Top down outlook

The Week Ahead In The Eurozone: PMI Indices, German IFO And Spanish Election

2011-11-21T11:19:00.002+01:00

In the Eurozone over next week fresh evidences that the economy may fall in recession in Q4 ’11 and further weaken in Q1 ’12 are expected from the PMI indices for November. Having fallen to 47.1 and to 46.4 respectively in October, both the PMI manufacturing and the PMI services may further decline in November: continue on seekingalpha...

A Look Into The Depths Of Europe's Recession

2011-11-17T08:43:00.000+01:00

The ZEW index released on Tuesday 15th confirmed that the outlook for the German economy – and as a consequence of the whole of the Euro zone economy - may further deteriorate in the next few months. The most important economic indication in the next few days (continue on seekingalpha)

Can The U.S. Consumer Save The World And The Equity Markets?

2011-10-26T08:55:00.002+02:00

Economic data for September (for the data and projections I used this calendar) released over the last few weeks came out better than expected, signaling the U.S. economic activity rebounded after the weakness over the summer...continue on seekingalpha

Bank Of England Policy Could Weaken The Sterling

2011-10-20T09:31:00.000+02:00

The Bank of England released today the minutes of the monetary policy committee meeting of October 5 and 6, in which a GBP 75 billion increase (to GBP 275 billion) of the asset purchase program was decided. The minutes confirmed that the BoE sees the risk that inflation (continue...)

The Week Ahead: European Summit And U.S. Economic Data

2011-10-15T10:13:00.000+02:00

In the eurozone, the focus will be on the October 23rd European leader summit that is expected to deliver a strong solution of the eurozone financial crisis. The expectations became strong (continue on seekingalpha)

Fed: no other money untill recession. Or a further decline of the equity market...

2011-10-13T10:43:00.000+02:00

The minutes of the 20 September monetary policy meeting - in which the Operation Twist was decided - indicated the FOMC members had different views on the best profile for the monetary policy. While 3 members out of 10 opposed the decision to implement the Operation Twist, two members preferred a stronger policy action, increasing speculation that the Fed may decide a QE3 in one of the next monetary policy meeting (the next one is on November 1-2).

Conclusion: in our view the minutes of the Fed did not give any indication of a further easing of monetary policy at the tail end of the year. The Fomc may decide to implement a QE3 program only in the case the economic outlook would deteriorate strongly and the possibilities of recession further increase. However, the better than expected data released since early October (ISM manufacturing – ISM non-manufacturing – employment report) indicated that the economic outlook in the short term may be better than expected (many economist revised upward their Q3’s GDP estimates after these data were released). For these reasons we do not see a QE3 plan in the short term.

UK unemployment rate and Euro zone industrial production

2011-10-12T19:00:00.000+02:00

The UK unemployment rate rose to the highest in 17 years in August (from 7.9% to 8.1%) with the number of unemployed increased to 2.57 million, the most since 1994. In the Euro zone the industrial production rose by 1.2% m/m (after +1.1% m/m in July) and 5.3% y/y in August. The data benefited from the the increase of industrial production in Italy (4.3% m/m) and France (+0.6% m/m) that offset the decline in Germany (-1% m/m).

Conclusion: the increase of the unemployment rate is a clear sign of the weakenig of the UK economy and strenghtned the view of the BoE that the UK economy needed an easing of monetary policy as soon as in October despite the high level of inflation. Following the aneamic rate of growth in Q2 (0.1% q/q), the UK economy may fall short of economists expectations also in Q3 (the NIESR today predicted a 0.5% q/q growth in Q3).

The Euro zone industrial production data indicated that the Euro zone outlook in the short term may be better than expected. However, with the main business confidence indices in a downward trend, we expect the rebound over the summer to be temporary and the financial crisis over the summer to weigh on the data starting from September.

Q3's earning season starts in the USA

2011-10-11T15:39:00.000+02:00

With the release of Alcoa’s (AA) Q3 results on Tuesday 11, the Q3’s earning session will have its traditional kick off:. After being caught by economic news and the debt crisis in the eurozone, the investors’ attention is likely to return in the next few weeks on corporate profits. continue on seekingalpha

The week ahead: focus on the Euro zone

2011-10-10T21:37:00.001+02:00

On Sunday Chancellor Merkel and President Sarkozy said they will announce a comprehensive package of measures to stabilise the euro zone, including the recapitalisation of European banks if they need it, ahead of the November 3/4 G20 meeting. They did not provide any detail on the plan and promised to give them by the end of October. The main issues coming from the press conference are: 1) not giving any detail on the plan, Merkel and Sarkozy did not eliminate concerns that that the two governments had yet managed to resolve their differences on which entity will in charge to recapitalize the banks; 2) getting the other 15 member states to agree can prove challenging. The next key date is the 23 October EU Council when further elements to address the situation in Greece, the bank recapitalisation and the enhanced efficiency of stabilisation tools (EFSF) will be discussed.

The Slovakian Parliament will vote on Tuesday 11th on the approval of the EFSF. The latest headlines over the weekend suggest the governing coalition has still not found a compromise and will meet on Monday again. With Slovakia being the last country to vote for the approval of the EFSF, the plan is very likely to have a positive vote.

On Tuesday 11 the Italian Government will sell EUR7bn of 1 year BOT and EUR2.5bn of 3 months BOT. On Thursday 13 the Italian Government will 5/7/10/14 year BTP. In the latest long term government bond auction on September 29, Italy solo bonds due in 2022 to yield 5.86%, up from the 5.22% it paid Aug. With long term yields declined in early October, yields in the Thursday’s auction are likely to be lower than in September. The main issue is the level of the demand after Italy raised less than targeted in September: we do not expect a strong improvement in the demand as concerns on the Italian economic outlook remain elevated due to high public debt.

The Euro zone industrial production may decline by 0.7% m/m (after +1% m/m) in August after German industrial production declined by 1% m/m. The data would increase the possibilities that the Euro zone economy may fall in recession as soon as in Q4.

In the USA the focus over the week will be on the consumer spending outlook. Retail sales are likely to rebound by 0.4 m/m (0.0% m/m in August) and by 0.2 % m/m (+0.1% m/m in August) in September. The data would be in line with a 0.4% q/q increase of real consumer spending in Q3 ’11. The University of Michigan consumer confidence index may increase from 59.4 in September to 60 in October, remaining well below long-term average (90) and indicating a poor outlook for the consumer spending in Q4 ’11.

The minutes of the Fed 20 September monetary policy meeting are not likely to give any indication of a further easing of monetary policy in the next meetings.

PMI services below 50 in the Euro zone: risk of recession increasing

2011-10-05T10:21:00.000+02:00

The PMI services indices released today all around the Euro zone came in worse than expected in September, signalling that the worsening of the economic outlook may be even stronger than projected. The Euro zone PMI fell from 51.5 to 48.8 - with a downward revision from the flash estimate of 49.1 - the lowest level since August '09. The index set below 50 - anticipating a contraction for the sector - both in Italy and in Germany while remained above 50 in France. The decline of the index below 50 in Germany is a sign that consumer spending may further weaken going forward, dampening the expectations that an improvement of German internal demand may sustain the economic activity and limiting the negative consequences on exports of the peripheral countries crisis. The Euro zone PMI services increased the chances that the Euro zone economy may fall into recession in Q4 '11.

USA: CPI higher than expected in August, Industrial production rose unexpectedly

2011-09-15T15:41:00.000+02:00

Negative data came out today in the USA, with the expection of industrial production:

1) Initial jobless claims rose in the week to September 10th from 417k (revised from) to 428k versus markets expectations at 411k. the 4 week moving average rose by 4k to 419.5k. The data signalled that labour market is likely to remain very week in September after the non-farm payrolls was unchanged in August;

2) The CPI rose more than expected in August: +0.4% m/m versus expectations at +0.2% m/m and the year-over-year change at 3.8% y/y vs +3.6% y/y in July. Moreover the CPI core rose by 0.2% m/m and +2% y/y (+1.8% y/y) in July - the highest since November 2008;

3) The Empire manufacturing index fell from -7.8 to -8.8, indicating a deteriorating of the manufacturing sector perspectives at year-end;

4) industrial production rose by 0.2% m/m in August versus market expectations at 0.1% m/m. The most positive news is that manufacturing production climbed by 0.5% m/m, led by 2.6% m/m increase in auto production.

Today's data increase the uncertainty on what the Fed would decide at the end of the next week monetary policy meeting. Indeed while the data on economic activity signalled a weakening of the economic outlook, inflationary pressures remains to high to see a strong easing of monetary policy, as we indicated yesterday in the article "Can The CPI Influence Monetary Policy Decisions?". While the possibility of an easing of monetary policy over the next week are at 50-50, we think that the impact on economic activity will be very low as long term interest are already at historically low level.

Can The CPI Influence Monetary Policy Decisions?

2011-09-14T14:03:00.002+02:00

The major central banks are widely expected to further ease monetary policy in the next few months amid the weakening of global economic growth: The Fed may implement a QE3 program, continue on seekingalpha...

German factory orders lower than expected in July

2011-09-06T13:59:00.000+02:00

Factory orders fell by 2.8% m/m in July, led by the 7.4% m/m decline in orders from abroad, while domestic orders rose by 3.6% m/m. Market expectations were for a decline by 1.5% m/m. Compared to the same period 1 year ago factory orders rose by 8.7%. The data is a clear indication that the weakening of international economy is having a negative impact on the German industrial sector, in line with the indications come from the IFO business index.

German IFO Business Confidence Index Shows Anything But Optimism

2011-08-25T09:51:00.000+02:00

The German IFO business confidence index fell more than expected in August, from 112.9 to 108.7 - the lowest since July 2010. The market expectations were for a decline to 111. According to the historical relationship between the IFO business confidence index and the German industrial production (continue on seekingalpha)

Sterling to Weaken vs. the Euro

2011-07-27T17:49:00.002+02:00

In the UK, the GDP grew by 0.2% q/q and 0.7% y/y in Q2, in line with market expectations. The year over year change is the lowest since Q1 ’10. The statistics office estimated that excluding factors such as the Japanese earthquake...(continue on seekingalpha)

German Equity Markets Should Continue Outperforming in the Eurozone

2011-06-16T13:49:00.002+02:00

In the following graphs, we show how the Dax index clearly overperformed other eurozone countries equity markets since 2003 when the Germany economy started to benefit from structural reform implemented in early 2000. Continue on seekingalpha...

The Euro May Start a Downward Trend

2011-06-14T10:21:00.002+02:00

Having touched a 5 weeks high on June 7th at 1.4696, the euro/U.S. dollar exchange rate tumbled in the following three days, falling below 1.44. Continue on seekingalpha...

Government Bonds: Not a Long-Term Buying Opportunity

2011-06-09T08:12:00.000+02:00

Government bond yields were expected to rise over the spring as the QE2 program of the Fed came close to an end in June and inflationary pressures remained elevated amid high energy prices. continue on seekingalpha...

The Week Ahead: GDP and Personal Spending Figures

2011-05-24T11:28:00.002+02:00

Our latest article on Seekingalpha: The Week Ahead: GDP and Personal Spending Figures

The Week Ahead: A Focus on Industrial Sector and Housing Market Data

2011-05-17T10:00:00.000+02:00

Here we are the link to our latest article on seekingalpha: The Week Ahead: A Focus on Industrial Sector and Housing Market Data

In Focus This Week: FOMC Meeting and GDP Numbers

2011-04-26T15:14:00.000+02:00

Our latest article on seekingalpha: In focus this week: Fomc meeting and GDP numbers:

Are Japanese Equity Markets a Buying Opportunity?

2011-02-15T22:51:00.002+01:00

The Japanese economy has had plenty of negative news recently, such as the Jan. 26 Standard & Poor's statement that it may downgrade the nation's current AA sovereign debt rating by one "notch,". continue on seekingalpha

Gold: End of a Trend or a Buying Opportunity?

2011-02-09T09:47:00.002+01:00

Even with the rally of the last few days, gold prices still have had a negative performance year-to-date despite two elements that should give sustained prices: continue on seekingalpha

Eurozone: Next Week's Focus on Industrial Production Data

2011-02-06T14:57:00.002+01:00

My latest article on seekingalpha: Eurozone: Next Week's Focus on Industrial Production Data

Trichet Sounds More Dovish on Inflation: EUR/USD Set to Decline

2011-02-04T09:27:00.001+01:00

As widely expected, the European Central Bank (ECB) left rates unchanged at 1% at the end of yesterday’s monetary policy meeting. Continue reading the article on seekingalpha

Senior Loan Officer Survey Indicates Stronger U.S. Growth Ahead

2011-02-01T17:34:00.000+01:00

My last article on seekingalpha: Senior Loan Officer Survey Indicates Stronger U.S. Growth Ahead

Bank of England more hawkish

2011-01-28T09:04:00.002+01:00

The Minutes of January 13th monetary policy meeting signaled that the tightening bias inside the Monetary Policy Committee has increased. Indeed, while the majority of the members voted to maintain unchanged both the bank rates at 0.5% and the asset purchase program at GBP200bn, Martin Weale joined Andrew Sentence in preferring a rate hike by 25bp to face inflationary pressures. Adam Posen confirmed its preference toward a further increase in the asset purchase program by GBP50bn. The minutes indicated that BoE’s concerns on inflationary pressures are increased in the last few weeks, especially as regards its consequences on inflation expectations. The inflation report due for release on mid-February will give more details on monetary policy outlook in the short term with publication of new BoE’s projection on CPI and GDP growth. Latest economic data indicated that U.K. economic outlook in 2011 may be worse than previously expected.

Indeed Q4 data released on Tuesday 25th indicated that UK GDP contracted by 0.5% q/q in Q4 ’10, coming in worse than market expectations for a 0.5% q/q increase. Compared to the same period 1 year ago GDP rose by 1.7% q/q versus market expectations for a 2.6% y/y increase. Output in the production industries increased 0.9% (0.5% q/q in Q3) while in the construction sector and in the service industries decreased 3.3% (following the 3.9% q/q increase in Q3) and 0.5% (+0.5% q/q in Q3) respectively. Business services and finance, construction and distribution, hotels and restaurants were the largest contributors to the negative growth this quarter (-0.2%).

The ONS estimated that bad weather is likely to be the main reason behind the contraction in GDP. Without this negative effect GDP may have remained flat in Q4. In every case the economic growth would have been weaker than expected by the consensus. With austerity measures beginning to have an impact on economic growth in Q1 ’11, the outlook for UK economy is likely to be weaker than previously projected increasing the possibility that the Bank of England will maintain rates unchanged in the foreseeable future despite higher than expected inflationary pressures in the last few months (3.7% y/y in December 2010). However the possibility that the BoE may decide to hike rates as early as in May are clearly increased after the release of January’s MPC’s minutes.

Why an ECB Rate Hike Is Not Imminent

2011-01-25T20:35:00.001+01:00

Despite financial markets movement following the Trichet press conference (both the Euro exchange rate and the long-term German government bond yields rose) we do not see the ECB hiking rates anytime soon. This is the link to our article on seekingalpha.

The IFO index and German government bond yields

2011-01-25T08:20:00.000+01:00

The increase in the IFO business confidence index is a negative sign for long-term German government bond yields. The link to the full article

The Week Ahead: FOMC meeting and Q4 GDP numbers

2011-01-21T15:34:00.000+01:00

My latest article on seekingalpha about economic data due for release over the next weak.

Bank of Canada maintain rate unchanged at 1%

2011-01-19T12:54:00.000+01:00

As widely expected the Bank of Canada left rates unchanged at 1% at the end of yesterday’s monetary policy meeting. In the statement released at the end of the meeting the BoC slightly raised GDP estimates for both 2011 (from 2.3% to 2.4%) and 2012 (from 2.6% to 2.8%). The BoC also confirmed that the output gap will close by the end of 2012. The CB also indicated that “net exports are projected to contribute more to growth going forward, supported by stronger U.S. activity and global demand for commodities” but said that “the cumulative effects of the persistent strength in the Canadian dollar and Canada’s poor relative productivity performance are restraining this recovery in net exports”. The BoC is not expected to resume a tightening monetary policy before the end of Q2 ’11.

Norges Bank lower rates expectations

2010-06-25T10:16:00.000+02:00

As widely expected, the Norges Bank left rates unchanged at 2% at the end of last week’s monetary policy meeting. In the Monetary Policy report released after the meeting, the Norges bank indicated that the uncertain outlook on Euro zone economy would postpone the rate hikes previously projected in 2010. Rates are expected to remain unchanged by the time of the publication of Monetary policy report: 3 on October 27th. Rates are also projected to remain on hold by the end of the year versus a previous projection of 2.5%. Key rate is projected to grow to 2.75% by the end of 2011. The new projections clearly indicated that the Norges Bank see the internal economic recovery negatively affected by the European debt crisis. Only in the case the European economy should prove more resilient than expected to the debt crisis the Norges Bank may revise their projections, hiking more aggressively.

