend.
If this breakout continues (despite Ben Bernanke desperately trying to talk down US prospects to keep the dollar weak) it will rapidly begin to undermine the logic of the carry trade as currency gains will be eroded, leading traders to take profits in risk assets, raising funds to close down (repay) their dollar positions. This could lead to some rapid corrections and although stock markets have shown mixed results a number of key commodities have shown sharp reversals in recent days.
If this scenario seems a little tenuous then the final chart, comparing the dollar/Yen exchange rate against the S&P 500, my help explain the concern. Until the middle of 2007 the Yen carry trade was the big news, with Japanese interest rates already pinned to around zero, compared to 4%-6% elsewhere. Hence traders borrowed in Yen to buy risk assets, in this case US stocks. Again the borrowed currency fell so again investors benefitted from both asset price appreciation and favourable currency movement. Once the carry trade came off in the summer of 2007 and the Yen began to appreciate traders scrambled to unwind their positions and the correlation to S&P 500 is clear.
As the credit crunch began around this time there was more at work than just this one trade but it was one of a number of key imbalances that helped destabilise markets as the edifice of unsustainable excess began to collapse.
The current hope for the markets is that we have begun to see the needed rotation into higher quality stocks in recent weeks. If this heralds the return of longer term investors there is a chance markets can survive a flight of short term punters (sorry traders) but the risks remain high.
And finally…..
Software Development Cycle
Software doesn't just appear on the shelves by magic. That program shrink-wrapped inside the box along with the indecipherable manual and 12-paragraph disclaimer notice actually came to you by way of an elaborate path, through the most rigid quality control on the planet. Here, shared for the first time with the general public, are the inside details of the program development cycle.
1. Programmer produces code he believes is bug-free.
2. Product is tested. 20 bugs are found.
3. Programmer fixes 10 of the bugs and explains to the testing department that the other 10 aren't really bugs.
4. Testing department finds that five of the fixes didn't work and discovers 15 new bugs.
5. See 3.
6. See 4.
7. See 5.
8. See 6.
9. See 7.
10. See 8.
11. Due to marketing pressure and an extremely premature product announcement based on an overly optimistic programming schedule, the product is released.
12. Users find 137 new bugs.
13. Original programmer, having cashed his royalty check, is nowhere to be found.
14. Newly-assembled programming team fixes almost all of the 137 bugs, but introduces 456 new ones.
15. Original programmer sends underpaid testing department a postcard from Fiji. Entire testing department quits.
16. Company is bought in a hostile takeover by competitor using profits from their latest release, which had 783 bugs.
17. New CEO is brought in by board of directors. He hires programmer to redo program from scratch.
18. Programmer produces code he believes is bug-free.
(It should be noted that there is absolutely no correlation between the use of this joke and a recent major software release. None whatsoever)
The Bald Eagle
The Bald Eagle belly flops?
The Dubai debt crisis has clearly garnering the attention of investors around the world but in reality the sums involved are small compared to those in the initial stages of the financial crisis and, in all likelihood, the surprises that still await us. More to the point is that the market reaction shows how nervous investors are at heart, with rapid economic recovery far from certain, particularly in the US.
While China is undoubtedly the star of the moment (although with serious concerns attached) the sustainability of its current rate of growth still ultimately relies upon its ability to export and the worlds biggest consumer continues to be the American public, who make up 70% of what is still the world’s largest economy by some margin. As a result the US consumer remains the single largest contributor to world trade and is central to any global recovery. Indeed unless the US picks up strongly global growth will remain anemic at best and increasingly vulnerable to shock.
Strong Growth ?
However on the 29th October the world received a much needed economic boost with news that the US economy had grown during the third quarter by 3.5% after declining for over a year. This has subsequently been revised down to 2.8% although of course this figure is annualised so the gain over the quarter was under 0.7%. We would humbly suggest though that those of an optimistic bent don’t spend too much time drilling down through the figures (made available in detail on the website of the Bureau of Economic Analysis – BEA – website. It’s laugh a minute).
Of the 2.8% it seems that 1.17% came from vehicles and recreational vehicles (cash for clunkers), 0.45% from residential investment (up to $8,000 tax breaks for first time buyers), 0.87% from inventory rebuilding (an expected and necessary rebound from the massive write downs in previous quarters) and finally an increase in Federal Government expenditure (by a government which is, oh so deeply indebted) of 0.65%.
