martedì 30 marzo 2010

Rescuing Greece

In line with last week’s emerging data, the most likely scenario for the next few years divides the Euro Zone into two, with the major northern European countries growing at a healthy pace and the peripheral southern European countries, including Ireland, remaining in a quandary for several years. On the one hand, the German IFO and French INSEE business confidence indices showed positive gains in March, indicating that the two largest economies in the Euro Zone could accelerate in the coming months. On the other hand, fears about the health of public finances in Greece and Portugal increased after UBS economist Paul Donovan predicted that Greece will fall into default at some point, and after the ratings agency Fitch downgraded Portugal to AA- with a negative outlook, indicating that further economic or fiscal underperformance this year or in 2011 may lead to another downgrade. According to Fitch, “although Portugal has not been disproportionately affected by the global downturn, prospects for economic recovery are weaker than 15 European Union peers, which will put pressure on its public finances over the medium term.”
However, the real commotion continues in Greece. Greek authorities are indeed faced with the particular dilemma of having to refinance a debt of 20 billion Euros between April and May. Only last Thursday, governments of the 16 Euro Zone countries endorsed a Franco-German proposal mixing IMF and bilateral loans at market interest rates while voicing confidence that Greece will need no outside help to cut Europe’s biggest budget deficit.
Nevertheless, the most clear and prominent revelation from data published last week is that the countries called to assist Greece in exiting the crisis are those who are particularly benefiting the most from this situation. Indeed, the most important effect of the Greek crisis in financial markets, in addition to the jump in Greek government yields, was the decline of the Euro against major international currencies. Year to date, the Euro has lost 6% against the U.S. Dollar, 3.7% against the Swiss Franc, 7% against the Japanese Yen and has gained solely against the British pound (1.3%).
A study entitled Standard Shocks in the OECD Interlink Model presented in 2001 by a handful of OECD economists, namely Dalsgaard, Andrè and Richardson, indicated an estimated 0.6% increase in the Euro Zone’s GDP both in the first and second year following a 10% depreciation of the Euro. The projected rise in the inflation rate (+0.4% in the following two years) should not be cause for concern as the ECB projected inflation to remain well below 2% in both 2010 and 2011. The Eurostat’s CPI flash estimate for March set to be published sometime next week should confirm the scenario projected by the ECB: consumer prices at 1% y/y, hence a slight increase from February’s 0.9% y/y. Inflationary acclivity should depend almost exclusively on rising oil prices, while the CPI core, scheduled to be published in the next few weeks, should remain near its all-time low of +0.8% y/y recorded in February.
Figures from the OECD indicated that a decrease in the single European currency caused by the Greek crisis is especially good for Germany and France, whose business confidence indices rose strongly in March. Germany may be the main beneficiary of the Euro’s decline as exports account for 48% of the German GDP.
This is especially true considering that the Euro is still overvalued against the US Dollar on the basis of estimated purchasing power parities calculated by the OECD, notwithstanding the recent downtrend. The OECD, in fact, estimated the fair value for the Euro/Dollar at 1.17.
Nonetheless, the Euro’s decline is likewise very positive for its peripheral countries. Another stumbling of the single European currency would enable Greece, Spain and Portugal to gain competitiveness in international markets, promoting an increase in exports, which would appear to be the only factor capable of boosting economic growth in the coming years. A low or negative GDP growth would in fact lead to a further deterioration of public finances.
It would be much more difficult for these countries to gain competitiveness against other European partners. The strong increase in unit labor cost and real exchange rate over the past few years (as indicated in the graphs below) eroded the competitive position of the Euro Zone’s peripheral countries vis-à-vis major countries of the region. Northern European countries, particularly Germany, do not seem to want to give up their model of growth based on exports or implement economic policies to boost domestic demand in exchange for a more competitive Spain, Portugal and Greece (and Italy). European partners are facing a long and arduous process, which must necessarily pass through a stage of very low wage growth, if not negative, with a strong risk of deflation. Thus, while last week’s decision on aiding Greece might reduce tensions on these countries in the short term, overcoming the current crisis for peripheral countries is a process that will take many years.