Bank of England concerned on inflation

2010-06-25T10:14:00.002+02:00

BoE's monetary policy minutes of 9/10 June had a major surprise: one member of the Committee (Andrew Sentance) voted against the decision to maintain rates unchanged at 0.5%, preferring an increase to 0.75%. The reason behind his vote was the higher than expected inflation trend in the last few months. However, according to BoE's minutes, inflation developments concerned the whole of Monetary Policy Committee. The minutes underscored that inflation was higher than expected in the last few months and that may remain above target if the private sector’s expectations of inflation over the medium term also rose. The major risks on inflation outlook were the measures to be announced in the budget and the "considerable uncertainties about the margin of spare capacity and the strength of its influence on inflation". Despite one member's vote in favour of rate hike, we believe that the building of a consensus inside the BoE toward a removal of easing monetary policy is hard to envisage in the short term due to moderate rate of growth. Only in the case the substantial margin of spare capacity would fail to lower inflation in H2 '10 the BoE will start considering raising rates.

Euro zone economy little affected by debt crisis by now

2010-05-24T15:50:00.000+02:00

Over the last week it was visible the effect of last few week’s debt crisis on economic data. The ZEW economic sentiment index fell more than expected in May (from 53 to 45.8 versus market expectations of 47) as institutional investors were concerned that economic growth in the next six months may weaken as a results of uncertainties on peripheral Euro zone countries. However, despite being lower than expected and having worsened in the second half of the month, the index remained well above long term average (27.4), confirming that German economic recovery is expected to continue.

As regards inflation, April figures indicated that headline CPI rose 1.5% y/y and that the CPI core fell from 1% y/y to 0.9% y/y – historical low of the index. April’s figure confirmed that inflationary pressures are subdued due to high unemployment rate and very weak internal demand. Deflationary pressures are likely to emerge in many countries. Should this trend continue, the ECB may decide to cut rates again or decide to not sterilize next government bond purchases.

Fed: rates unchanged for an extended period

2010-04-29T21:48:00.000+02:00

In the statement released at the end of last week monetary policy meeting, the Fed confirmed the pledge to leave rates unchanged for an “extended period” due to low rates of resource utilization, subdued inflation trends, and stable inflation expectations. As in the two previous meeting, the president of the Federal Reserve Bank of Kansas City Thomas Hoening dissented on maintaining this pledge as he believed “it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly”. Albeit confirming that rates will still remain unchanged for some months, the Fomc gave an upbeat picture on US economic outlook, indicating that labour market is improving (it was seen as stabilizing in March) and that consumer spending has picked up. The Fomc reaffirmed that inflation is likely to remain subdued for some time. In the statement released at the end of the meeting the Fomc clearly confirmed that despite economic activity improved in the last few months a rate hike is not on the card. Only a sustained improvement in labour market will be the trigger for the beginning of a tightening monetary policy. Moreover it seems very likely that the Fed will consider the risk to increase rates too later lower than the risk to increase them too early.

Rescuing Greece

2010-03-30T15:24:00.000+02:00

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.

The Fed and the markets

2010-03-23T11:11:00.000+01:00

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.

Commodities update

2010-03-17T15:21:00.000+01:00

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.

A follow up on UK negative outlook

2010-03-12T14:50:00.000+01:00

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...

For the entire article look here: http://www.telegraph.co.uk/finance/economics/7423138/Europes-banks-brace-for-UK-debt-crisis.html

Forget UK!

2010-03-10T11:48:00.000+01:00

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.

Waiting for a warmer spring

2010-03-03T18:26:00.000+01:00

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.

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

2010-03-02T22:09:00.000+01:00

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%

2010-03-02T22:04:00.000+01:00

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.

Japanese economic trouble: why we should underweight japanese financial markets

2010-02-23T21:58:00.001+01:00

An excerpt form our latest Top Down Outlook. Go on our website for a 1 month free trial.
Over the last few weeks, investors have been focusing on the negative outlook for peripheral Euro Zone countries, especially Greece, due to their high deficit and public debt. However, albeit at a slower pace, uncertainties over the future of public accounts concern a vast majority of developed countries. For instance, public debt, in % of the GDP, may rise to 65% in the USA, 88.2% in the UK in 2011 and 83.7% in the Euro Zone as a whole.

Notwithstanding the above, the country that may suffer the most in the next few years due to elevated public debt is Japan. Indeed, public debt ballooned in the last two decades from 59% of the GDP in 1990. Further, the International Monetary Fund estimates that debt may have risen to 218% in 2009, and thus could reach 227% and 246% in 2010 and 2014 respectively. This jump in public debt substantially replaced the falling private sector debt, increasing the level of total debt/GDP, according to data from McKinsey Global Institute, from 420% in 1995 to 471% in Q2 ‘09. We used 1995 as a benchmark year, since this is when non-financial business debt reached its highest level (148% of GDP). After 1995, non-financial business sectors began a deleveraging process that finished only recently (non-financial business debt fell to 91% of the GDP in 2005 and now stands at 95% of the GDP).

Despite the huge increase in public debt and the estimated further increase in the years ahead, government bond yields have remained very low. The 10-year Japanese Government Bond yield has been below 2% since 1998, with no meaningful changes over that period. By now, Japan holds the record for both the highest general government debt and the lowest long-term government yield among developed countries; which is in stark contrast with economic theory.

The grounds for this “conundrum” are explained in a recent working paper “The Outlook for Financing Japan’s Public Debt” by IMF economist Kiichi Tokuoka, who enumerated the factors behind the low and steady JGB yields:

1) Large pool of household assets: household saving rate was around 10% until around 1999 when it began to decline sharply;

2) Strong home bias: JGBs have been financed largely by domestic investors (94 %of holdings as of end-2008), who may exhibit more stable behaviour than foreign investors. The strong home bias is driven by the household sector whose appetite for risk assets has remained weak. The share of currency and deposits in households’ financial assets is as high as 55% (at end FY2008)—well above 16% in the U.S.—and a large part of these funds is invested in JGBs mainly through the banking sector;

3) Existence of large and stable institutional holders as the Japan Post Bank and the Government Pension Investment Fund;

4) Recent large saving flows from the corporate sector.

Nevertheless, Tokuoka explained that structural shifts in the Household Balance Sheet and key market players could weaken the absorptive capacity of the JGB market, making yield more sensitive to the debt level. For instance, the role of the household sector in providing funds to the JGB market is likely to decline as the savings rate may further fall from the current level (2.2% in 2007). The author’s simulation indicated that, based on current trends, the gross public debt in 2015 could exceed gross households’ financial assets, that is, of course, assuming that the household saving rate remains at 2.2%.

Tokuoka concluded that it would be critical to establish a credible framework over the medium term to ensure fiscal sustainability. The framework would need to feature a clear timetable for comprehensive tax and expenditure reforms to be implemented once the economy recovers.

However, a shift in the expansionary fiscal policy adopted by the Government in the last few years is not yet on the horizon. The latest macroeconomic data, while posting a better than expected growth of 1.1% q/q GDP in Q4 ‘09, indicated that economic growth is mainly driven by exports in spite of the surprising rebound of both consumer spending and business investment. The most worrying aspect of Q4 GDP figures, however, was the 0.9% q/q decline of the GDP deflator – a 54 year low.

Deflation weighs on the Japanese economy in two ways: 1) it weakens consumer spending, and 2) it dampens business investments because real yield is higher than in the rest of the developed world.

This negative situation will unlikely change in the short term as the output gap is indeed very wide (about 7% according to the Cabinet Office’s estimate for July-September 2009), and a meaningful recovery is not expected over the next few months. Moreover, internal demand is likely to remain weak as wage declines are influencing sales over a broad range of discretionary goods, and investment spending will unlikely pick up considerably due to uncertainties on current economic recovery. For these reasons, only further significant improvements in exports could trigger a sharper upturn in the economy.

On the other hand, increases in exports are limited by the Yen's sharp appreciation in recent months, particularly against the U.S. Dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with its June 2007 peak, the Yen has advanced by over 27% against the U.S. Dollar, eroding profit margins for the nation's exporting companies. Based on the OCSE Purchasing Power Parity estimate, the current level of the Yen surpasses an overvaluation of 25% against the U.S. Dollar.

Therefore, a devaluation of the Yen is the most efficient way to spur growth in Japan’s economy in the short term, even though it appears difficult to implement, given that almost all major international economies rely more or less heavily on their currency devaluation to revive the economy. Moreover, both the Bank of Japan and the Treasury Minister seem to have limited possibility to implement further policy action to stimulate the economy. Last week, the BoJ left rates unchanged at 0.1% and did not take decision on its quantitative easing program.

All the same, we believe that should the Japanese Yen’s upward trend versus the U.S. Dollar resume in the months ahead, the Bank of Japan will be ready to take extraordinary measures to weaken the exchange rate, i.e., increasing lending term facility for commercial banks or raising government bond purchases. Fiscal deterioration is another factor prompting a decline of the Japanese Yen. We believe that there are no likely prospects of the Japanese Yen strengthening beyond its current level in the months ahead.

For this reason, we would not invest in any asset classes denominated in Japanese Yen. The Japanese equity markets have underperformed other major international equity markets. Thus, in view of potential Yen devaluation in the medium term and low bond yields, we recommend not to invest in the Japanese bond market.

Finally, the economic scenario for the Japanese economy we have depicted above reinforces our recommendation to BUY the AUD/JPY exchange rate, which fell in the previous weeks due to a surprising RBA decision to leave rates unchanged at 3.75% at February’s monetary policy meeting in conjunction with the increase in risk premiums on international financial markets. However, the AUD/JPY rebounded last week as the RBA made clear in the minutes of February’s monetary policy meeting that the tightening monetary policy will resume in the next few months. Following the higher than expected increase in employment in December, we foresee the RBA hiking rates to 4% as soon as in March. We continue to expect the Australian and Japanese Central Banks to each implement a highly restrictive and expansionary monetary policy in 2010 among major Central Banks, making the AUD/JPY the favorite exchange rates for carry traders.

Momentum indicators still say overweight equity

2010-02-17T09:32:00.000+01:00

An excerpt form our latest Top Down Outlook. Go on our website for a 1 month free trial.

Following the sell-offs of recent weeks, major international equity markets continue brandishing negative performances since the beginning of 2010: The S&P500 has declined by 3,55%, the DJ Eurostoxx by 8,22%, the Nikkei by 4,3% and the FTSE100 by 4,99%. Emerging markets as a whole also have kindled negative performances in 2010: the MSCI Asia fell by 5,9%, the MSCI European emerging by 3,8% and MSCI Latin America by 3,7%.

Even renowned strategists and economists now differ on the outlook of equity markets over the next few months, especially with regard to the S&P500. Barton Biggs, chief global strategist at Morgan Stanley from 2003 to 2007, and now head of the hedge fund Traxis Partners, recently said that valuations are ok, and that there are a number of good opportunities on the market. Last September, Biggs said that the S&P500 may climb to 1350 in 2010. However, according to New York University Professor Nouriel Roubini, the stock market will be flat or almost unchanged at the end of the year. More pessimistic is the outlook depicted by Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co, who said investors should underweigh stock because the S&P500 is above what he believes to be its fair value at 850.

As we indicated in 11 January’s “Global Strategy Weekly” , we believed that the S&P500 was slightly overvalued at the beginning of the year according to our long-term valuation model, which analyses the average earnings for the past 10 years, the average earnings annual growth rate and the average P/E for the past 30 years. Following last week’s sell off, investors may now expect a compound return of 6% in the coming 10 years, slightly below the actual historical average return of 7%, but above the average of 5.4% predicted by the model in the past.

Nonetheless, we have also maintained a BUY rating on many equity markets; especially those in emerging countries (see 1 February’s “Global Strategy Weekly – Equity Emerging Markets Outlook”). Among the equity markets in developed countries, we have a BUY recommendation on the Nasdaq 100. In 1 February’s report, we have underlined all the fundamental reasons behind our decision to confirm our rating on those markets. However, an important reason for this rating is that we are great followers of momentum strategies and these markets are still in an upward trend. In this week’s “Global Strategy Weekly”, we will be analyzing what the most popular momentum strategies say on the perspectives of major international financial markets.

Momentum strategies have been the subject of a long series of working papers in academic literature that indicate how they are able to generate significant extra yields. One important report by Jegadeesh and Titman, "Returns to buying winners and selling losers: Implications for stock market efficiency", published in The Journal of Finance (1993, Issue 1), prominently demonstrates this theory. In this report, the two authors affirmed that the strategy of buying securities which, during the last period (3 to 12 months earlier) had achieved the best performance, gained positive abnormal returns during the period 1965/1989 in the U.S. market. For instance, the strategy which selects stocks based on their past 6-month returns and holds them for 6 months realizes a compounded excess return of 12.01% per year on average. This is an important verification by the two authors that these returns were not due to the presence of systemic risk or a delayed reaction to common factors. This study was followed in subsequent years by several reports related to other international equity markets that found similar results.

Leaving aside what might be the causes of these results, we are going to examine the results of a very simple momentum strategy with reference to the major international asset classes. We will take some Eurizon’s mutual funds (Eurizon is one of the bigger asset managers in Italy) as a benchmark, not in order to judge their goodness, but in order to assess the actual return achievable by an Italian investor in the past 11 years using momentum strategy. We evaluated 10 mutual funds that invest in different asset classes: as regards the stock markets, we considered funds invested in Asia, Europe, Japan, Italy, North America and Nasdaq100; and as regards bond markets, we considered funds invested in Euro medium/long-term Government Bonds, Euro short term bonds, US Dollar bonds and emerging markets bonds. The strategy consists of: at the end of the month to buy the 3 mutual funds (out of 10) with the best year-over-year performance and keep them in the portfolio until the end of the following month, and then make a new selection. The chart below indicates that such a strategy would have granted an investor a performance close to 60% from 1999, compared to 6% which would be recorded dividing the initial investment in equal shares in each of the funds.

Considering the 30 major asset classes identified among the Italians ETF (stock markets, bonds and commodities), the six financial markets that this strategy suggests as overweight now are: equity Eastern Europe, equity Latin America, equity Emerging Asia, equity Africa, equity China and the Nasdaq 100. With the exception of China, which we do not include in our portfolio due to fears of excessive credit growth in 2009 (as we explained in 19 December’s Top Down Outlook), these are the asset classes that we overweighed in our Top Down Portfolio (Equity emerging Asia has been recommended since 19 December, the whole of the other equity markets since the inception of the portfolio on 5 December).

Choosing these assets would appear to go against the trend of recent weeks, which saw major stock markets trend downwards. However, this should not come as a surprise when considering that the buy or sell indications of momentum strategies lags behind the reversal of the trend. On the contrary, the decline of recent weeks afforded investors, who had not entered the equity markets in recent months, to possibly invest with a better risk/return profile than at the beginning of the year. In fact, after the fall, most of the stock markets were brought closer to what is seen as a watershed between upward and downward trends: the 10-month moving average. In the following table, we have highlighted the results of a very simple trading system: buy an equity index when the closing price is greater than the 10-month moving average and exit the market when the closing price is lower. Performances using this simple strategy are rather positive (we did not consider the gains from bond markets in the months when we were not investing in equity markets).

We have also highlighted the distance of the current close from the 10-month moving average. A combination of the two previous strategies could be used to buy equity markets currently indicated by the momentum strategy, setting a stop loss below their respective 10-month moving averages to limit losses in the case of reversal of the long-term upward trend.

The Week Ahead in US: CPI and capacity utilization most important data

2010-02-15T14:01:00.000+01:00

Empire Manufacturing Index (Tuesday 16) – The Empire Manufacturing Index rose in January to 15.9 from 4.5 in December, indicating improved conditions for the manufacturing sector in early 2010 in the New York area. The data was substantially in line with indications coming from the ISM Manufacturing Index as regards the USA as a whole. The index is likely to indicate that industrial production will continue to trend upwards in the months ahead, remaining almost unchanged at 15.2. The equity markets’ decline in the past few weeks is likely to be the main reason behind the slight downtick in the index.

NAHB Housing Market Index (Tuesday 16) – Confidence among US Homebuilders dropped in January from 16 to 15 – its lowest level since June ’09. We expect the index to rebound to 16 in February, as real estate may begin feeling the effects of the tax credit extension and expansion for home buyers.

Housing Starts (Wednesday 17) – Housing Starts tumbled by 4% to 557k in December, with poor weather conditions probably taking their toll on the data. With weather conditions still negative for the sector in January, housing starts may have continued falling over the month: we estimate a 2% m/m decline to 545k. Housing Starts are likely to rebound in the months ahead thanks to a tax credit extension to June.

Industrial Production and Capacity Utilization (Wednesday 17) – Business confidence indexes rose in January (the ISM Manufacturing Index marked its highest level since August 2004), anticipating a continuance of the upward trend in industrial production. In line with the increase in the index of aggregate weekly hours, we estimate industrial production to rise by 0.5% m/m in January. Compared to January ’09, industrial production may rise by 0.9%, the first year-on-year positive change since March ’08. Capacity utilization is likely to increase to 72.3% from 72%. The index should nevertheless remain well below its historical average (80.6%), indicating soft inflationary pressures in the months ahead.