That is 3.14% growth (so 112% of the total) largely on the back of unsustainable government spending, short term stimulus, promoting more consumer debt and by a rebound in inventories which was inevitable unless we were facing the mother of all depressions. There seems a fair chance that as stimulus is removed (which it must be, such is the parlous state of the governments finances) growth will fall away dramatically, if not back into outright recession.
Unemployment, Less Bad Apparently
The November US non-farm payrolls were well taken with the headline figures beating expectations and certainly far better than those seen earlier in the year. Unfortunately markets are so busy looking at the monthly numbers the key fact seemed to be missed by many and that was the total percentage of the workforce unemployed jumped to 10.2%. One of the problems with US unemployment figures is that if you stop looking for work for four weeks you are removed from the statistics. You are officially no longer unemployed. No, really.
It is thought likely that with a slight increase in optimism at the end of summer more people started looking for work and were then re-registered as unemployed. If those who are underemployed (those who want to work full time but have accepted part time hours) are also included it is estimated the true unemployment figure is over 17%
But US Retail Sales are pretty good!
Headline sales figures for October were slightly ahead of expectations, with same store sales up by 5% year on year, which followed on from good September figures, prompting some headlines to declare US consumer spending was on the up. Unfortunately sales volumes and money spent are two different things, a point made recently by the excellent Texan analyst John Mauldin (whose regular commentaries can be found at www.2000wave.com). As he points out, one way to really see how much is being spent is to look at sales tax figures as these are based upon actual receipts and many states posted significant double digit declines in tax received during October.
Overall sales volumes may be up but the amount being spent has clearly fallen. Furthermore combined with falling income tax receipts this is rapidly leading into another problem, apparently overlooked by many.
Fiscal Stimulus falters faster than anticipated
With sales tax receipts slumping and growing unemployment slashing income tax revenues some individual US states are facing huge budgetary problems. We all know that California is flirting with bankruptcy, delaying inevitable hard choices but other states face difficult decisions, with budgetary cuts of up to 20% expected in low profile Michigan for instance. Apparently some of the budgetary shortfall has been met by utilising federal aid for infrastructure projects, which in turn will dull the stimulatory impact of these measures.
Record numbers late on US loans
A headline in the FT on 20th November, reported on how one-in-seven US mortgages are either in arrears or in foreclosure. The highest level since records began in 1972. Enough said?
Well not quiet, home sales have picked up lately (on the back of the first time buyers tax break) but prices are still falling in many states, which is likely to continue if foreclosed homes are pushed back into the market.
US Insider selling
A slightly alarming figure we have recently encountered indicating that the ratio of corporate insider selling shares (legally and visibly) against buying stock in the market is now at 18-to-1. This hardly inspires us with confidence.
Strong third quarter results
The bulls are keen to point out how strong the Q3 reporting season in the US has been, although as we have mentioned before when forecasts have been slashed to the bone beating them shouldn’t be too difficult. Nonetheless across the US overall profits (in aggregate) surged by $123 Bln, or 13.4% which is pretty impressive. However if you drill down through the figures you find that $97 Bln of that (79%) of that came from the financial sector (which makes up about 25% of the market) which is in receipt of the massive stimulus injected into the markets and benefitting from nearly zero interest rates.
Average profits from non-financials were up 0.6%, which is pretty poor from depressed recessionary lows.
The end is not nigh
As we have stressed repeatedly; we are not all doomed, but the continued refusal of certain mainstream commentators (who did not foresee the trouble we have blundered into) and major investment banks (who had a large role in creating the hole we are in) to even examine the detail of our current position is alarming. The thought that we can simply take the massive government and central bank largesse as being normal, with no concurrent consequences, stores up likely future disappointments
How and when reality reasserts itself remains uncertain but perhaps our worst fear is that sufficient momentum will continue to generate superficial strength for sometime, all the while allowing the underlying problems to grow larger while simultaneously blowing new bubbles. Then when reality again bites there will be no ammunition left in the bag to respond.
This is not our base case but the risks grow the longer markets ignore them.
And finally……
Deep within a forest a little turtle began to climb a tree.
After hours of effort he reached the top, jumped into the air waving his front legs and crashed to the ground.
After recovering, he slowly climbed the tree again, jumped, and fell to the ground.
The turtle tried again and again while a couple of birds sitting on a branch watched his sad efforts.
Finally, the female bird turned to her mate.
"Dear," she chirped, "I think it's time to tell him he's adopted."