martedì 23 marzo 2010

The Fed and the markets

This is an excerpt from our weekly Top Down Outlook:

International financial markets extended a particularly warm welcome to the Fed's decision at the end of last week’s monetary policy confirming that rates will remain unchanged for an extended period, which was widely expected by economists. Major international stock indices have in fact protracted the upward trend of recent weeks, and Government bond yields remained unaltered despite the overall better-than-expected economic data published over the past week in the U.S.
The Fed’s Fund Rates are likely to remain unchanged for at least another 4 to 6 months (the horizon construed by the markets under the term "extended period" without contradicting the Fed), thus the conditions for a continued upward trend in U.S. equity markets are still well in place, despite the slight S&P500’s overvaluation after the recent rally: the ratio P/average earnings for the past 10 years rose over 20 versus a long term average of 18.
The confidence seen in the stock market’s outlook is mainly bolstered up by the fact that until the Fed Fund Rates have begun to rise, the yield curve will continue to be very steep, with the differential between the 10-years and 3-months Government Bond yields remaining well above 300bp. As we highlighted in Global Strategy Weekly’s January 18 report "What Is The Yield Spread Telling Us" (see here for an excerpt), a very steep yield curve is in fact a positive sign not only for economic growth (according to econometrics model presented in past academic studies, the chances of recession under current conditions are almost as high as 0) but also for the U.S. stock market itself.

Since 1953 a strategy consisting in buying the S&P500 when the yield curve is positive and exiting the equity market and investing in T-Bill when the yield curve is inverted has produced a 7.7% average annual compound return against +7.3% of a buy and hold strategy – without considering the returns delivered by T-Bill when no position has taken on equity markets. The average monthly return stands at 0.74% when the yield spread is positive and at -0.2% when it is negative. When the yield spread is above 3% as it is now (this has occurred in 64 months since 1953, 10% of the total), the S&P500 sees a 0.5% monthly return. For this reasons, should the yield spread remain above 3%, we would expect a positive performance for the S&P500, though lower than the historical average monthly return (+0.65% since 1953). A positive performance but slightly below the average would be in line with the slight overvaluation of the S&P500.
The main reason for the S&P500’s good performance, though more generally for all equity markets, is that the presence of a very steep yield curve is historically accompanied by sustained growth of corporate profits in the years ahead. This correlation is clearly shown in the chart below, taken from national accounts data, comparing the spread between the 10-year and the 2-year government bond yields with the developments in corporate profits in the following three years.

Set to be published on Friday 26, the final national accounts data for Q4 (the GDP growth is likely to be confirmed at 5.9% q/q annualized) should confirm that corporate profits, following the sharp decline in the last two and a half years, are returning to healthy growth: having grown by 10.7% q/q in Q3 '09, profits may rise by 3.8%, remaining almost 15% below the peak in Q3 '09.
Even the bond market will be strongly influenced in the short term by Fed's decision to leave rates unchanged for an extended period. The flattening of the yield curve that we expect in the coming months is likely to be delayed. Moreover, a very steep yield curve has usually been followed by a decline in long term rates and an increase in short term rates.
Nevertheless, we believe that the expectations of the consensus of economists in the Livingston survey, conducted by the Federal Reserve Bank of Philadelphia last December (rating the U.S. 10-years government bond yield could rise to 4.1% at the end of 2010, and 4, 64% by the end of 2011), reflect assumptions too optimistic about US economic growth perspective, and too pessimistic on inflation in the next few months.
Indeed, despite economic recovery signal emerged in the last few months, the last two years crisis is likely to have reduced the growth potential of the U.S. economy. In particular, the deleveraging process that would take place both in the households and business sector should take its toll on economic growth for several years.
Data released this week indicated that there are no signs of inflationary pressures in the short term. In contrast, in February, core inflation fell to 1.3% y/y, the lowest level since February 2004, while overall inflation has fallen from 2.6% y/y to 2.1% y/y.