FOMC Minutes (Wednesday 17) – In line with our estimates, the FOMC upgraded its view on the US economic outlook in a statement released after its 27 January Monetary Policy Meeting. The FOMC confirmed that “economic conditions, including low rates of resource utilization, subdued inflation trends and stable inflation expectations are likely to warrant exceptionally low federal fund rate levels for an extended period of time”. However, this opinion was disputed by Kansas City Fed President Thomas Hoening, who said in the press release that “financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Federal funds rate for an extended period was no longer warranted”. The minutes of the latest monetary policy meeting will furnish more insight on the particular views of the members of the Board of Governors concerning the economic outlook. In particular, it has to be seen whether other members, aside from Hoening, would have preferred removing the expectations of a low level Federal Funds rate for a long period, but might have decided to concur with the majority.

Consumer Price Index (Friday 19) – The Consumer Price Index rose to 2.8% y/y in December from 1.9% y/y in November, exclusively for the base effect in energy prices. The core inflation edged up to 1.8% y/y from 1.7% y/y in November, due to higher vehicle prices that were only partially compensated by shelter prices (unchanged m/m in December). We expect consumer prices to increase by 0.2% m/m and by 2.7% y/y in January as inflationary pressures are likely to remain subdued in the short term, hence reflecting low pricing power. Core inflation may edge up 0.1% m/m to 1.7% y/y.

Central Bank Monitor: BoE and Riksbank on the spotlight

2010-02-12T14:15:00.000+01:00

Bank of England:

At the press conference on the Inflation Report, the BoE’s Governor King confirmed that the decision to forestall purchasing government bonds was not definitive, and that its extension could be decided if consumer prices became worse than previously estimated. As for the projections on economic activity and inflation, the BoE has slightly lowered its estimates on GDP growth and raised its estimates on inflation in the short term, vis-à-vis November’s Inflation Report. The growth rate of GDP is projected to be about 3% y/y in late 2010, and to surge at the same pace in 2011 should interest rates coincide with market expectations, or scend by 4% should rates remain steady at 0.5%. Nonetheless, Governor King stressed that the British economy will not recover the pre-crisis growth trend for many years. Inflation is foreseen to breach 3% y/y during the first part of 2010, probably in January, mainly due to the disappearance of the temporary VAT reduction. Towards the end of 2010, inflation should submerge below 1% and should not buoy up to 2%, the targeted high tide in two years. With inflation expected to remain below the 2% mark at a two-year horizon, a wide output gap expected for the long haul, and a fiscal policy that could become more restrictive in the coming months, we think that the Bank of England should find little reason to raise rates substantially in the near future. We pencil in the BoE to raise rates only by the end of 2010 and only after the Fed and the ECB have decided on a similar action.

Riksbank:

As widely expected the Riksbank left rates level at 0.25% at the end of last week’s monetary policy meeting. In the Monetary Policy Report, the Swedish Central Bank revised the CPI projection for 2010 upwards, from 0.8% to 1.6%; and slightly downwards for both 2011 (from 3% to 2.9%) and 2012 (from 3.6% to 3.1%). As regards economic growth, the GDP is expected to climb by 2.5% in 2010 against the 2.7% projected in December’s Monetary Policy Report update. This is the result of both the improved functioning of financial markets and positive economic indicators, signaling that economic recovery stands on much firmer ground. The Riksbank anticipated monetary policy normalization as the first rate increase in now expected during the summer or early autumn (in December it was expected in autumn). At the same time, the current assessment is that the Repo Rate increase may occur more gradually and its forecast in the longer term has therefore been adjusted downwards slightly. The Repo Rate is expected to grow to 1.25% in Q1 2011 (previous estimate at 1%) and to rise to 3% only at the end of 2011 and not in Q3 2011 as previously expected. The real Repo Rate has been revised upwards, but will remain negative during 2010.

Riksbank outlook: no rate hike on the radar screen

2010-02-10T18:37:00.002+01:00

At December’s monetary policy meeting, the Riksbank decided to leave the repo rate unchanged at 0.25%. The Central Bank also confirmed its previous path estimate of the rate for the coming years, as it is expected to remain steady at the current level until autumn 2010, then rise to 0.5% by the end of 2010, to 2.5% by the end of 2011, and to 4.25% by the end of 2012. The Riksbank is widely expected to leave the rate unchanged at 0.25% and to confirm the previously estimated rate path in the Monetary Policy Report released at the end of the meeting. The report will also contain the new projections on the progress of inflation and economic growth. Deputy Governors Nyberg and Wickman-Parak may enter yet a third consecutive reservation against the repo rate path. During December’s monetary policy meeting, they considered that it would be necessary to raise interest rates sooner than indicated by the proposed interest rate path, but that the path would consequently not need to be so steep during the remaining forecast period. We do not expect Deputy Governor Svensson to vote for another rate cut. Despite the better-than-expected economic data published over the past few weeks, we believe that the Riksbank will not tighten rates until the ongoing economic recovery proves itself well established. Moreover, the Riksbank is seeking a Krona appreciation in the coming years. Thus, it is highly unlikely that rates will be raised before other Central Banks (i.e. the ECB). Subsequently, we do not pencil in a rate hike by the Riksbank before H2 ’10. Nonetheless, we believe that the Riksbank will raise rates higher than actually forecasted.

US and Euro Zone Bond Market Outlook

2010-02-09T17:14:00.000+01:00

Since its inception, we have not incorporated any bond asset class categories in our Top Down Portfolio.

This is simply because the “Top Down Portfolio” is designed to replicate the asset allocation of a diversified macro hedge fund and is therefore well suited for the most aggressive section of any active investor’s portfolio. Considering our preference for momentum strategies, we have seen many equity markets (especially emerging markets) and some currency exchange rates (i.e. AUD/JPY and NOK/SEK) offering a better risk/rewards profile compared to bond markets, while Gold and Silver provide stronger protection against the potentially increasing risk premiums on the international financial markets.

However, we are well aware that bonds are usually the main asset class category in investment portfolios, going unaltered even through the steep yield decline over the past few years. Nevertheless, according to the latest US data gathered by Michael Belkin, author of “The Belkin Report”, only USD24bn had gone into various kinds of equity funds over the entire recovery rally starting in March ’09, versus USD178bn into bond funds.

Accordingly, this week’s “Global Strategy Weekly” will be analyzing bond market perspectives in both the US and Euro Zone, though we shall not be altering the 10 asset class categories in our “Top Down Portfolio”.

In the “Global Strategy Weekly” published on 18 January entitled “What is the yield spread telling us?” (look here for an exerpt), we underscored that very steep yield curves (the spread between 3m US T-Bills and 10y T-bonds is still well above 300bp) are usually followed by a decrease in long term rates and an increase in short term rates. We are of the opinion that a flattening yield curve in both the US and Euro Zone (we consider the German bond market as a benchmark) is the most likely scenario in the medium term.

With short-term Government Bond yields close to historical lows in both the US and Euro Zone, we see very few reasons to invest in them now. Thus, investing in short-term Government Bonds would make sense solely in the event of fresh financial turmoil, or should deflationary pressures resume.

More uncertainties surround the outlook of long-term Government Bond yields. On the one hand, we are skeptical insofar as the decline of long-term rates in the next few months, as the steepness of the yield curve would indicate. Indeed, despite huge advances since its lowest level, posted in December 2008 (at 2.42% in the US and at 2.95% in Germany), long-term yields still remain low, especially considering the global economic recovery. On the other hand, we cannot agree with the general belief that yield may climb much further in the next few quarters (the economists in December’s Livingston survey conducted by the Federal Reserve Bank of Philadelphia predicted that rates may rise to 4.1% in the US by the end of 2010, and to 4.64% by the end of 2011).

Further, we estimate that economic growth in the US and Euro Zone over the next few years is likely to be subdued, since the potential growth rate has declined following the past two years in crisis. Moreover, the deleveraging process that would take place in major developed countries (i.e. total Debt as % of GDP is at 296% in the USA and at 285% in Germany) should eventually take its toll on economic growth.

Two other factors will play a positive role in lowering long-term yield in the next few quarters. US long-term Government yield will continue to benefit from foreign purchasing of US bonds. According to the paper “International Capital Flow and US interest rate”, the Federal Reserve’s economists Francis Warnock and Veronica Warnock demonstrate that foreign flows have an economically large and statistically significant impact on long term interest rates. While a slowdown of foreign buying is possible, the prospects of international investors completely abandoning the US market in the months ahead are unlikely. For this reason, foreign acquisition of US bonds should likely continue benefiting the US economy.

In the Euro Zone, difficulties surrounding the outlook of peripheral countries are likely to have a positive effect on German Bonds, which should continue to be seen as a safe heaven.

Our main scenario is that long-term Government Bond yields in the US and Euro Zone should rise in the short term (especially in the US), which is in line with economic recovery gathering momentum in early 2010, and then decline when the respective Central Banks begin increasing rates in H2 ’10, with investors setting off to discount more moderate economic growth and lower inflationary pressures. While we are not recommending investing in long-term government bonds now, we do see the potential for long-term Government bonds to gain positive returns in the next few months. We believe that the best choice for bond investors is to have their portfolios buttressed to last as long as possible.

Notwithstanding the above, a sudden increase in inflation is the main risk to our projection. In the working paper “Inflation Hedging for Long-Term Investors”, published in April 2009, IMF’s economists Alexander Attiè and Shaun Roache verified that “long-term treasury bonds are the worst performing asset class in the immediate aftermath of an inflation shock as yield increase”. However, the two economists also noted that “after about 3 years the return dynamics begin to work in favor of long-term treasuries, albeit gradually.”

Nonetheless, we believe that the prospects of a big spike in inflation are slim due to slack capacity utilization and the effects of deleveraging process on consumer spending, which we have emphasized previously. We substantially concur with the economists’ consensus in the Livingston Survey, in that consumer price should rise by 2.2% in 2010, and by 1.8% in 2011. The break-even inflation rate for the next 10 years (implicit in the TIPS) is at 2.27%.

Should inflation rise well above current expectations, bond investors should switch to inflation-linked bonds.

The Week Ahead in US: retail sales and U.Michigan consumer confidence Index

2010-02-08T21:17:00.000+01:00

From our weekly Top Down Outlook

Trade Balance (Wednesday 10) – With consumer spending rebounding at the tail end of the year, we expect exports to increase more than imports in December, widening the trade balance deficit. Our estimate is for imports to increase by 2.6% to USD179.12bn and exports by 2% to USD141bn. Should our estimates prove correct, trade balance surplus may rise to USD38.1bn.

Retail Sales (Thursday 11) – Retail sales figure were highly volatile over the last few months, probably reflecting problems with adjusting data for seasonal issues. Retail sales rose by 1.2% m/m in October, by 1.8% in November, and fell by 0.3% m/m in December. Notwithstanding December’s decline, the underlying trend in retail sales remains solid, and we expect the sales’ climb to resume in January. We project retail sales to increase by 0.6% m/m in January (3.8% y/y), and by 0.9% m/m ex-auto (4.3% y/y). These figures would suggest that a consumer spending rebound is likely to continue in early 2010.

Michigan Sentiment Index (Friday 12) – The Michigan Sentiment Index rose to 74.4 in January, up from 72.5 in December. Given the broad sell-off in equity markets over the past few weeks, labor markets still bogged down, and notwithstanding signs of an emerging bottoming-out in the last few months, we do not pencil in a sizeable short-term improvement in consumer confidence. We expect the Michigan Sentiment Index to remain unchanged at 74 in February, remaining well below the long-term average (89.6), which indicates that consumer spending recovery may remain subdued.

Monetary policy Update: a review of CB's Meeting over the past week

2010-02-05T14:42:00.000+01:00

From our next Top Down Outlook:

The ECB decision to leave rates unchanged at 1% at the end of last week’s monetary policy meeting was widely expected. Addressing the press after the meeting, President Trichet reiterated the outlook depicted at last month’s monetary policy meeting with respect to a cautious approach to current recovery, emphasizing the temporary nature of the stimulus and strengthening the view that inflationary pressures would remain subdued in the medium-term. However, the most important element of the press conference was Trichet’s indication that in March “the Governing Council will take decisions on the continued implementation of the gradual phasing out of the extraordinary liquidity measures that are not needed to the same extent as in the past”. As regards the interest rate outlook following last week’s ECB monetary policy meeting, we see no reason to alter our estimate that rates are likely to remain unchanged, at least until the end of H1 2010, where they should gradually climb to 1.5% by the end of 2010, in line with our projections on downside risk.

Following last week’s monetary policy meeting, the BoE announced its widely-expected decision to leave rates unchanged at 0.50% and to pause its asset purchase program totaling GBP200bn. In a statement released after the meeting, the BoE said that “the Committee will continue to monitor the appropriate scale of the asset purchase program and further purchases would be made should the outlook warrant them.” It appears that the BoE is keeping the door open for a possible expansion of the program, though it does not expect to do so at this stage. The Inflation Report due for publication last week will give more information on the BoE’s economic outlook for the months ahead.

The Norges Bank decided to leave rates unchanged at 1.75% at the end of last week’s monetary policy meeting. The CB indicated that “activity in the Norwegian economy has increased, but capacity utilization is still lower than normal”. Other important factors influencing the outlook of monetary policy were “house price inflation is high and growth in household credit remains relatively strong” and “at end-January” the Krone was a good 1.3% stronger than projected for the first quarter in the October 2009 Monetary Policy Report. The result of last week’s meeting is in line with our base scenario; hence the Norges Bank should increase rates to 2% at the next monetary policy meeting scheduled on 24 March. According to our estimated equilibrium rate model, the NB’s ever-tightening monetary policy is likely to continue in the months ahead: the Key rate may rise to 2.75% by year-end.

The Reserve Bank of Australia (RBA) surprised markets by deciding to leave rates unchanged at 3.75% during last week’s monetary policy meeting. This came after having increased them by 0.25% in each of the last three monetary policy meetings in 2009. All 20 economists in the Bloomberg survey predicted a rate hike.

In the press release published at the end of the meeting, Governor Glenn Stevens explained that “since information about the early impact of those changes is still limited, the Board judged it appropriate to hold a steady setting of monetary policy for the time being”. However, Stevens added that “interest rates to most borrowers nonetheless remain lower than average. If economic conditions evolve broadly as expected, the Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term”. Although, last week’s decision to leave rates unchanged came as a surprise, we believe that further rate hikes in the months ahead are still a clear possibility. Moreover, should employment and home loans data, which are due for publication sometime next week, come out higher than expected, the RBA may decide to raise rates again at next month’s monetary policy meeting.

ECB and BoE decisions' on extraordinary measures expected

2010-02-03T09:09:00.000+01:00

From our latest Top Down Outlook:

The ECB is widely expected to leave the rate unchanged at 1% at the close of its monetary policy meeting on Thursday, since economic data published in the last few weeks did not change the economic outlook depicted by ECB Chairman Trichet during the latest press conference in January. While economic activity continued dilating at the end of 2009, uncertainty as to the sustainability of current economic recovery remains high as a number of supporting factors are merely temporary. Moreover, inflationary pressures have been well contained and are expected to remain below the ECB’s 2% target both in 2010 and 2011. Trichet also emphasized that the ECB will continue supporting the credit market, but will gradually phase out extraordinary liquidity measures. We estimate that rates are likely to remain unchanged at least until the end of H1 2010, gradually rising to 1.5% by the end of 2010. Nevertheless, we believe that the running risk facing our projections is that rates may be lower and not higher than our year-end estimate.

With interest rates expected to remain unchanged at 0.5%, the main item of interest of Thursday monetary policy meeting will be the BoE’s decision on the asset purchase programme. At the end of January’s monetary policy meeting, the BoE announced that thus far the purchase of GBP193bn out of GBP200bn has been made and that the programme shall take another month to complete. We believe that the BoE may decide to stop the programme in February as the economy is showing signs of bottoming out from recession. However, we believe that a rate hike by the BoE is hardly at hand. The latest economic data published in the UK (i.e. Q4 GDP figures) indicates strong prospects of economic activity rebounding in the next few months, though economic recovery is likely to be subdued. Moreover, even if the CPI rose to 2.9% y/y in December, and possibly exceed 3% in January, inflationary pressures are likely to soften in the months ahead. We do not pencil in a rate increase by the BoE, at least until Q4 2010. The inflation report of 10 February and the ensuing press conference by BoE Governor King will further detail the BoE’s monetary policy outlook.

