I Like These Calm Little Moments Before the Storm
By Christian Thwaites
June 18, 2012
It is the job of investment managers to look beyond the gloom. There's plenty of it. The big list last week was the slow hand clap the market gave to the Spanish bank rescue, the probable downgrade of India, one of the dead cert BRICs we all read about, and queasy economic data from the US. Now we don't just jump in and buy on all the bad news. We're not likely to retain clients that way. But we do see some clarity on the number of possible outcomes, which is a healthier place to be than for most of the last few weeks. Here are four questions on our mind as we look at the week:
1. Spain: are we done?
No. Spain bailout is a patch...not a new beginning. One of the issues is how the loans are accounted for: sovereign or private? Answer: sovereign. So Spanish debt goes up and money comes out of the EFSF...so no net new money into the system. It also jumps Spain's already stressed debt/GDP ratio by about 10%. Remember the ECB played NO role in this. That's why Spanish bonds and stocks fell 6% on the news. If the Irish experience is anything to go by, the debt, bad loans and write-offs will far exceed the €100bn commitment. Sky high unemployment and falling property prices are hardly good omens for profitability. Spanish banks are at the same level as they were in 1997. And the economy continues to weaken.
2. Europe: moving towards what?
Tough call. The calls to move towards greater union (like deposit insurance, euro bonds, banking union) are fiercely resisted by Germany. And when the risk of anyone pulling out of the euro is still in the air, then a banking union solves nothing. Over in Greece, we had the second round of parliamentary elections this past weekend. Voter polling is not allowed two weeks prior to an election, so no one really knew which way it would go. As it turns out, a narrow, very slender and timorous victory for the pro-EU group, postpones problems another month. Meanwhile, we know there's capital flight to the tune of €500m a day and scenarios for an exit. The markets continue to slide in Europe; most of them were flat to down 2% last week, down 10% YTD and down 20% over the year. Spanish bonds ended up well over 7%, a critical threshold.
It was always going to be a disorderly queue from Greece to Spain to Italy (because Portugal and Ireland had hammered out deals ensuring comatose status). And so we now learn that Italy's economy contracted 3.2% and fixed investment fell 14%. Real GDP is only 1% higher than the 2009 depths. This is very grim. The worry here is that Spain has received assistance. So it is likely that more will come but from an ever diminishing central pot. That means stocks will be cheaper yet.
On a broader note, one clear image from Europe is the lack of any hegemon. ECB: no mandate. Germany: too punitive. IMF: not funded. US: unwilling. EU: unable. China: uninterested. Yet each retains a veto. So muddle through it is, then.
3. US Economic Stats: all weak, right?
Up to a point. Sure, the big ones, like NFPs and claims, are a lot softer than a few months ago. But trade revisions were favorable with revisions up for Q1 and down for Q4...so that creates a better base effect for Q1 GDP (remember the Q1 revisions aren't over yet). The other one is the NFIB survey (for small/med sized companies) where the headline number was unchanged but hiring decisions were strong indicating that NFPs may bounce back in the next few months. Another sign that may be good for jobs is weakening productivity growth, which fell in Q1. The more mature the cycle, the more productivity slows and so, with a given rate of GDP growth, generates faster job creation. It even went negative last quarter. Here's what it looks like:
Source: Federal Reserve Bank of St. Louis, Economic Research
So potentially good for NFPs.
Another key data point was retail sales, ex-autos, which fell 0.4%. A lot of this was a decline in gas prices which fell 2.2%. Compare that to March when gas prices were increasing closer to 7.5%. Now a funny thing happens when gas prices start moving around. First the CPI falls. And we saw that in the headline CPI which rose by only 1.7%. Second, because demand for gas is inelastic in the short term, meaning price changes barely alter demand because consumers don't have time to change behavior, the money saved equals stored up demand. There has been a distinct change in the way people get around. Here's a new data set from our friends at FRED showing vehicle miles traveled.
Source: Federal Reserve Bank of St. Louis, Economic Research
That's more than cyclical. It suggest new patterns of driving and probably ties into the rapid growth in the "5-units or more" section of housing starts: less single home formation, more multi-housing units, more central location, less need to drive. So we may see some benefits of gas prices come through in the next few months in the form of extra spending. What is clear is that inflation remains painfully low. Even in the otherwise grim Empire Manufacturing Index, the "Prices Paid" reading fell 18 points. And over in the monthly Treasury statement we continue to see contraction with the "Big 5" expenditure categories falling by $50bn YTD or a nice round 0.6% of GDP.
So headlines weak on sales, NFIB, Empire and jobs. But better on inflation, gas prices and housing. Put it all together: there's weakness but no rollover. Yet.
4. So, will they QE or not?
Probably not because, as David Brownlee points out, the market is already there. Taking long bonds down another 25bps is going to make no difference to lending practices. Remember Op Twist was all about selling short-term treasuries to buy long term. That made it different from QE1 which was outright purchases and reserve crediting. The Fed only has $180bn of short-term treasuries to sell so there's a limit to how much more they could buy in a Twist #2. For QE to come in more force, we would have to see significant loss of momentum in the economy (i.e. jobs, output) and inflation below 2%.
Another opening for the Fed could be to push equities higher (see the
household balance sheet point in last week's TOTW) and the only way they
could do that
would be to take competing assets out of the market. That's the
"portfolio balance" channel and it would take a hefty amount to push
It's an important meeting this week. There's probably insufficient data to change forecasts now and the camps in the Fed still talk more about inflation credibility than they do employment. One option might be some really stern talking about an easing bias with the trigger ready to go on Twist #2. Yes, that's it. Unless Europe falls apart.
Bottom Line: Still a lot of price movement in treasuries. The 30-year traded between $103 and $107 in last few days and now yields 2.7%. The range seems to be 2.65% to 2.85%. This thing has a 20.1 duration, hence the volatility. The 10-year has a similarly tight range of 1.42% to 1.72%. The demand for longer term debt continues; both the 10- and 30-year auctions last week had healthy bid/covers and more active direct bidders.
When macro and political headlines keep crossing, markets ignore company fundamentals. We see plenty of opportunities to look through the gloom. So it's a good time to continue to pick up stocks.
Sources: FT Alphaville, Brad DeLong, Capital Economics, National Federation of Independent Business, High Frequency Economics, Tim Duy's Fed Watch, Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Bloomberg, US Census Bureau, US Dept of Commerce, Federal Reserve, Bureau of Labor Statistics, US Treasury Department, Luc Besson, The Professional; Sentinel Asset Management, Inc.
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