Unless an unexpected surge in inflation, the causes of whom are very difficult to envisage, we do see the potential for long-term Government bonds to gain positive returns in the next few months.

mercoledì 17 marzo 2010

Commodities update

Over the first 3 months of 2010, major commodities recorded a very positive performance. Between the major ETFs and ETCs listed on the Italian Stock Exchange, ETCs on gold, silver and oil had some of the most brilliant results, rising by 5.7%, 5.7% and 6% respectively. However, the ETF based on the CRB Commodity Index was substantially unchanged in early 2010.
When considering the major international asset classes that can be replicated with Italian ETFs, only European equity emerging markets, US equity indices and the Japanese equity market had better performances.
However, the aforementioned commodities gained sound performances since the beginning of the year almost exclusively for European investors. Indeed, the performances were largely dependent on the decline of the Euro’s exchange rate versus the U.S. Dollar, as year to date gold and silver rose by just over 2% and oil by about 3%. The CRB Index dropped by 3.3%.
Various factors are at the root of the behavior of gold and silver differing from the CRB Index of commodities. Gold and silver in fact benefit from fears that expansionary monetary policies by major international central banks could lead to higher inflation over the next months. The expected increase in public debt over the next few years is another source of concern. The sum of public and private debt may create financial instability in the majority of developed countries. In this scenario, and in view of low interest rates on both sides of the Atlantic, the cost opportunity to maintain gold or silver in the portfolio is very low. Moreover, precious metals could continue to benefit over the coming months from purchases by many central banks, especially the People’s Bank of China, looking to diversify reserves to limit its exposure to the U.S. dollar.
However, the CRB Index is reacting to expectations that monetary policy in China could become more restrictive over the coming months, slowing its demand for raw materials. The Chinese economy, in fact, was one of the main engines of growth during 2009 under the force of a massive Government fiscal stimulus program. Data published Thursday 11 have shown that the Chinese economy may overheat. Inflation, in fact, increased by 2.7% y/y against consensus expectations of 2.5% y/y; and may rise, according to some Chinese economists, within a couple of months to 3%. But the main source of concern for Chinese authorities is the trend of private sector credit. New loans to the private sector rose by 700bn Yuan in February, down from 1300bn in January, but higher than the 600bn expected by consensus. These numbers make it difficult to achieve the target for new loans of 7500bn in 2010, representing a decrease of 22% compared to 2009. This may in turn lead to higher interest rates over the coming months for the first time since December 2007.
The behavior of oil prices presents a challenge in itself, especially since supply on the market seems to be much higher than demand. However, the rise in oil prices in the short term may be influenced more by expectations of continuing international economic growth, as evidenced more by the correlation between the U.S. ISM Manufacturing Index and oil prices, than by the actual dynamics between demand and supply.
The early 2010 increase has not changed the outlook for precious metals in the upcoming months for a number of reasons. Firstly, easing monetary policies by major central banks and fears about the state of public finances should remain for several months, or even years with regard to the latter. Secondly, gold and silver have maintained an even keel during the crisis over the last 3 years on their capacity to offer sound diversification from the stock market. The correlation between gold and the S&P500 has in fact remained below 0.1 (the correlation ranges from 1, maximum correlation, and -1, inverse correlation), while the correlation between silver and the S&P500 increased to 0.17. Much higher, however, was the correlation between the S&P500 and the CRB Index (0.5), suggesting that the CRB is no longer able to ensure adequate portfolio diversification. Likewise around 0.5 is the correlation between oil prices and the S&P500 over the past 3 years.
For these reasons, it would still makes sense to invest in at least one of the products related to trends in precious metals, whereas to invest in the general index of raw materials or oil would be riskier and inefficient.
Notwithstanding the above, caution should be exercised when investing in gold and silver given the strong optimism that currently surrounds them, negative from the contrarian perspective. Mark Hulbert, for instance, showed that the Hulbert Gold Sentiment Index (HGSI), which reflects the average recommendation of a specialized series of newsletters on gold, has risen to 46.6% last week compared to 32.3% in early February. All of this in spite of virtually unchanged yellow metal prices.
Even very optimistic price targets from several major investment banks fade quietly in the short term. For instance, Goldman Sachs recently issued a report predicting a rise in gold prices up to USD 1,400 an ounce. Much more optimistic was Charles Morris of HSBC, saying that gold will rise until USD 5,000 an ounce in five years. In the face of such forecasts, one might recall Goldman Sachs’ prediction in May '08 that oil would reach USD 200 a barrel. The month after, oil reached a historical record of USD 145 a barrel before plunging down to 30.