Why we are still bullish on emerging countries equity markets

2010-02-02T09:35:00.001+01:00

This is an excerpt from our weekly Top Down Outlook. To subscribe a 1 month free trial go to our website

Equity markets in emerging countries gained spectacular returns ever since major equity indices began their overall upward trend in March ’09: the MSCI East Euro advanced by 81%, the MSCI Emerging Asia by 102% and the MSCI Latin America by 67%. Unsurprisingly, these indices were also the hardest hit by sell-offs in the past two weeks. Compared to 2010’s highest value recorded in the first days of the year, the MSCI East Euro declined by 6.2%, the MSCI Emerging Asia by 7.5% and the MSCI Latin America by 6.3%.

The negative performance over the past two weeks weighted on our Top Down Portfolio, as we recommended buying the whole of the emerging countries’ equity markets since the inception of the Portfolio. However, even after the correction over the past two weeks, we are not going to change our buy recommendations on these markets because the majority of the elements spurring the emerging markets rally are still soundly in place.

The most important factor supporting equity emerging markets are the expectations that economic growth is likely to be robust both in 2010 and 2011. For instance, in the World Economic Outlook Update released over the last week, the IMF raised its estimate for GDP growth in emerging and developing economies compared to 2009 WEO projections, from 5.1% to 6% in 2010 and from 6.1% to 6.3% in 2011. This major upward revision concerned Asia, which is projected to grow by 8.4% both in 2010 (against the 7.3% forecasted in November) and 2011 (8.1%). China is expected to continue growing at a robust pace, with a 10% GDP growth projected in 2010.

Nonetheless, news sources coming from China are the main reasons behind the underperformance of Asian/ex-Japan equity markets in the last few weeks. After the higher than expected GDP growth in Q4 ’09 (+10.7% y/y), Chinese authorities have initiated the first restrictive measures to slowdown credit growth and to curb inflationary pressures (1.9% y/y in December). In fact, the People’s Bank of China raised the ratio for required reserves, the timing of which was earlier than expected for the market. The PBOC also raised its 3-month, 6-month and 1 year bill over the past weeks. However, rumours that major banks were said to stop lending were denied.

While the markets were disappointed by signals of a more restrictive monetary policy in China, which dragged down commodity prices and should most likely trigger lower economic growth, we believe that this decision is the consequence of both strong economic growth and the Chinese Authorities’ willingness to curb excessive credit growth, subsequently precluding much bigger problems in the months ahead. The sharp increase in the country’s debt pile throughout 2009 (new loans amounted to 9.21 trillion Yuan in 2009 and they are expected to fall to 7.5 trillion Yuan in 2010 according to Morgan Stanley estimates) is indeed a big concern when considering the forward course of China’s financial stability. For these reasons we see the PBOC decisions as positive in the medium term.

Emerging markets are also likely to continue benefiting from excessive liquidity created by the major central banks around the world. Although the improvement in economic activity, monetary policy is likely to remain expansive in the major international economies. This is especially true in the USA, Euro zone, UK and Japan. As we have pointed out in past editions of “Global Strategy Weekly”, we believe that the Fed, the ECB and the BoE shall start increasing rates in H2, while the BoJ is expected to leave rates unchanged for the whole of 2010 (and probably 2011). This means that rates are likely to remain below their neutral levels for all of 2010. Contrariwise, Morgan Stanley analysts pointed out from a recent investigation that emerging countries’ central banks could hike rates sooner than expected due to strong economic growth. The tightening monetary policy in EM will bring capital inflows, a strong basis for expecting continued economic and asset overperformance.

Finally, the most important emerging markets may benefit from the lower leverage of the economy as a whole when compared with most developed countries. A recent study conducted by the McKinsey group showed that the total debt/GDP is much lower in developing countries than in developed countries. The deleveraging process that would take place in developed countries over the next few years would drag economic growth in these countries for many years to come, making the outlook of emerging countries appear rather rosy.

Moreover, albeit the recent strong upward trend, emerging markets do not appear as excessively overvalued at current levels. Indeed, the 12 month forward P/e is below historical average both in Asia (13.2x versus 14x) and Emerging Europe (8.9x versus 10.4x) and it is above the historical average only in Latin America (13.6x versus 10.6x).

We would reiterate our buy recommendation on emerging countries equity markets in view of the trend for these indices to remain on the upside. Indeed, notwithstanding the recent correction, the whole of the benchmark indices are still well above the respective 200-day moving average, and our preferred momentum indicators (based on performance in the latest 1 month, 3 month, 6 month, 9 month and 12 month), which gave a buy signal at the end of April ’09, are still positive. Should these indicators turn negative, we would reconsider our position on the indices.

Norges Bank's tough decision

2010-02-01T20:03:00.001+01:00

Following the unexpected rate hike by 25bp to 1.75% in December, the outcome of wednesday's Norges Bank monetary policy meeting is highly uncertain. At the end of December’s meeting, the NB said that it did not pencil in another rate increase until the publication of the March Monetary Policy Report (March 24) and announced that the Key policy rate would likely be raised gradually thereafter. Our base scenario is that the Bank will raise rates by 25bp to 2% in March. However, with underlying inflation being higher than expected in the last few months, we are well aware that a rate hike following next week’s monetary policy meeting is a clear possibility. The Norges Bank’s tightening monetary policy is also likely to continue in the months ahead. According to our estimated equilibrium rate model, rates may rise to 2.75% by year end.

Reserve Bank Of Australia preview

2010-02-01T15:56:00.000+01:00

The Reserve Bank of Australia (RBA) hiked rates 3 times in 2010, raising them from 3% to 3.75%. The RBA is likely to continue its tightened monetary policy in February, raising rates to 4%. Economic data published in the last few weeks indicate that economic recovery is well under way in Australia. The more positive indication came from the labour market: in December, employment rose by 35.2k, three times more than economists had expected. Moreover, the consumer price index increased by 0.5 q/q in Q4 versus market expectations of 0.4% q/q, signalling that inflationary pressures may be higher than expected in the months ahead. With housing prices expected to trend upward in the next few months, the RBA may further tighten monetary policy in the months ahead.

The Week Ahead: not meaningful recovery expected in US Labour market

2010-01-29T17:18:00.000+01:00

This is an excerpt from out latest Top Down Outlook:

ISM Manufacturing Index (Monday 1) – The ISM manufacturing index has been above the 50 ceiling since August ’09, indicating a comeback by the manufacturing sector. In December the index rose to 55.9 – the highest since May ’06 – highlighting the manufacturing sector’s momentum-gathering recovery at the tail end of the year. We expect the index to slightly edge down in January to 55.3 as the economic outlook is still clouded with uncertainty. However, the outlook for the manufacturing sector is likely to remain positive in the short term, driven by the reinvigorated global economy and a slight improvement in internal demand.

Construction spending (Monday 1) and pending home sales (Tuesday 2)– Both construction spending and pending home sales fell markedly in November. Construction spending figure is likely to further tumble in December (our estimate: -0.8% m/m) as the non-residential sector will no doubt continue its descent. Having slumped by 16% m/m in November, pending home sales may rebound by 4% m/m in December as the federal tax credit to first-home buyers has been extended through June.
ISM non-manufacturing (Wednesday 3) – The ISM Non-manufacturing Index was highly volatile in the last few months as the uncertainty on consumer spending outlook remains high. We expect the index to edge up to 54 in December, indicating the recovery in the widest US economic sector is likely to continue into early 2010, albeit at a subdued pace.

Labour market (Friday 5) – Non-farm payrolls came in worse than expected in December, declining by 85k. However, the contraction was the lowest since January ’08; with the exception of November ‘09, when non-farm payrolls increased by 4k. Two current sources of data showed that the labour market may at least be close to bottoming out. Indeed, in the last few weeks, prospects for bottoming out in the short term came from a batch of data: initial jobless claims have been trending downwards since August ’09, the “jobs hard to get” sub-index in the Conference Board Consumer Confidence Index fell to 48.6 in December and employment sub-index in the ISM Manufacturing Index remained above 50 for the third consecutive month in December. However, we still expect a slight contraction in non-farm payrolls in January: -10k. The unemployment rate is likely to remain stable at 10% and we do not expect a sustained improvement in the short term. The unemployment rate surge was less than forecasted in the last few months as the number of discouraged people leaving the labour workforce rose strongly. Should the labour market outlook improve, these people are likely to return to actively seeking work.

The KOF leading indicator likely to show Swiss economic recovery to continue

2010-01-28T21:41:00.000+01:00

The KOF leading indicator rebounded for eight consecutive months and reached 1.68 in December – a 23-month high. The global economic upturn should push the KOF index even higher in early 2010 on rosier outlooks for Swiss exports. However, the index’s pace of recovery has decelerated in the last few months as uncertainties emerged on the sustainability of the current economic recovery. The KOF index is likely to increase to 1.82, a level consistent with a higher-than-expected long-term average growth of the Swiss economy in the coming six months.

Australian Dollar/Japanese Yen outlook

2010-01-28T14:17:00.000+01:00

It was an extremely volatile week for the whole of the asset classes in our Top Down Portfolio, with major international equity markets erasing early year’s gains, commodity prices falling and carry trades losing momentum. The only exception was the NOK/SEK exchange rate, which was little changed ahead of the 3 February Norges Bank monetary policy meeting that may see the CB hiking rate to 2%. Our base scenario is that the Bank will not tighten until the March 24 monetary policy meeting.

Three main events triggered an increase in risk premiums on major international financial markets: 1) early signals that China may tighten monetary policy following robust GDP growth in Q4 (10.7% y/y); 2) the Obama administration’s plan to limit the size and trading activities of financial institutions prohibiting banks from running proprietary trading operations solely for their own profit and sponsoring hedge funds and private equity funds; 3) lower than expected corporate results in the US.

As regard our investment portfolio, a higher risk premium prompted a fall in the Australian Dollar against the Japanese Yen. The decline in commodity prices and the unwinding of carry trades were the main triggers of the Australian Dollar’s drop. Compared to 5 December, when we built our first Top Down Portfolio, the AUD/JPY exchange is little changed, having given back previous gains (we do not consider the positive return coming from interest differential).

Although uncertainty surrounds the short term outlook, we believe that the AUD/JPY exchange rate will likely appreciate medium term. Indeed, the Australian Central Bank, after lifting interest rates three times in 2009, is widely expected to continue its tightening policy in 2010 as labor market strength may increase inflationary pressures, with a further rate hike during the 3 February monetary policy meeting that is a clear possibility. Moreover, while the markets were disappointed by signals of a more restrictive monetary policy in China, which dragged down commodity prices (a variable well-correlated with Australian Dollar exchange rate) estimating that it will trigger lower economic growth, we believe that this decision is the consequence of both strong economic growth and the Chinese Authorities’ willingness to curb excessive credit growth, preventing bigger problems in the months ahead. By contrast, in Japan the Central Bank should continue to implement an expansionary monetary policy for a long time in the face of a persistently sluggish demand and prolonged deflation.

Only an increase of the Vix Index (used as a proxy of risk premium on international markets) above 30 will lead us to abandon our bullish stance on the AUD/JPY. Indeed, since 1998 a strategy based on buying the AUD/JPY when the Vix index was below 30 and selling the exchange rate when the VIX was above 30 has gained a total return of 38%.

IFO index preview

2010-01-26T08:13:00.000+01:00

In December, the IFO index rose for the ninth consecutive month to 94.7, from 93.9 in November. We expect the IFO’s upward trend to continue into January, albeit at a slower pace: our estimate is for an increase to 95.1 – the highest since July ‘08. The current situation index should rise from 90.5 to 91.4, while the expectations index should remain unchanged at 99.1, as economic recovery is likely to weaken in the months ahead. Should our estimate prove correct, the IFO should remain slightly below the long-term average (95.5), indicating a continuance in the economic recovery in early 2010.

Will the Fed strengthen the US Dollar?

2010-01-25T18:26:00.001+01:00

An excerpt from out weekly Top Down Outlook

Over the last week the Euro exchange rate declined versus the major international currency : the Euro fell by 1.66% versus the US Dollar, by 0.53% versus the UK Sterling and by 2.61% versus the Japanese Yen. More limited was the fall against the so-called commodity currencies (Australian Dollar, Canadian Dollar, New Zealand Dollar and Norwegian Krone), as they felt the negative effect of lower commodity prices due to both the uptrend in the US Dollar and the tightening of monetary policy in China.

The Euro’s fall was mainly triggered by the negative pieces of news coming from Greece. Last week, the country’s Government Bond yields hit their highest since the adoption of the Euro: the two-year note jumped to 4.23% and the 10-year bond to 6.17%. The spread between the Greek and German Bund widened to almost 300bp and the credit default swap rose to 345bp. Investors drove higher Greek Government Bond yields amid fears that the Greek Government might struggle to sell its debt to fund the deficit – the biggest within the European Union – and questioned the country’s ability to implement the deficit-reduction plan presented to the European Commission on 15 January.

Under the plan, Greece will slash spending and raise revenue by about €10bn this year, bringing the deficit/GDP ratio down to 8.7% by year-end. The deficit/GDP ratio is seen falling to 3% by 2012. According to the plan, the Greek Government should sell more than EUR53bn in debt this year (16bn in Q2).

Further uncertainty over the Greek economic outlook is also provided by the numerous statements made by many European authorities, according to which the European Union will not bail out Greece (Finance Minister Papaconstantinou said during the past week that a rescue package won’t be needed), hence suggesting that the European Union is likely to adopt a tough stance towards Greece not to encourage moral hazard among other European countries with ballooning national debt (i.e. Spain, Portugal and Ireland). A we have pointed out in the 11 January Global strategy weekly (“A good start for 2010”), although we believe that there is little chance that Greece will default in the next few years and that the European Union will not take action to help derail a default, we believe that the country’s negative outlook will continue to weigh on the Euro going forward.

However, other factors are penalising the Euro. The economic data published in early 2010 confirmed our view that the pace of the recovery will be more moderate in the Euro zone than in the US. The 2009 German real GDP figure published on Wednesday 13 provides a clear example: GDP contracted by 5% in 2009 against consensus estimates of -4.8%. This indicates that Q4 GDP may have been much weaker than previously expected, with a flat GDP that seems the most likely outcome in Q4. The Zew index, published last week, declined for the fourth consecutive month in January, showing that economic growth may soften sharply in the coming quarters. Next week, attention will focus on the German IFO index for January, due for publication on Tuesday 26. Although the business confidence index is expected to edge up, the increase is likely to be slim, confirming that economic recovery is losing momentum due to the imminent ending of the fiscal measures that have sustained the economy in the last few months. The latest economic data released in US, particularly in the real estate sector, offered evidence that also the US economic upturn is clouded in uncertainty. However, as we have suggested in last week’s Global Strategy Weekly (“What is the yield spread telling us?”), all leading economic indicators show that the economic recovery continue into the months ahead.

Next week, the FOMC monetary policy meeting will take centre stage. Although we do not expect major surprises on the interest rate outlook, we believe that the Federal Reserve might slightly upgrade its economic estimates, albeit confirming that the economic activity will stay sluggish for some time. Though confirming that the Federal Reserve will not hike rates any time soon (at least not until H2 ’10), an upgrade in economic outlook by the Fed will likely bring investors to increasingly discount the possibility that the Fed and not the ECB will be the first Central Bank to tighten in 2010.

Overall, we reiterate our view that the Euro might continue to trend downward against the US Dollar: we stick to our recommendation to sell the EUR/USD with a medium/long term target of 1.17, in line with the fair value of the EUR/USD exchange rate based on the PPP calculated by the OECD.

UK inflation hedged up and unemployment rate improved

2010-01-24T20:28:00.000+01:00

Inflation in the UK climbed by 2.9% y/y in December, scaling 1% more than in November. This sharp increase was due to 1) the base effect in energy prices; 2) the reversion of last year’s temporary VAT reduction; 3) the decline in Sterling. The reversion of last year’s VAT reduction and the Sterling’s depreciation are likely to push up prices again in January. However, the effect of the former is highly uncertain, since it depends on how retailers will respond. With consumer spending still weak, the possibility of raising prices is limited. Inflation may surpass 3% in January, consequently calling for the BoE Governor to report to the Chancellor explaining the reasons for the increase of the CPI above the inflation target (2% with a 1% tolerance). With inflation expected to weaken throughout the year as spare capacity continues to put downward pressure on inflation, we believe that the BoE will not change its monetary policy stance in the short term.

The UK unemployment rate fell at its fastest pace since April 2007 as the economy showed signs of emerging from its worst recession on record: the widely-watched claimant count measure of unemployment in December fell by 15,200, much larger than the 4,600 decline forecasted by the consensus. The 7.8% UK jobless rate swam underneath the 10% figure submerging both the USA and the Euro zone. The trend towards more favorable employment conditions is likely to continue in the next few months, though at a very slow pace. Indeed, the UK’s economy is likely to exit from recession in Q4 and grow at a very moderate pace throughout 2010.

The Week Ahead in US: Fomc meeting and Q4 GDP on the spotlight

2010-01-22T15:00:00.000+01:00

This is an excerpt from the "Top Down Outlook" we will publish over the week end.

Existing home sales (Monday 25), New home sales (Wednesday 27) – While the worst of the crisis appears to be behind the real estate sector, a return to a healthy growth rate is not on the horizon. With the labor market failing to reverse the two-year negative trend and foreclosures expected to rise in the months to come, we do not expect a rebound in the real estate sector over the short term. The drop in the NAHB housing market index signaled that real estate’s recovery may remain soft in the coming months due to competition from foreclosed homes on the market. After falling to 355k in November, we expect new home sales to increase to 366k, while existing home sales may rise from 6,54m to 6,69m, as the steady two-year decline in housing prices may continue attracting bargain hunters.

Consumer confidence index (Tuesday 26) – Having increased to 52.9 in December from 50.6 in November, we expect the Conference Board’s consumer confidence index to slightly edge down in January to 52.4. Notwithstanding the strong equity markets and the stabilization of the housing markets, we believe that only a strong turnaround in the labor market may push consumer confidence further upward. The index will indicate a moderate increase in consumer spending in the next few months.

FOMC meeting – interest rate decision (Wednesday 27) – No major pieces of news are expected from next week’s FOMC’s monetary policy meeting. Indeed, the FOMC is widely expected to maintain the target range for the Federal Fund rate at 0 to 0.25%. The Federal Reserve may continue its somewhat optimistic position on the economic outlook, particularly with regards to the business investment outlook, but may also continue to indicate that economic activity is apt to remain weak for the time being. The FOMC is also likely to elaborate on the removal of QE measures. We expect the Fed to maintain its view that “economic conditions, including low rates of resource utilization, subdued inflation trends and stable inflation expectations are likely to warrant exceptionally low federal fund rate levels for an extended period of time”. With capacity utilization well below historical average, unemployment at 10%, and core CPI expected to remain below 2% for a long period of time, we believe that the Fed will not raise rates before the end of H1 ’10, and that the subsequent tightened monetary policy will be very gradual (we pencil in the Fed fund rate at 1% by the year’s end).

Durable goods orders (Thursday 28) – Durable goods orders rose by 0.2% m/m in November, albeit the sharp decline in the transportation component (-5.5%). Orders ex-transportation rose by a solid 2% m/m, underlining the positive trend in durable goods orders in recent months. We project the positive trend to continue in December, in line with indications from the ISM new-orders sub-index, which rose to 65.5 in December – the highest since December ’04. We forecast durable goods orders to increase by 1% m/m. However, when compared with December ’08, orders would decline by 2.4%. December durable goods orders are likely to strengthen the view that US economic recovery will continue into early 2010. However, should our estimate prove correct, total durable goods orders would remain 27% below the September ’06 peak, indicating that US economy is still running well below its potential.

Gross Domestic Product (Friday 29) – Having grown by 2.2% in Q3, US real GDP is expected to increase by 4.2% in Q4. This economic rebound is likely to be driven by total investments, which we project to grow by 1.7% q/q. Real personal spending is likely to rise by 0.4% q/q, having so far risen by 0.4% in October and by 0.2% m/m in November. Inventories are likely to contribute positively to total growth, while the contribution from net trade is likely to be slightly negative. In 2009, the GDP may have dipped by 2.5%

Chicago PMI (Friday 29) – In December, the Chicago PMI index rose to its highest mark since May 2007, indicating a strong recovery in industrial production. While we expect the industrial production recovery of recent months' to continue into early 2010, we project the Chicago PMI to slow down to 58.3 in January. The Chicago PMI would anticipate an increase of January’s ISM index, due for publication the following week.

What is the yield curve telling us on financial markets

2010-01-20T11:55:00.001+01:00

In the post What is the yield curve telling us about economic recovery we have analysed the development of the yield curve and its messages as regards the economic outlook. In the following post, we are going to explore the messages of the yield curve development on financial markets. This is an excerpt from our latest Top Down Outlook:

Considering that the slope of the yield curve is a reliable indicator of economic direction, it is interesting to assess the predictive power of the yield curve relating to major financial markets. As a first step, we should look at the S&P500 returns as a function of different assumptions about the yield curve steepness. 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.

However, equity markets recorded their highest returns when the spread between the long term rates and the short term rates was above 1% but below 2%. In this case the average monthly return was 1.3%. 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).

The slope of the yield curve also has a reliable predictive power for the returns delivered by all other international equity markets. For example, since 1993 the German Dax Index has brought a 1.2% average monthly return when the spread between the long term rates and the short term rates was above 1% and a 0.2% return when the spread was below 1%.

Finally, we should consider the predictive power of the yield slope with respect to the government bond market. A very steep yield curve has been usually followed by a decline in long term rates and an increase in short term rates. This relation is not a major surprise. Indeed, we have showed that a very steep yield curve has been traditionally followed by robust economic growth. This has prompted many Central Banks into monetary tightening, hence pushing up short term rates, which are closely correlated with the overnight rates set by the Central Bank, but into lowering long term rates as investors start discounting more moderate economic growth and growing inflationary pressures. A similar pattern has also appeared in the German Government bond market. Overall, we are looking for a flattening of the yield curve both in the US and in the Euro zone in the months ahead.

What is the yield curve telling us about economic outlook?

2010-01-19T12:00:00.000+01:00

In our weekly Top Down Outlook we have analysed the development of the yield curve and its messages as regards the economic outlook

The onset of the New Year has failed to lessen investor uncertainty concerning the ongoing economic recovery and equities uptrend. Based on a recent economic commentary by the Cleveland Fed economist Joseph Haubrich, we have used the yield curve as a forecasting tool to try understanding what might happen to the economy in the months to come. Indeed, since the 80s, a large number of academic studies have suggested that the yield curve is a reliable predictor of recessions: for example, before each of the last seven recessions, including the last one, short term interest rates (3 month T-Bill) rose above long term rates (10y T-Bond), producing what economists call yield curve inversion. Although the yield curve has made a poor job in forecasting the magnitude of economic growth, it is a great forecaster of the direction of the economy. More generally, the rule of thumb is that an inverted yield curve indicates a recession in about a year, a flat curve indicates weak growth and a steep curve indicates sharp growth. The recent slope of the yield curve offers ample evidence that the pace of recovery is unlikely to moderate in 2010. Between December 2009 and early January 2010 the slope of the yield curve increased to almost 380bp, up from November’s 335bp and from October’s 332bp.

The outcome of past academic studies also enables us to calculate the likelihood of a recession in the 12 months ahead using the steepness of the yield curve. In particular, we are using a probit model, which exploits the normal distribution to convert the value of a measure of the yield curve steepness into a probability of recession one year ahead. The model developed by the NY Fed economists Estrella and Trubin (“The yield curve as a leading indicator: some practical issues”) suggests that the current yield spread is in line with a 0% chance of recession in the coming 12 months. Another meaningful probit model was developed by the Fed economist Jonathan Wright in the paper “The yield curve and predicting recessions”. This model uses both the yield spread and the level of the Fed fund rate to determine the probability of recession. According to Wright calculations, the predictive power is higher than that of the yield spread alone. Even under this model, the chances of another recession in the subsequent 12 months appear to be close to 0%.

Are we sure that a recession will not occur in 2010? An argument against taking too much comfort from the positive slope of the yield curve was provided by Paul Krugman, who had previously predicted a 30/40% chance of a recession materializing in 2010. In his NY Times blog, Krugman said that, given that the Federal Reserve cannot cut rates from here, long-term rates must be higher than short-term rates because they are like an option: short rates might move up but they cannot go down.

Krugman reinforced his view highlighting that in Japan the yield curve was positively sloped all the way through the lost decade.

However, unless the US economy experiences a lost decade, as it occurred in Japan - a possibility that we do not rule out but that we consider thin - the yield curve message should be taken seriously. Only signals of a new recessionary phase before the Fed begins to raise rates will bring us to reconsider the yield curve as a forecasting tool.

The predictive power of the slope of the yield curve is not limited to the US economy. In a paper published in 1996 (“Does the term structure predict recessions? The international evidence”) BIS’s economists Bernand and Gerlach highlighted that home country yield curves have predicted recessions in 8 countries. Hence, based on most recent data, no major developed countries will likely slip into recession in 2010. The steepness of the yield curve also gives us useful indications of the corporate profits outlook. Indeed, a considerable gap between the 10 year T-Bond and 2 year T-Bill has been usually followed by a sharp increase in corporate profits in the subsequent three years (see chart below). Obviously, this does not come as a surprise considering the above-mentioned yield curve ability to anticipate economic growth.

Bank of Canada outlook: rates expected to remain unchanged

2010-01-18T13:49:00.000+01:00

Bank of Canada: interest rate decision (Tuesday 19) – During next week’s monetary policy meeting, the Bank of Canada is widely expected to leave rates unchanged at 0.25%. We also estimate that the BoC will confirm its view that rates should be held steady until the end of Q2 ’10. The Canadian economy showed signs of picking up in Q4 (latest data on employment, retail sales and housing activity came in better than expected) strengthening the view that economic activity will gather momentum in early 2010. The Consumer Price Index is expected to show volatility in commodity prices, but overall inflationary pressures should remain subdued as the output gap will not close before the end of the year. With inflationary pressures subdued and the Canadian Dollar strengthening against the US Dollar, we see the possibility that the BoC will maintain rates longer than projected by the Bank and longer than our interest rate rule would prescribe. Indeed, we believe that unless there is a weakening of the Canadian Dollar, which is overvalued by almost 15%, the BoC is unlikely to tighten monetary policy ahead of the Fed (we predict the Fed will not raise rates before H2 ’10). However, our interest rate rules indicate that, should economic recovery be stronger than expected or inflationary pressures less subdued than forecasted, the BoC has the possibility to hike rates considerably (e.g. to 2%) before the end of 2010. In this case the Canadian Dollar may strengthen considerably against other major international currencies, mainly against the US Dollar.

A quick recap of last week data in Europe

2010-01-16T11:24:00.000+01:00

An excerpt from the lastest Top Down Outlook

Euro Zone

As widely expected, the ECB decided to leave rates unchanged at 1% during the monetary policy meeting last week. At the press conference the ECB president Trichet did not contradict the possibility that rates are likely to remain unchanged at least until the end of H1 ’10 and then gradually increase to 1.5% by the end of 2010. Trichet pointed out that economic activity in the Eurozone continued to expand towards the end of 2009, although a number of supporting factors are only of a temporary nature. The level of uncertainty is very high. Inflation is expected to remain at about 1% in the short term and expectations concerning inflation over the medium to long term are firmly held. Far-reaching risks associated with the economic outlook and inflation are on the whole balanced. Trichet also emphasized that the ECB will continue to support the credit market, but will gradually phase out the extraordinary liquidity measures. As for Greece, Trichet shunned the hypothesis that the country will leave the Eurozone and that much work remains to be done.

A mixed batch of data came out over the course of last week. On the negative side, the worst indications came from actual GDP growth in Germany during 2009: GDP contracted by 5% in 2009 as against market expectations of -4.8%. This means that Q4 GDP may have been much weaker than previously expected and a flat GDP seems the most likely outcome in Q4. The public sector deficit was at 3.2% in 2009, slightly below market expectations of 3.5%. Italian industrial production was also lower than market expectations in November, rising by 0.2% m/m as against market expectations of 1% m/m. Compared to November ’08, industrial production contracted by 5.2%. On the positive side, both French industrial production and the business confidence index came in better than expected. However, this may be the result of the French recovery being slower than that of the other major European economies.

Data published during the last week were in line with expectations of the European economy coming out of recession very gradually.

Macroeconomic data published during the last week came as a reminder that economic recovery in the UK is likely to be subdued in the short term. Even if industrial production rose more than expected in November (+0.4% m/m as against market expectations of +0.3% m/m), this was the result of the increase in the mining and utilities sectors, while manufacturing production unexpectedly stalled for the second consecutive month. The lower than expected figures in the manufacturing sector indicated that in Q4 the UK economy should come out of recession, but that the growth rate may remain very low. As regards the real estate sector, a sign of caution came from the RICS house price balance: in December the number of estate agencies reporting that prices rose exceeded those reporting declines by just 30%, down from 35% in November. The data shows that the property market lost momentum in December.

Sweden

Inflation rose higher than expected in December: +0.2% m/m as against market expectations of 0.0%. Prices increased by 0.9% compared to December ’08, the first positive year-on-year change since March ’09. After adjustment for the direct effect of the decrease in interest rates, the December rate of inflation was 2.7 per cent. Even if they were higher than expected, the December figures on CPI do not alter our view that the Riksbank will mantain rates unchanged until at least H2 2010.

Norway

In December, inflation was substantially in line with market expectations, rising by 0.2% m/m and 2% y/y. Price rises in electricity and airline fares contributed most to the monthly growth, while the year on year change was mainly due to price increases in fuel and lubricants. CPI-ATE remained unchanged at 2.4% y/y. The December figures did not help determine whether the Norges Bank will increase the rate again in February or March (our base scenario).

The week ahead: leading indicator should indicate US recovery will continue in the months ahead

2010-01-15T16:58:00.000+01:00

This is an exerpt from our weekly Top Down Outlook:

NAHB housing market index (Wednesday 20) – Notwithstanding the improvement over recent months, the real estate sector remains very weak. This was reflected in the NAHB housing market index, which fell from 17 to 16 in December. With the labour market failing to reverse the negative trend of the last two years and foreclosures expected to rise in the months to come, we do not expect a rebound in the real estate sector over the short term. The NAHB housing market index is likely to remain unchanged at 16 in January.

Leading indicators (Thursday 21) – The leading indicator are likely to continue the upward trend of recent months, rising by 0.6% m/m in December. The steep yield spread and the fall in weekly jobless claims are likely to be the major contributors to an increase in the leading indicators. The leading indicators should anticipate that the US economic recovery is likely to continue in the next six months.

Philadelphia Fed (Thursday 21) – The Philadelphia Fed went up for the fifth consecutive month in December, rising to 20.4 – the highest level since April 2005. We expect the index to continue its upward trend in January, rising to 27. The Philadelphia Fed should indicate that industrial production recovery will continue in early 2010 as global economic recovery gathers momentum and the weakness of the US Dollar boosts exports.

ECB monetary policy meeting preview

2010-01-12T22:24:00.000+01:00

At the December monetary policy meeting, the ECB began to apply its exit strategy from non-conventional lending measures, indicating that the December LTRO would have been the last one and that the last 6m LTRO shall be in March. However, ECB President Trichet underlined that the decision on non-conventional lending measures does not imply anything with respect to the Refi rate perspective. Thursday's ECB monetary policy meeting promises nothing particularly newsworthy: the ECB is widely forecasted to leave the rate unchanged at 1% with no further decisions on QE exit strategy on the cards. We estimate that the Refi rate will stay unchanged at least until the end of H1 ’10, and our base scenario is for the rate to end up at 1.5% in 2010. Even though the new ECB projections on economic growth and inflation are in line with a rising Refi rate (to 2% by the end of 2010), we do not expect the ECB to tighten monetary policy unless the Fed implements an exit strategy as this would strengthen the Euro against the US Dollar.

US data preview: 11 January week

2010-01-11T16:55:00.002+01:00

This is an excerpt from our Top Down Outlook - The Macro view

Trade balance (Tuesday 12) – Following unexpected improvement in October, shrinking from USD35.7bn to USD39bn, the trade balance deficit is expected to widen to USD36.4bn in November. In view of consumer spending rebounds in recent months, imports are likely to increase more than exports notwithstanding a weak US Dollar and global economic recovery.

Retail sales (Thursday 14) – November retail sales rose above market expectations (1.3% m/m versus +0.5% m/m), indicating strengthened consumer spending in Q4. In light of the December rally by consumer confidence indexes (the Conference Board index rose from 50.6 to 52.9) and evidence that the labour market is bottoming out, we expect retail sales to continue their recent upward trend in December, albeit at a slower pace. Retail sales may increase by 0.4% m/m (+5% y/y), in line with the ex-auto data (+4.8% y/y). The increase in retail sales should anticipate a persistent consumer spending rebound in the short term. However, we expect consumer spending growth to remain subdued in the medium term as the deleveraging process of the household sector is far from over.

Consumer price Index (Friday 15) – After eight months of negative year-on-year change, base effects in the energy sector led headline inflation, turning positive in November (+1.9% y/y). Energy related base effects (oil prices fell by 55% in the period September/December 09) are likely to drive inflation up in December and early 2010, which is likely to edge up to 2.8% y/y. Nevertheless, inflation is expected to increase by a moderate 0.1% when compared to November, since consumer spending remains substantially weak. We expect core inflation to rise by 0.1% m/m and by 1.8% y/y. Inflation is likely to rise in the next few months as economic activity improves, though we expect inflationary pressures to remain subdued in the face of slack capacity utilization.

NY Empire Manufacturing Index (Friday 15) – The Empire Manufacturing Index, the first relevant US business confidence index to be published monthly, fell from 23.51 to 2.55 in December, indicating the possibility that the manufacturing sector’s upward trend may be reaching an end. However, this negative prodigy was denied by other business confidence indexes that posted strong increases in December (the ISM manufacturing index advanced from 53.6 to 55.9). The Empire Manufacturing index is likely to reverse the huge decline in January, rising to 21.7 and bolster estimates that manufacturing production may continue rising early in 2010.