venerdì 12 marzo 2010

A follow up on UK negative outlook

In our post Forget UK! we have indicated the reasons why we believe it is unsafe investing in UK asset classes now. A reminder of negative UK economic outlook came today from a Telegraph article that reported words from Kornelius Purps, Unicredit 's fixed income director. He said "I am becoming convinced that Great Britain is the next country that is going to be pummelled by investors". He also said "Britain's AAA-rating is highly at risk. The budget deficit is huge at 13pc of GDP and investors are not happy. The outgoing government is inactive due to the election. There will have to be absolute cuts in public salaries or pay, but nobody is talking about that," and "Sterling is going to fall further over coming months. I am not expecting a crash of the gilts market but we may see a further rise in spreads of 30 to 50 basis points".
These words strenghten our negative view on UK...

mercoledì 10 marzo 2010

Forget UK!

Last week, the BoE decided to leave rates unchanged at 0.5% and to forestall expanding on its GBP 200bn asset-purchase program, which was widely anticipated by the whole of economists in the Bloomberg consensus. It was hard to see any reason for the BoE to change the outlook for monetary policy in the short term, having decided to pause the program in February.
The latest economic data confirmed that the wait-and-see stance recently adopted by the BoE is appropriate. Over the last week, GDP growth in Q4 was revised upwards from 0.1% q/q to 0.3% q/q; the CIPS Manufacturing Index remained well above 50 in February (56,6, unchanged from January); and the CIPS Services Index rose from 54,5 in January to 58,4 in February. However, these data confirmed that the UK economy is likely to grow at a moderate pace in the next few quarters and will not recover the pre-crisis growth trend for many years, as BoE’s Governor Mervyn King stressed in the press conference for the presentation of February’s Inflation report.
Neither the higher than expected increase in inflation is likely to change the monetary policy outlook in the short term. Indeed in January inflation jumped from 2.9% y/y to 3.5% y/y, requiring the BoE’s Governor to write a letter to the Chancellor to explain the reasons for the CPI leaping above 3%. Three factors have driven inflation up: 1) standard VAT rate restoration to 17.5%; 2) oil price increases over the past year; 3) exchange rate weakness. While inflation is expected to remain well above 3% in the short run, Mervyn King confirmed that inflation will fall below 2% in H2 ‘10. Only in the case the expected downtrend in inflation fail to materialize, the BoE monetary policy outlook will change.
However, even if inflationary pressures prove to be higher than expected, we do not see the BoE tightening up monetary policy. Indeed, an increase in inflation would contribute in solving a major problem in the UK economy: the high level of total debt compared to GDP. According to data published in the McKinsey Group’s report “Debt and deleveraging: The global credit bubble and its economic consequences”, the UK has a total debt/GDP ratio of 466%, compared to 296% in the USA and 285% in Germany. Only Japan at 471% has a higher ratio.
The high debt/GDP burden will likely drag the UK economy as both household and business sectors should embark on a deleveraging process in the years ahead. Consumer spending and business investments are likely to remain moderate for many years. A different trajectory is likely to be taken by public debt, which is expected to grow considerably in the next few years. The projections in the 2009 budget see an increase in public debt from 71.9% in fiscal year 2009/2010 to 82.1% in 2010/2011, reaching 90.7% in 2013/2014. However, in the next few years, even government spending is likely to be put under control facing these large deficits.
Weak domestic demand and high levels of debt are factors that may contribute to a BoE’s expansionary monetary policy for a lengthy period and, moreover, longer than its major trading partners. In fact, a more protracted monetary easing from the BoE compared to the Fed and the ECB, in view of a higher level of inflation, will lead to further depreciation of the Pound in the coming months, hence favoring exports. In fact, exports at this time seem to be the British economy’s only hope for a return to sustainable growth. BoE’s Governor King has on many occasions pointed out that a depreciation of the Pound would be welcomed, highlighting the positive role of a weaker Sterling in increasing the profits of export companies and limiting deflationary pressures (which are still seen as the chief reason for concern within the Bank of England).
Thus, the Sterling’s fall in value since the beginning of the year against both the US dollar (-7%) and the Euro (-2%) is likely to be seen favorably by the Bank of England. The decline in early 2010 resulted in a Sterling that is fairly valued versus the US Dollar based on the OECD’s estimate of Purchasing Power Parity and 15% undervalued against the Euro.