Industrial Production and capacity utilization (Friday 15) – The whole of leading indicators released over the past few weeks anticipate that industrial production’s positive momentum is likely to continue in December and early 2010. The Conference Board leading indicator rose in November for the ninth consecutive month and the ISM manufacturing index remained well above the 50 threshold in December. Moreover, factory orders rose in November for the third straight month. We expect industrial production to increase by 0.7% m/m. Capacity utilization should edge up from 71.3% to 71.7%; a subdued level indicating slight inflationary pressures going forward.

Michigan Sentiment Index (Friday 15) – With equity markets extending on an upward trend the past few months and the labour market showing tentative signals of bottoming out, the Michigan sentiment index may rise from 72.5 to 72.8, anticipating a strengthening of consumer spending in the upcoming months. However, the index will remain well below the long term average (89.6), indicating that consumer spending recovery may nevertheless remain subdued.

Is it time to overweight US financial markets?

2009-12-21T18:21:00.000+01:00

This is an excerpt from out latest Top Down Outlook:

In the first three weeks of December US financial assets have significantly outperformed other international financial assets, driven by the US Dollar appreciation against all major currencies. Indeed, the Dollar Index has risen by almost 3% so far in December, and by 4.7% against the Euro, boosting returns on US equity and bond indexes. The table below shows the December performance by major equity and bond indexes using the European ETFs as a benchmark, as they replicate the underlying index performance.

The exchange-traded funds give ample evidence that the Nasdaq100 and the S&P500 are the top performers for December and that the US bond indexes have outperformed both the European and emerging market bond indexes this month.

As we pointed out in last week’s Global Strategy Weekly (“Focus on exchange rate market”), we expect the Euro to continue its downtrend against the US Dollar into the coming months as there is a clear possibility that the Fed and not the ECB will be the first Central Bank to hike rates in 2010. The news items that emerged during the week support this idea. In the US, industrial production for November and the leading indicator for December came as positive surprises. Both the data suggested that US economic activity is gathering strength and that the economy will likely continue on its path to recovery in the first half of 2010. In Europe, the Greek crisis seems far from resolved, with the rating agency Standard and Poor’s following Fitch in cutting its rating on Greek government debt to BBB+ from A- on the grounds that the measures the Greek authorities have recently announced to reduce the high fiscal deficit are not enough to rebalance public accounts.

Moreover, Germany’s industrial production and factory orders data for October released last week served as a grim reminder that the economic upturn may be slower than many economists have been expecting. The improvement in the December IFO business climate index is unlikely to assuage investor concern short term. Only a sharp upswing in economic activity at the tail end of the year may revive investor optimism about the European economic prospects. Overall, we believe that the Euro will weaken further against the US Dollar with a medium/long term target of 1.17, in line with the EUR/USD exchange rate fair value based on the PPP calculated by the OECD.

However, the majority of the Central Banks will likely wait the first rate hike by the Fed before tightening, with some minor central banks (i.e. Australia, Israel, Norway, India) the only exception. This may well be the case of the Swiss National Bank and the Riksbank, which are not seen tightening ahead of the Fed and the ECB as inflationary pressures are under control and with a view to fending off currency appreciation. Even the BoE does not forecast a rate hike any time soon, as economic growth is expected to remain anaemic for several quarters.

Under this scenario, US financial assets will likely continue to outperform other international financial assets going forward, unless negative economic surprises emerge. For this reason, beginning next week we recommend buying the Nasdaq100, which we prefer relative to the S&P500 due to its higher relative strength.

Norges Bank may raise rates to 1.75% tomorrow

2009-12-15T17:24:00.001+01:00

In our weekly Top Down Outlook we pubblished over the week end we have analysed the outlook for the Norges Bank monetary policy meeting. The Norges Bank was the first European Central Bank to reverse the expansionary monetary policy pursued since the crisis erupted in 2007. On October 28 the Norwegian CB hiked rates by 25bp to 1.5% as economic activity picked up more rapidly than previously expected, driven by the implementation of several monetary policy measures (rates were slashed from 5.75% to 1.25% in less than 9 months), larger fiscal stimulus packages and investments in petroleum. In the statement released after the meeting, the Norges Bank predicted a 0.25% rate increase to 1.75% in the period to the publication of the Next Monetary Policy Report (March 24, 2010). Although we do not see any urgency for the CB to raise rates given the encouraging international environment, we do not exclude the possibility that the Norges Bank will decide to tighten rates again in December, in line with the indications of our estimated equilibrium model based on the Norges Bank’s estimated equilibrium model. Indeed, underlying inflation is higher than the economic weakness anticipated and slackness in economic activity is low. Looking ahead, we expect the Norges Bank to continue to tighten rates in 2010 as economic activity is likely to be stronger in Norway than in other major international economies. Indeed, a global recovery will likely push up oil prices, with positive effects on the country’s economy. Moreover, should other major central banks set upon a tightening path, this could boost the Norwegian Key Rate as the external money market rate is a key variable for the NB’s equilibrium model. Only a sharp appreciation of the Norwegian Krone could prompt the NB into loosening its policy.

FOMC meeting preview: only slight change in the statement expected

2009-12-15T15:32:00.000+01:00

In our weekly Top Down outlook report we said the announcement due after current week’s monetary policy meeting the Fed is widely expected to make only minor changes to the statement released after the November 4 FOMC meeting. Following the latest monetary policy meeting, FOMC members have repeatedly confirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period". Indeed, while the economic prospects have improved in recent weeks, even though less than previously estimated, the medium-term economic outlook is clouded in uncertainty as economic growth seems to be fuelled only by the fiscal and monetary stimulus packages that governments have implemented so far. Given a rosy short-term inflation outlook we expect the Fed to consider that the costs of moving too soon are probably higher than those of being late. We do not pencil in a Fed rate hike before H2 2010, when the current slack in resource utilization could reverse and inflation expectations improve should the ongoing economic recovery turn out to be sustainable.

Euro/Dollar update

2009-12-14T15:16:00.000+01:00

Over the past couple of weeks the foreign exchange market has been hit by various news items that could change the foreign exchange scenario in the months ahead. In the Euro area, investor attention has focused on the negative Greek national accounts figures, which triggered a downgrade by Fitch from A- to BBB +, and, although to a lesser extent, on Spain, which saw its outlook revised down from stable to negative by Standard & Poor's, a move that follows the January downgrade from AAA to AA+ by the rating agency.

Nevertheless, Greece’s market environment is very different from that of Spain. On the one hand, Greece, which is plagued by a severe credibility crisis due to the lack of a clear plan to slash the high public deficit and upset by growing internal tensions, could pull itself out of recession only with the support of the European Union and by paying a high price in terms of unemployment and economic growth for several years. On the other hand, Spain, one of the hardest-hit countries over the past two years, should not see its credibility undermined going forward, although economic growth is expected to remain more sluggish than that of the EU due to the need to revamp its economic model based on the real estate market and to the loss of competitiveness in recent years. Therefore, last week’s fall of the euro against the U.S. dollar - the single currency slipped below the 1.47 mark from the 1.51 level touched a week earlier - wasn’t totally unexpected. Investors were even surprised at the euro’s slight decrease against the US dollar, as clear evidence that the problems facing Greece are not a real threat to the Eurozone economy. Indeed, the country’s GDP accounts for only just over 2% of the Euro area GDP.

The troubles affecting the Greek economy, therefore, may only confirm that the economic upturn in the Euro area will likely be slower than estimated by the data released in the past few weeks. Germany’s industrial production and factory orders for October showed that the economic recovery may decelerate in the coming months as the positive effect of the fiscal stimulus that has supported the central part of 2009 wanes. The idea that the Fed and not the ECB will be the first central bank to raise interest rates during 2010, even though the ECB is in the early stages of an exit strategy (decided in the December meeting) might therefore take concrete shape among operators

The above-mentioned view had already started to circulate among operators last Friday after the publication of the U.S. labour market report for November, which showed that non-farm payrolls were almost flat (compared to consensus expectations of a loss exceeding 100 thousand units) and the hours worked per week increased. Furthermore, the Euro/Dollar exchange rate should also bear the brunt of its overvaluation against the PPP calculated by the OECD (approximately 30%), which was usually been accompanied by a price realignment. Overall, the US Dollar seems highly likely to begin to stage a gradual rebound against the Euro. In the face of fresh turmoil in world financial markets leading to higher risk premiums, the dollar would retain its safe haven role.

Swiss National Bank Outlook

2009-12-09T18:19:00.001+01:00

Swiss National Bank monetary policy meeting (Thursday 10) – The SNB will hold its quarterly monetary policy meeting on Thursday 10 and is broadly expected to leave the target range for the three-month Libor unchanged at 0-0.75%, aiming for a three-month Libor of 0.25%. Even though the Swiss economy has performed better than expected in the last few quarters (with 0.3% GDP growth in Q3 and a further increase in leading indicators, the SNB is likely to revise up both its 2009 and 2010 GDP forecasts), we believe that the SNB is highly unlikely to start removing the expansionary monetary policy it has implemented since the crisis erupted in 2007. In particular, we expect the Central Bank to confirm its intention to prevent the Swiss Franc from appreciating further against the Euro. We believe that the SNB will maintain its current exchange rate stance until the economic recovery is well-established both in Switzerland and in the Euro zone. Indeed, the EUR/CHF exchange rate is likely to be a one-way bet for investors until a widespread recovery takes place in the Euro zone, as the Swiss Franc would appreciate due to the high current account surplus. The SNB will likely change its stance on the exchange market either in March or June and should not adjust its target range for the three-month Libor before H2 2010.

German industrial production highlighted uncertainty surrounding Eurozone recovery

2009-12-08T14:49:00.001+01:00

Following the unexpected drop in October’s German factory orders (the data was released Monday 7), today’s figure for October’s German industrial production came in as a wakeup call for the believers in a strong recovery in the Euro zone economy. Industrial production fell by 1.8% m/m, versus the +1% m/m expected by the consensus. Manufacturing output fell 1.6% in October, driven by a 3.5% m/m drop in production of investment goods, energy production declined 3.4% m/m and construction output dropped 2.4% m/m. The annual change is -12,4%.

While the upward trend in IFO business confidence index indicate that industrial production may resume a growth path in the next few months (the December figure due for publication on December 18 will give more hint on German economic outlook), the growth rate is likely to weaken as the measures to stimulate growth will wane. The decline in German industrial production in October is also a negative signal for French and Italian data due for publication on Thursday 10.

Today’s data confirmed that, albeit the last week ECB’s decision to remove some long term extraordinary refinancing operations, the ECB is likely to leave rate unchanged at 1% for a long time. We do not pencil in a rate hike by the ECB before the end of H1 2010 as the ECB is very unlikely to do anything that could further strengthen the Euro.

Reserve Bank of New Zealand outlook

2009-12-08T13:48:00.000+01:00

This is an excerpt from our weekly Top Down Outlook:

Monetary Policy Statement and OCR announcement – During the week, the Reserve Bank of New Zealand is seen keeping rates steady at 2.5%. In the statement released on October 29, Governor Bollard said that he expects to leave the Official Cash Rate (OCR) unchanged at the current level until the second half of 2010 and we do not see any reason for the New Zealand CB to raise it any time soon as inflation is expected to remain within the target range at the end of the reference period and a rate hike may further widen the current account deficit (the RBNZ projected the current account deficit at 5.8% in 2010 and 7% thereafter). Indeed, although an early rate hike may have the positive effect of dampening the increase in house prices, which should boost demand in the short term, it may strengthen the NZ Dollar upward trend, hence prompting a further widening of the current account deficit.

Preview of the Bank of Canada's monetary policy meeting

2009-12-07T09:56:00.000+01:00

The Bank of Canada is widely expected to hold rates steady at 0.25% during tomorrow's monetary policy meeting. In our opinion, the economic data released after the October meeting did not change the short/medium-term outlook for the Canadian CB. Notwithstanding the above-estimate increase in the October cpi core (from 1.5% y/y to 1.8% y/y) the Bank of Canada should not revise its October projection and should maintain the policy rate on hold at 0.25% until the end of Q2 2010. Indeed, inflationary pressures will likely remain subdued in the coming months in the face of a stubbornly wide output gap and as the economy is not expected to reach production capacity before late 2011. Q3 GDP came in lower than the market expectation (+0.4% q/q ann.; see economic commentary section in the weekly "Top Down Outlook" report), suggesting that the pace of the economic upturn may be even slower than projected. With the Canadian Dollar close to its historical high against the US Dollar, we see the Bank of Canada leaving rates unchanged much longer than predicted and start rising them only after the Federal Reserve implements its exit strategy. Indeed, should the Bank of Canada raise rates ahead of the Fed, the Canadian Dollar would appreciate further against the US Dollar, dampening the expansion of exports (exports to the US account for more than 75% of total exports) as the CAD is already 13% overvalued against the USD according to the OECD’s Purchasing Power Parity.

Green shoots in US labor market

2009-12-04T15:48:00.002+01:00

November’s labor market data came in a lot better than market expectations, in line with the last two weeks positive indications in the initial jobless claims data. Initial jobless claims fell in the week to November 28 to 452k the lowest level since August ’08. The non-farm payrolls declined by 11k, versus market expectations of -120k and the unemployment rate edged down from 10,2% to 10%. Revisions added 159,000 from payroll figures previously reported for October and September. The October reading was revised to show a 111,000 drop in jobs compared with an initially reported 190,000 decline. Employees in the goods producing sector fell by 69k and in the service producing sector increased by 58k. Average workweek rose from 33 to 33,2 a very positive signal as employers expect are expected to increase hours for their current workers before hiring new ones. The indexes of aggregate weekly hours increased by 0,6 points, from 98,5 to 99,1, indicating that industrial production may have continued its recovery in November. Average hourly earnings were almost flat at USD18,74.

However, the labor market medium term outlook remains uncertain and a more sustained improvement is not expected in the short term. Some economists underlined that the November's improvement was due seasonal adjustment reasons and the fall in unemployment rate was due to a 291k decline in the size of the labor force. The participation rate fell to 65%, the lowest since recession began. Employers are not expected to return hiring until capacity utilization return to higher level (it was at 70,7% in October).

Some thoughts on today’s ECB’s press conference

2009-12-03T16:33:00.003+01:00

The ECB held today its monthly monetary policy meeting and the President of the ECB, Jean Claude Trichet, held a press conference at the end of the meeting.

The most important pieces of news arrived from today’s meeting were:

1) The December 12-month longer-term refinancing operation will be the last one and the rate will be fixed at the average minimum bid rate of the MROs over the life of this operation.

2) This decision on the 12-month longer-term refinancing operation does not imply anything as regards the perspective of Refi rate, held unchanged at 1% today.

3) The 2010 mid-point GDP projection was revised upward to 0,8% from 0,2% in September. 2011’s GDP was forecasted at 1,2%. Inflation estimate for 2010 was revised upward from 1,2% to 1,3%.

4) Trichet confirmed that he believe a strong US Dollar is in the interest of the USA, indicating in a polite way that the ECB is not happy with regard to the EUR/USD exchange rate trend.

Following today’s Trichet press conference we do not see any reason to change our estimate that the Refi rate would stay unchanged at least to the end of H1 2010. Even if the new ECB projections on economic growth and inflation are in line with a rising Refi rate to 2% by the end of 2010, we do not expect the ECB tightening monetary policy unless the Fed implements an exit strategy from its expansionary monetary policy before.

Indeed, an early ECB tightening monetary policy may further strengthen the Euro upward trend versus the USD. In a study published in Vouex.com ("Can we understand the recent moves of the euro-dollar exchange rate"), the economists Brender, Gagna and Pisani have offered evidence that the Euro/Dollar exchange rate moved broadly in line with the Fed’s and ECB’s monetary policy estimates until Lehman Brothers went bust.

With a EUR/USD already 25% above fair value according to OECD’s Purchasing Power estimate is very difficult to envisage that the ECB may take a similar decision. Moreover, due to Euro upward trend in the last few months, the Euro zone Monetary condition Index is well above the long term historical average, with a dampening effect on Euro zone economic recovery.

Looking ahead, the ECB is very unlikely to do anything that could further strengthen the Euro.

Monetary policy update: RBA increase rates to 3,75% and BoJ left rate unchanged in an unscheduled meeting

2009-12-01T10:00:00.000+01:00

The Reserve bank of Australia (RBA) increased rates by 0,25% for the third consecutive month to 3,75%. While the decision did not come as surprise (it was forecasted by 19 of 20 economists surveyed by Bloomberg News), it was far from sure and was criticized by the Australian Industry Group Chief Executive Heather Ridout, who said in a Bloomberg interview that policy makers “could have afforded to take a pause until the New Year when the business outlook is clearer.”

In the Governor Steven’s statement released at the end of the meeting were underlined the reasons behind the rate hike. As regards economic outlook, Steven said that “Prospects for ongoing expansion of private demand, including business investment, have been strengthening. There have been some early signs of an improvement in labor market conditions. The rate of unemployment is now likely to peak at a considerably lower level than earlier expected”. As regards inflation Steven said that “inflation should continue to moderate in the near term, though it will probably not fall as far as thought likely six months ago.” Steven also indicated that the rise in exchange rate during this year will have the effect to dampen both in inflation and growth (via external sector) in the medium term.

Finally, Steven said that “These material adjustments to the stance of monetary policy will, in the Board’s view, work to increase the sustainability of growth in economic activity and keep inflation consistent with the target over the years ahead.”

Having increased rates for a third straight month, the RBA is likely to wait some months before taking other tightening steps to see the effect of recent rate increase on the real economy. Notwithstanding the positive signals recently came from both the labor market (employees increased by 24,5k in October) and the residential sector (house prices rose by 10% this year) the inflation is likely to remain subdue in the medium term due to the low level of capacity utilization worldwide. The RBA will not have a meeting until February 2010, and rates may remain unchanged a bit longer, even though rates are expected to continue rising in 2010.

In Japan, the Bank of Japan decided today in an emergency meeting to provide short-term loans to commercial banks amid pressure from Prime Minister Yukio Hatoyama’s administration to address falling prices and the yen’s surge last month to a 14-year high of 84.83 per dollar. The size of the short term loans is JPY10trilion, while the Central Banks monthly purchases of Government Bond remain unchanged at JPY1,8trilion. Today’s decision is another desperate move by Japanese monetary policy makers to bring the economy out from deflation and to face a rising Yen. We continue to do not see any reason to invest in Japanese asset classes by now, particularly in Japanese Government bond, as we said in the post “Away from the Empire of rising sun”.

US labour market preview: health improves but remains fragile

2009-11-30T16:20:00.002+01:00

Following the fiscal and monetary stimulus that pulled the U.S. economy out of recession in the third quarter (but the growth rate, +2.8%, was lower than the previous estimate of +3.5%), economists now almost unanimously agree that the labour market upturn will be key to ensuring a continuation of the ongoing recovery into the months ahead. This is in tune with the Fed’s thinking, as indicated in the minutes of the November 3-4 FOMC meeting. Indeed, only better employment conditions will likely translate into a sharp upswing in private consumption, which account for 70% of GDP. By contrast, a persistently negative labour market environment would likely trigger a further increase in foreclosures, which would weaken further private consumption and increase the savings rate.

Not surprisingly, this week’s major macroeconomic data release will be the publication of the November’s U.S. labour market report on Friday 4.

Encouraging signs on the labour market trend came last week from initial jobless claims, down from 501,000 for the week ending November 21 to 466,000. The four-week moving average, which traditionally smoothes out weekly volatility, dropped to 496,000 from 513,000 the previous week. Although the figure remains far from levels usually associated with job-creation, it gives clear evidence of a turnaround that could mark the beginning of unemployment downtrend in the medium term.

Another positive signal on the labour market outlook was the increase above 50 of the employment sub index in the ISM manufacturing confidence Index. Indeed, the data showed that an increasingly larger number of companies are considering returning to hire in the coming months.

Nevertheless, consumers appear to be less optimistic about employment prospects. The “jobs hard to get” sub-index included into the Conference Board’s consumer confidence index, a good leading indicator of unemployment trend, has worsened further in November, up from 49.4 to 49.8. Therefore, consumers do not expect a sharp labour market upturn near term but they fear it will deteriorate further.

As regards the November figure, though a further drop in non-farm payrolls seems to be inevitable, a continuation of the recent improvement in employment conditions, with job losses shrinking below 150,000 units (vs. Bloomberg’s consensus estimate of 125,000) from 190,000 in October and the unemployment rate on hold at slightly above 10%, would be welcome news.

However, the labour market (and a consequent net creation of jobs) should not turn the corner any time soon despite the strong increase in corporate productivity and profit margins in the third quarter of this year. Before returning to hire companies will likely raise the number of hours worked by existing staff and transform the contracts of those employees who have accepted a reduction in the hours of work not to lose their post from part-time into full-time work. According to the latest data by the U.S. Bureau of Labor Statistics, in fact, the average hours worked per week have decreased from 33.8 pre-recession to 33 and 9.3 million part-time workers are longing for a full-time contract.

A rapid and sustained improvement in the labour market has also being hindered by capacity utilization in recent months. The chart below shows that the labour market has deteriorated less than anticipated by the collapse in capacity utilization to 68.3% - the lowest level in the past 40 years. For example, at the time of the December 1982 record low of 70.9%, the unemployment rate climbed to 10.8%, well above the present value. With capacity utilization at 70.7% in November, a further improvement in this data, which is obviously closely correlated with the economic cycle, is necessary to record lower unemployment rates.

On the other hand, even in the face of a continuation of the upturn in economic activity throughout 2010, unemployment conditions would take time to get better. Indeed, the jobs to be created for new entrants to the labour force (about 100,000 per month) should be added to the jobs needed for those who have lost them in the past two years (over 7 million).

The November FOMC meeting minutes, for example, showed that the Fed members’ average estimate is for a decline in the unemployment rate to 9.5% in late 2010. With a projected workforce increase of 1% in 2010 (to 155 million), the Fed’s central estimate implies a creation of some 2.5 million jobs over the next 14 months. A considerable advance - though certainly not enough to recover the ground lost in the past two years. Under this scenario, the recession that began in December 2007 would have ended well before the third quarter of this year, which is highly unlikely given the recent development in industrial production and household income. The unemployment rate continued to rise during the 14 months subsequent to the end of each of the last two recessions. Considering the last six recessions, the unemployment was either in line or exceeded the Fed’s predictions only in two cases (in 1975 and 1982). The Fed’s forecast of a 9.5% unemployment rate at end-2010 could therefore prove to be overly optimistic.

All in all, the November labour market data should provide two key indications. First, the worst for the U.S. economy, and ultimately for the labour market, should be over. Second, the recovery should be very slow and the fallout from the crisis should be felt for several years. According to leading U.S. newspapers, President Obama is understood to be under increasing pressure to implement new programmes to ease labour market conditions.

Why should we overweight Eurozone Government Bonds

2009-11-25T09:44:00.000+01:00

The expansionary monetary policy that the Fed and the ECB will likely continue to pursue going forward, the steep yield curve and the weak US Dollar should be taken into due consideration when evaluating the outlook for the European and US bond markets. The first two show that both countries enjoy a similar scenario: yields should be little changed for several months and then experience a flattening of the curve, the scope of which will depend on inflation. Due to the strength of the Euro against the US Dollar, investors should not invest in the U.S. bond market until the dollar’s negative trend reverses.

The prospects for the European bond market appear to be rosier. Given that interest rates will likely rise slightly and gradually, we recommend overweighting the short and medium end of the curve in the Euro area. By contrast, the long end of the curve would face greater risks should inflationary pressures mount. Only a deflationary scenario, which is highly unlikely to materialize for the time being, would suggest investing on the long end of the curve. In the medium term, higher gold prices and the rise in the expected future inflation rate as implied by the TIPs show that the market is beginning to fear a pick-up in inflation in the months to come. Reducing the duration of portfolio securities to focus on Euro-denominated medium-term stocks (3-5Y), seems to be a viable solution.

Emerging markets Government bonds are likely to perform in line with major international stock markets. Indeed, the former have largely benefited from a lower financial risk premium and expectations that the worst for the global economy may be behind. With U.S. government bond yields unlikely to rise sharply in the near term, the uptrend shown by emerging market government bonds would come to an end should financial market tensions resurface and the global economic upturn prove short-lived.

Equity market outlook remains positive

2009-11-23T12:06:00.000+01:00

The stock market outlook remains rosy despite last week’s widespread uncertainty, with the major indexes suffering from mild profit-taking and the publication of some negative data on the U.S. economy. Mounting expectations that the ongoing economic recovery will gather further pace in the first half of 2010 are the main reason behind the persistent uptrend in stock indices. Notwithstanding a high degree of scepticism towards the duration of the economic recovery - some economists indicated that it only depends on the fiscal and monetary stimulus implemented by the governments, emphasizing the risk of a relapse into recession in the coming quarters -, the leading international institutions are revising up their estimates for 2010 and 2011. Last week, the OECD upgraded its 2010 growth forecasts for the biggest international economies (the 30 member countries are now seen gaining 1.9% vs. +0.7% last June) and for the first time released its growth projections for 2011, which foresee a continuation of the global recovery (+2.5%).

The equity market upswing also reflects the acknowledgement that major central banks will continue to pursue an expansionary monetary policy going forward. The Fed, ECB and BoE are not seen raising rates in the first half of 2010 and might even leave them unchanged until late next year. As the Bank of England Governor Mervin King suggested speaking about UK economy during the presentation of the latest “Inflation Report”, a short-lived return of the UK GDP to its pre-crisis level would not be enough to make up for what the country has lost over the last two years.

Expectations that major central banks will not tighten rates for a long time are impacting the Government yield curve: the differential between the 10-year and 3-month government Bond yields is over 300 basis points in the U.S. and UK and more than 280 basis points in the euro area.

The graph below shows that a very steep yield curve has been traditionally followed by a very positive performance during the following 12 months in the S&P 500, the leading indicator for the overall U.S. stock market.

As we suggested in the post S&P500: a mildly positive outlook, the S&P 500, with an average P/E ratio for the past 10 years of 19 (broadly in line with the post-WW2 average), does not look overvalued, despite the strong rally staged in recent months. Given the positive outlook for the S&P 500, with a consequent positive impact on the whole of international indices, we recommend overweighting other equity indices. Indeed, the weak dollar is a great concern for the U.S. stock market. Over the last few months, there has been a strong reverse correlation between the US Dollar and the S&P 500. The equity market rebound has combined with a fall in the greenback and vice versa. Therefore, a new rise in equity markets might prompt a further drop in the U.S. currency, even though many indicators (including the OECD’s Purchasing Power Parity) have suggested that the US Dollar is more than 20% undervalued against the Euro. By contrast, emerging markets, which are benefiting from a reduction in the size of the financial risk premium, should be favoured more than the developed countries by the international recovery, even due to currency appreciation. Although the risk/return profile of emerging markets has worsened in the wake of the sharp rise since last March, we recommend betting on a continuation of the emerging markets uptrend.

Eurozone economy improves thanks to big economies

2009-11-16T11:37:00.000+01:00

Data released Friday 12 confirmed that the Eurozone, as well as the U.S. (+3.5 % q/q annualized) and China (+8.9% y/y), joined the global recovery in the third quarter. In line with the improvement recorded in industrial production, Eurozone GDP grew 0.4% q/q, only slightly lower than the +0.5% q/q expected by the consensus. German GDP, +0.7%, came in substantially in line with market expectations, while French GDP, up 0.3% q/q, fell short of expectations of +0.6% q/q. This was the second consecutive quarter of growth for both countries, which therefore confirmed that the worst may be behind them. Italian GDP gained 0.6% q/q in Q3, below consensus forecast of +0.8% q/q, but its first increase after five quarters of contraction.

The ongoing recovery is highly likely to persist into the coming quarters. The European Commission has recently revised higher its 2010 economic growth forecasts, with the Eurozone economy seen improving by 0.7% from -0.1% projected in April. The ECB Survey of Professional Forecasters is even more optimistic, with an expected growth rate of 1% in 2010. According to the European Commission and other major international organizations, economic growth rates will differ from one country to another. In particular there is a clear divergence between the recovery expected for the Euro area’s leading countries (Germany and France are seen improving by 1.2% and Italy by 0.7%) and the so-called peripheral countries (Ireland -1.4 %, Greece -0.3%, Spain -0.8% and Portugal +0.3%). These projections offer clear evidence that the countries that, more than others, benefited from the housing and credit market bubbles have still a long way to go before they pull themselves out of recession and that a return to growth, albeit below the average for the whole Eurozone, should not materialise before 2011. Therefore, the -0.3% q/q in Spain’s Q3 GDP did not come as a surprise. With the unemployment rate seen exceeding 20% in 2010, the chances of a quick upturn in the Spanish economy look slim. Indeed several factors may continue to penalize the peripheral countries over the coming years. First, the sharp growth posted in the last few years, due to a higher increase in the labour cost per unit of manufacturing output than in other countries, has lowered the peripheral countries’ competitiveness against the Eurozone countries through a devaluation of the real exchange rate. Second, given the bursting of the housing bubble, which slackened consumer spending and therefore inflation, real interest rates in these countries are higher than in the rest of the Euro area. Hence, while the housing bubble was being inflated, the ECB monetary policy was over-expansionary for the peripheral countries but excessively restrictive for the biggest countries in the region. Now the situation could paradoxically reverse.

For these reasons, the task of pulling the Eurozone economy out of recession is in the hands of its major countries. Specifically, Germany appears to be the leading candidate to act as the driving force – not only for its big size. Unlike other countries such as Italy, Germany might still implement a large fiscal stimulus to revive its domestic economy, with the deficit/GDP ratio that could mark the 3% threshold in 2010 (without falling back to this level until 2013) and the debt to GDP ratio that could reach 80% in 2011. In this direction goes the new fiscal stimulus announced by the Merkel’s administration aimed at boosting consumption and investment to rebalance an economy excessively skewed towards exports. Thanks to the efforts to contain labour costs, Germany has enhanced its own competitiveness and boosted exports (as proven by its huge current account surplus) in the last few years but has seen the investment/GDP ratio decline from 21% in 2000 to 18% in 2009, while the household consumption/GDP ratio has hovered around 55% over the course of the past 15 years. Nevertheless, given the sharp decline in consumption in Germany’s major export markets, the country’s export-driven growth model may be put at risk in the medium term. Policies aimed to stimulate domestic demand and investments, would be necessary at a time when they could shrink further in the face of the global downturn. Indeed, the Office for National Statistics’ announcement that Q3 growth was driven by a recovery in exports and by an increase in business investment comes as a very positive indication. Personal spending which weakened in Q3, may improve slightly in the coming quarters in spite of the negative trend shown by the labour market should German families decide to reduce their savings rate (over 11% of disposable income in 2008). Another boost to German domestic demand could also be provided by a continuation of an expansionary monetary policy by the ECB. Due to a rising Euro against major international currencies, in fact, the Monetary Conditions Index (MCI) is well above its historical average. Furthermore, considering that inflation might stay below 2% throughout 2011, the Taylor rule does not seem to require a rate hike until late 2010.

The medium term outlook for France and Italy looks rosy. France, which the European Commission expects to grow as much as Germany in 2009 (1.2%), will likely continue to be led higher by private consumption, while investment should stay stagnant. In Italy, a major positive came from OECD leading indicator, the highest within a panel of European countries in September. Notwithstanding the well-known structural problems facing the Italian economy and highlighted by the sharp increase in the real exchange rate in the past few years, and the country’s huge public debt, the Italian economy could surprise to the upside going forward.

S&P500: mildly positive outlook

2009-11-08T20:03:00.000+01:00

In the last few weeks neither good economic news (Q3 GDP grew 3.5% q/q annualized against consensus expectations of 3.2% q/q annualized) nor encouraging quarterly results (over 80% of the S&P 500 companies have so far beat consensus expectations – their best showing since 1993 according to Bloomberg agency’s calculations) were enough to push the S&P500 to a new 2009 high. As fears that the economy might enter a severe depression - which led the market to its lowest since 1996 in March - receded, the US stock market now appears to be increasingly more dependent on the continuation and strength of the economic recovery under way. Leaving aside short-term movements, which are mainly triggered by speculative factors, the medium-term S&P500 performance is highly reliant on corporate profits. The chart below, for example, shows that the S&P 500 and the corporate profits of its constituents have followed a similar trend over the course of the past 20 years.

Looking back at the early 1950s and considering national accounting profits after taxes and adjusted for inventory valuation and capital consumption adjustments instead of S&P500 corporate profits, results are substantially the same, though profits outperformed the S&P500 (dividend distribution is not taken into account). The only period in which profits and stock market did not move in the same direction was during the '70s, when, due to the high inflation, profits grew sharply while the S&P 500 was substantially flat (in spite of substantial price volatility), in line with the negative performance delivered by all financial assets. Therefore, investors fear a return of inflation to values more in line with those last seen in the '70s. Nevertheless, this scenario now seems to be highly unlikely despite the recent return of tips-based inflation expectations to above 2%. If the stock market trend will depend primarily on profits, an analysis of the S&P 500 outlook can only start from their future potential performance.

Standard & Poor's estimates for earnings as reported (net of write-downs of extraordinary items) for 2010 are extremely cautious: following the 197% bounce in 2009 (they slumped 77.5% in 2008), profits are expected to edge up 2.9% in 2010 but to jump 34% in 2011. Operating profits projections are much more optimistic: after gaining 12.6% in 2009 (-40% in 2008), profits are seen improving by 33% in 2010.