The decline of the Pound against the Euro and the US Dollar had a negative impact on both European and U.S investment in British assets. A clear example of this is the trend of some ETFs on British assets quoted on Italian equity markets: DB Trackers Eonia, Ishares Ftse UK Gilt and Ishares Ftse100.
The former has lost 1.7% year-to-date, while the ETF specializing in long-term bonds has gained 0.8% year-to-date, though it has lost 0.6% compared to March ‘09 due to higher yields.
However, the negative impact of developments in the British Pound on asset performance is very clear when looking at the development on the FTSE100’s ETF. Therefore, compared with the 2.1% year-to-date gain recorded by the FTSE 100, the best performance among the major stock markets in Europe, the ETF we took into account has gained only 0.9%.

These performances are a reminder of the words delivered in January ’09 by Jim Rogers, co-founder and former member of the Quantum Fund, angering many British investors and commentators: "Sell any Sterling you might have. It's finished. I hate to say it, but I would not put any money in the UK”. As long as the outlook on the Pound is not stabilized, which does not appear likely in the short term due to numerous uncertainties about the outlook of the British economy, not least the result of forthcoming elections, the advice of Rogers still has relevance.

mercoledì 3 marzo 2010

Waiting for a warmer spring

Economic data published in the past weeks came in generally weaker than expected in both the USA and the Euro Zone, increasing uncertainties on the sustainability of the current economic recovery and revitalizing downward pressures on major international equity markets.
In the USA, the Conference Board’s Consumer Confidence Index disappointed investors, as it fell more than 10 points to 46, its lowest readings since April 2009. Economists forecasted that confidence would dip to 55 from a previously reported 55.9 for January (revised to 56.5). The rise in initial jobless claims related to bad weather conditions and eroding opinions on Washington are likely to be the main reasons behind the huge decline in consumer confidence – at least according to the Conference Board’s readings. The decline in the Consumer Confidence Index implies caution on the consumer spending outlook, despite the fact that academic studies published in the past years have yet to come to a clear conclusion on the link between consumer confidence and consumer spending.
The real estate sector is seeing negative indicators coming from new home sales figures, which fell by 11% in January to its lowest level on record, signaling that the extended Government tax credit may be insufficient to rekindle demand in the short term. Investors were also disappointed by the decline in durable goods orders, ex-transportation (-0.6% m/m versus market expectations of 1% m/m) and by the rise in initial jobless claims (+22k to 496k).
In the Euro zone, the IFO Business Climate Index fell in February for the first time since April ‘09 – from 95.8 to 95.2 – versus market expectations of an increase to 96. The index indicated that the German economy, having stalled in Q4 ‘09, may grow at a very subdued pace in early 2010.
Adverse weather conditions are generally considered to be the main reasons behind the negative surprises in the last few weeks. Indeed, the first two months of 2010 have seen temperatures well below seasonal average, and widespread snowstorms in both the USA and the Euro Zone have accompanied slackened economic activity.
Thus we expect fairly weak economic data to be published in the next few weeks with regard to January and especially February.
The first test of strength for our expectations will be the ISM Manufacturing Index and employment data for February in the USA – due to be released on Monday 1 and Friday 5 respectively. No major data on Euro Zone economic activity are set for publication next week. We expect the ISM Manufacturing Index to remain unchanged vis-à-vis January owing to the positive outlook for exports, but we see the labor market further weakening: non-farm payrolls are likely to decline by 30k in February compared to the 20k decline in January.
With data on economic activity in January and February lower than expected, US and Euro Zone economic growth in Q1 ‘10 is likely to be weaker than previously forecasted by economists. The US economy is unlikely to repeat its 5.7% q/q ann. of Q4, while economic growth in the Euro Zone may also prove as anemic as in Q4 ‘09 (+0.1% q/q).
Consequently, corporate earnings in Q1 ‘10 are likely to be lower than projected by analysts. These underperforming earnings are likely to exert further downward pressure on equity markets and bond yields in the short term.
However, should the slowing down in early 2010 turn out to be merely temporary, we may expect economic activity to rebound in the next few months. In fact, Fed economist Martha Starr-McCluer emphasized this in the working paper “The Effects of Weather on Retail Sales”. While monthly data show considerable evidence of weather-related dips, the quarterly data nevertheless attest to fewer effects, and the explanatory power associated with the weather variable is generally quite modest. In this case, a rebound of equity markets and bond yields is a clear possibility.
Nonetheless, the absence of a spring economic rebound would be a clear signal that economic activity in all 2010 will be very disappointing. This scenario would drag down equity markets and bond yields even further, and the Fed would thus maintain Fed Fund Rates unchanged for an extended period.

martedì 2 marzo 2010

Canada: better than expected GDP growth but the BoC left rates unchanged at 0.25%

Canadian economy rose by an annualized 5% in Q4 ’09. Economists expected GDP to increase by 4% and the Bank of Canada had projected a 3.3% gain in the January 2010 monetary policy report. Statistics Canada revised its estimate of the Q3 growth rate to 0.9% from the earlier reading of a 0.4% pace. Q4 had solid gains in most of the major domestic expenditure categories: consumer spending rose 3.6%, residential investment 29.7% and government spending 5.8%. Business investment was the main source of weakness dropping 8.8%. On the external side of the economy, exports rose a robust 15.4% that more than offset an 8.9% rise in imports, which resulted in net exports adding 1.5 percentage points to overall fourth-quarter GDP growth.
Stronger than expected GDP growth did not have short-term consequences on the BoC monetary policy. The BoC left rates unchanged at 0.25% at the end of last week monetary policy meeting and repeated a pledge to leave it unchanged through June unless the “current” inflation outlook shifts. As regards economic activity the BoC said that “The level of economic activity in Canada has been slightly higher than the Bank had projected in its January Monetary Policy Report” and that “the persistent strength of the Canadian dollar and the low absolute level of U.S. demand continue to act as significant drags on economic activity in Canada”. On inflation, the BoC highlighted that “Core inflation has been slightly firmer than projected, the result of both transitory factors and the higher level of economic activity” and that “main macroeconomic risks to the inflation projection are roughly balanced”. The bank’s statement dropped a reference made in January to inflation risks being “tilted slightly to the downside.” and omitted a reference to the central bank having “flexibility” even with the key interest rate close to zero. While we do not see the BoC raise rates before H2 ’10, we believe that the BoC may increase rates aggressively. Indeed, our interest rate rule indicate that the BoC has the possibility to hike rates considerably (e.g. to 2%) before the end of 2010.

Reserve Bank Of Australia raised rates to 4%

The Reserve Bank of Australia raised rates by 0.25% to 4% during today's, as 14 of 19 economists in a Bloomberg survey predicted. In the statement published after the monetary policy meeting, the RBA’s Governor Glenn Stevens said that “Labour market data and a range of business surveys suggest growth in the economy may have already been at or close to trend for a few months” and “the Board judges that with growth likely to be close to trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average”. The outcome of last week’s monetary policy meeting indicated that the RBA is likely to continue tightening monetary policy in the months ahead. The cash rate may be raised to 4.75% by year-end, with a rate hike delivered every couple of months.