However, a more reliable barometer for understanding the earnings outlook of U.S. companies is the analysis of national accounting data, as it is less influenced by the budget choices of individual companies. To analyse the earnings outlook we have used two variables that have a good track record in projecting the trend in profits, as shown in the graphs below: profit margin, defined as the ratio between national accounting profits and nominal GDP, and the yield differential between 10 year and 2 year Government Bonds.

Though not nearing the 1982 recession trough, over the past two years profit margins have achieved a level usually followed by a higher average weighted earnings growth in the following 5 years than the long term average (8.4% versus 7.3%). Reassuring signals also come from the analysis of the yield curve. The steepness of the Government yield curve, with the ten-year yield 200 basis points above the 2-year yield suggests that profitability should rise sharply in the next 3 years. Therefore, positive earnings growth in the years ahead might be jeopardized only by a marked fall in nominal GDP, which should coincide with a major deflationary phase.

Although a positive earnings outlook is a good precondition for a S&P 500 uptrend going forward, investors are growing increasingly worried about the equity market valuation in the wake of the recent rally. The ratio price/average earnings of the last 10 years partially confirms these fears. After plunging to 13x in March, the ratio rose to 19x in October, slightly above the 18x long-term historical average. Therefore, the S&P 500 seems to be fairly valued at current levels. Considering that the corporate profits outlook appears to be rosy for the equity market and that the S&P 500 is fairly valued, it is important to project the index performance in the years ahead to assign the right weight within the portfolio. We will use a model derived from John Bogle (founder of Vanguard mutual fund group) to estimate the S&P500 performance in the next 10 years. The model takes into account the average earnings of the past ten years and the average annual earnings growth of the past 30 years. It subsequently calculates the S&P500 weighted average growth rate so that at period end the index is in line with the average of the past 30 years. The chart below gives clear evidence that the model has historically been able to anticipate the S&P 500 performance for the subsequent 10 years. At current prices, the weighted average earnings growth over the next 10 years stands at 6%, which should then be added to the annual dividend, now at around 2%. Should these projections be confirmed, the equity market performance in the years ahead would be in line with the historical average. Given also the low level of interest rates (the ten-year U.S. Government bond is at 3.53%), we would recommend assigning at least a neutral weight within institutional investors’ portfolios.

Away from the empire of the Rising Sun

2009-11-05T18:24:00.000+01:00

As in the case of major international economies, Japan showed reassuring signs of recovery over the summer, though the process of economic normalization appears to be far from over. The country’s industrial sector improved sharply, with production up 1.4% m/m in September (against consensus estimates of +1.1% m/m) from +1.6% m/m in August. Nevertheless, industrial production dropped by 18.9% on a year earlier. Another positive signal came from a sharper than expected (+0.9% m/m versus 0.2% m/m) increase in retail sales for September. As in the case of industrial production, retail sales fell 1.4% from the same period a year ago but improved on August (-1.8%). Retail sales are also seen improving further in the coming months due to the resilience shown by the labour market, with the unemployment rate unexpectedly down from 5.5% to 5.3% in September. Therefore, national accounting data due November 16 will likely confirm that Japan has joined all the other countries emerging from recession in Q3.

Although the Japanese economy should continue to show signs of improvement in the short term, its medium-term outlook remains clouded in uncertainty. First, Japan has a long way to go before solving the problem that has plagued its economy the most over the last few years: deflation. The national data for September showed that deflation persisted into September, -2.2% y/y for the cpi measure and -1% y/y for the cpi core. The October’s data for Tokyo even suggested that a further deterioration might be likely in the short term, so that some economists believe that Japan will not move out of deflation for at least two to three years. Indeed, private consumption is highly unlikely to recover any time soon, so as to trigger an increase in retail prices, as the improved employment scenario combined with a 1.6% y/y wage cut in September.

Against this backdrop, there are slim hopes of a recovery led by domestic factors and only a significant improvement in exports could trigger a sharper upturn in the economy.

But exports are hampered by the yen's sharp appreciation in recent months, particularly against the U.S. dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with the June 2007 peak, the yen has advanced by over 27% against the US Dollar, eroding profit margins for the nation's exporting companies. Based on OCSE Purchasing Power Parity estimate, at current levels the Yen is overvalued by over 30% against the U.S. dollar.

Therefore, a devaluation of the yen is the most efficient way to spur growth in Japan’s economy in the short term even though it appears difficult to implement, given that almost all major international economies rely more or less explicitly on their currency devaluation to revive the economy.

In the medium term, the major cause for concern for the Japanese economy is the high level of public debt. According to the International Monetary Fund estimates, in fact, public debt may rise to 218% of GDP this year, and reach 227% and 246% in 2010 and 2014 respectively. The sharp increase in the supply of government bonds is likely to intensify tensions in the bond market going forward as purchases by domestic investors may soon fall. The savings rate of Japanese families declined from 15% in the ‘90s to around 2% today because of the ageing population and workforce reductions. These tensions have already begun to emerge, with yields on ten-year notes up 11 basis points in October and the cost of the insurance against default in Japan in the credit default swap market exceeding the levels seen in the U.S., Germany and the UK. An increased securities offering and softer domestic demand could therefore lead to increased yields, with severe repercussions on the public budget and investor portfolios. Considering also the possible devaluation of the yen in the medium term and the low bond yields, we warmly recommend not to invest in the Japanese bond market.

China: a 2010 clouded in uncertainty

2009-11-04T11:23:00.001+01:00

The latest economic data published in Asia have shown that the major economies of the region have emerged successfully from the crisis of recent years. Smaller countries such as the Philippines and Indonesia have completely avoided plunging into recession, Singapore emerged from the crisis in the second quarter, while South Korea’s GDP grew 2.9% in the third quarter of this year. India, thanks to increasing flows of direct investment, is likely to come as a positive surprise in the coming months. All this has resulted in an upward revision to IMF’s economic growth estimates for Asia both in 2009 and 2010. The Washington Institute now forecasts 2.8% and a 5.8% growth in Asia in 2009 and 2010 respectively against earlier estimates of 1.2% and 4.3%.

But investor attention remains focused on China’s economic growth. The recently published third quarter data has suggested that the worst may be behind for the Chinese economy. The most encouraging indication came from GDP, + 8.9% y/y in real terms from +7.9% y/y in the second quarter and +6.1% y/y in the first quarter. Indeed, it is commonly believed that the Chinese economy needs to grow around 9% a year not to record higher unemployment rates. Further signs of improvement came from industrial production, up 13.9% y/y in September, and exports, whose pace of decline slowed to 15.2% yoy from 23.4% in August. Retail sales should continue to move upward in the medium term (+15.5% y/y in September vs. +15.4% y/y in August), mainly driven by improved sales of cars (+44.5% y/y), furnishing (+34% y/y) and construction materials (30.2% y/y). A boost to private consumption (down from 67% in 1981 to 48% in 2007 as a percentage of GDP) to the detriment of exports was, in fact, considered key by most economists to help rebalance the Chinese economy when the crisis broke out.

However, many investors and economists fear that the ongoing recovery might not be due to the strength of the economy, as argued by Goldman Sachs economists, but only to the aggressive expansionary policy pursued by the Government and that 2010 may produce negative surprises.

In the face of last two years’ crisis, in fact, the Chinese government has implemented a USD586bn fiscal stimulus plan, mainly aimed at infrastructure construction, post-earthquake reconstruction and affordable housing building.

More importantly, major domestic banks and small regional banks have started easing credit standards following the directives enacted by the central government. In the first nine months of 2009, in fact, new loans amounted to 8670 billion yuan, compared with 3480 for the same period last year. Although new loans have began to slow in the second half of this year (from a monthly average of 1230 billion in the first half to 428 trillion in the first 3 months of the second quarter), loan growth remains significant, hence raising fears that the Chinese economy could soon begin to suffer from excessive indebtedness.

Chinese authorities are particularly concerned that a large share of these new loans were not used to underpin the real economy but to heighten speculation on financial and real estate markets, increasing the risk of new speculative bubbles. For example, China Business News, citing government sources, indicated that almost 20% of the new loans in the first six months of the year had been invested in the Shanghai stock market. New loans to the property market also rose sharply. According to the National Office of Statistics, house prices in 70 reference cities rose by 2.8% y/y in September, up from +2% y/y in August. The sharp improvement led Moody's upgrade its outlook for the Chinese residential market from negative to stable.

Considering also the higher-than-60% stock market rebound since the beginning of this year, the Chinese authorities appear to be ready to take action to prevent this trend from jeopardising the country’s financial stability.

The Commission for banking regulation will introduce new measures to ensure that the new loans are not used for purposes other than supporting the real economy. According to a draft reform published in the Commission's website, loans exceeding 300 thousand yuans (about 30 thousand Euros) would be paid directly to the counterparty. "This is the first step towards a removal of the expansionary policy and it was decided after the latest reassuring economic data" said Gabriel Gondard, Fortune SGAM Fund Management CIO in Shanghai to Bloomberg news agency. Nevertheless, market experts are divided over the Chinese authorities’ future economic incentives choices. For example, economists at UBS and Credit Suisse believe that reserves to be held at the Central Bank by commercial banks will be increased by the end of the year. By contrast, Stephen Roach, chairman of Morgan Stanley Asia, said that Chinese authorities aim to maintain social stability, which can be only guaranteed by sustained growth. A new economic downturn, a clear possibility in 2010 should the Government remove the fiscal stimulus, is, therefore, to avoid.

The trend of prices is another factor that helps maintain the ongoing expansionary policy in place. Despite the sharp increase in M2 money supply (+29% y/y in September), consumer prices (-0.8% y/y in September) are expected to edge up in 2010. Economists at Morgan Stanley, for example, see inflation averaging at 2.5% in 2010, with an upward pressure that should only come from a stronger-than-expected international recovery, which would push higher commodity prices. According to Morgan Stanley, the government will not raise rates ahead of any such move by the Fed, which is expected to start tightening in mid-2010, given the close relationship between the Dollar and the Yuan.

The Council of State has shown that a continuation of government stimuli would be necessary to rebalance the Chinese industrial sector, which is skewed towards given sectors. As a first step, the government decreased the number of financing projects for the production of aluminium, steel and cement to prevent excess capacity. The challenge facing the Chinese economy in 2010 will therefore be to sustain economic growth while avoiding over-indebtedness. This will be crucial not only for the country’s but also for the global economy. Should a rebalancing of the economy fail to materialize, a renewed focus on exports would be inevitable.

U.S. returns to grow but still faces debt problems

2009-11-02T10:44:00.000+01:00

For the first time since Q2 ’08, the U.S economy returned to grow in Q3’ 09, +3.5% q/q annualized, ahead of the +3.2% q/q annualized expected by the consensus of economists. Nevertheless, positive third-quarter GDP growth did not help dispel the uncertainty surrounding the US economic outlook as the fiscal stimulus implemented in Q3 comes to an end. Indeed, economic growth in Q3 was driven by the measures adopted by the Obama administration to rescue the residential and automotive sectors. A clear example is the 22.3% increase q/q annualized in third-quarter car sales thanks to the "cash for clunkers" programme, which accounted for 1% of total GDP growth. But car and home sales (-3.6% in September) returned to fall once the incentive programme ended.

Not surprisingly, the recent recovery has been looked with scepticism by consumers, as indicated by the Conference Board’s consumer confidence index, which dropped from 53.4 to 47.7 in October. The negative trend in the labour market was the main reason behind a weakening consumer confidence. Indeed, despite early signs of improvement in the economic cycle, the unemployment rate continues to remain high (9.8% in September), and is expected to deteriorate further in 2010 (above 10%). The persistent rise in foreclosures is another negative factor affecting consumers, who will likely further increase their savings rate above 3.3% of disposable income in the third quarter.

Economists, though believing that the worst is finally behind them, consider the Q3 ’09 improvement of a transitory nature and are looking for a further slowdown in Q4 ‘09, when growth should come in at 2.4% and stay at this level throughout 2010, before slightly improving to 2.8% in 2011. Therefore the "new normal" scenario set out by PIMCO bond manager Bill Gross, who projected the U.S. economy to experience many years of growth below the average of the last 60 years (3.4%), seems to be very likely.

The economic imbalances that have plunged the U.S. into recession and that are far from solved remain the most serious risk factor facing the medium-term U.S. economic prospect. As indicated by the latest GDP data, US economic growth continues to be highly dependent on personal spending, which has steadily accounted for 71% of GDP over recent quarters. With the unemployment rate likely to increase further going forward, estimating a sharp rise in personal consumption over the coming months remains somewhat risky, even though the recent stock market recovery has increased both the ratio of total household debt to total household assets and the ratio of net worth to disposable income. The household sector deleverage is likely to weigh on personal consumption and the labour market. Data from the Federal Reserve for the last few quarters, in fact, have shown that households are gradually reducing their debt pile (-168bn dollars from the record peak hit in Q2 2008), although the ratio to GDP remains close to 97% due to the GDP decline in the first half of 2009.

With companies also committed to reducing their debt level (-50bn in Q2 compared to Q1), the U.S. economy is highly unlikely to be driven by a sharp upswing in investment in the coming quarters.

While a narrowing of U.S. household and corporate debt is positive, a rise in federal debt is cause for concern. It accounted for 51% of Q2 09 GDP from 44% in 2008, and is seen mounting further in the months to come. According to the Congressional Budget Office, public debt held by private individuals should achieve 61% in 2010 and hit an all-time high of 67.8% in 2019. However, many analysts have projected an increase in the debt ratio up to 100% of GDP over the next few years. Consequently, even government spending should hardly be able to underpin economic growth in the quarters ahead.

All in all, only an increase in exports appears to be able to provide a boost to the economy, even though third quarter trade balance data showed that relying on net foreign demand may prove illusory. Indeed, a slight improvement in consumer spending was enough to widen the external deficit to 348bn dollars from 330bn in Q2 despite the weak U.S. Dollar, hence breaking a downward trend for net trade deficit that had lasted since 2007.

The problem of excess borrowing in the U.S. economy might be still far from being solved and weigh on economic growth for several years. As shown in the chart below, in fact, the total debt level, excluding state and local government debt, has neared 220% of GDP this year and is unlikely to decrease in the years to come. U.S. authorities might well decide to reduce the debt burden by increasing inflation. This would cause serious damage to the entire global economy, which would have to search for a new growth trigger.

Gold, the only means of effective portfolio diversification

2009-10-27T13:59:00.000+01:00

In the commodity world a special place must be reserved for gold because of its peculiarities, which make it a must-own asset for many investors.

As mentioned in the post How many risks behind commodities, gold is one of the few raw materials with a very low correlation with the stock market - a correlation that has not increased sharply over the past two years. Therefore gold is the only asset that seems to still be able to provide the necessary diversification within a portfolio. The peculiarity of gold has also been underlined by two IMF economists, Roache and Rossi, in a study published in July 2009 ("The effects of economic news on commodity prices: Gold is just another commodity?"). The two economists have discovered that gold is the only commodity to respond to major macroeconomic data published in the U.S. and Euro area and that such movements are counter-cyclical, in line with its status as a safe haven. Gold should also defend the portfolios both in case of a surge in inflation, as it happened in the '70s, and of deflation, as it happened in the '30s. However, the ability of gold as having a positive impact on the portfolios of European investors could be severely limited by the performance of the Euro/US Dollar. The recent rise in the bullion, in fact, has been accompanied by an increase in the single European currency. Although gold has hit a record high above $1,000 an ounce, for European investors this is still almost 9% below the record high set in March. Buying gold could be a rewarding choice in the long run should the crisis of the last two years not be fully overcome or inflationary pressures increase but in the near term, investing in gold might turn out to be disappointing for European investors.

How many risks behind commodities

2009-10-25T14:31:00.000+01:00

Three are commonly recognized as the main reasons behind the recent uptrend in commodities. First, investors fear that the expansive monetary policy conducted by major international central banks might significantly boost inflation in the years ahead. Commodities, in fact, traditionally yield positive returns in periods of high inflation, just as in the 1970s. Second, there are widespread expectations that an economic recovery, mainly driven by emerging economies (Chinese GDP gained 8.9% in Q3), can lead to stronger demand for commodities going forward, also due to a sharp increase in money supply globally. Finally, the rise in commodity prices may have been caused by the US Dollar’s fall.

Furthermore, leading international institutional investors are reshuffling their portfolios, increasing the weight of commodities. Indeed, commodities are particularly popular with investors because of their greater capacity to ensure an excellent portfolio diversification without penalizing the overall performance. Several academic studies published in recent years have shown that commodities can optimize the risk-return profile of a business or financial investment portfolio. In the study "Facts and Fantasies about Commodities Futures" (2004), the economists Gorton and Rouwenhorst have offered evidence that in the period 1954/2004 the performance of a portfolio constructed using 34 equally-weighted commodity futures was in line with the stock market return but with lower volatility and little correlation with stock and bond markets. Nevertheless, the CRB performance (composed of 17 major futures) did not confirm this trend: the index compound annual growth rate between 1956 and 2009 was 1.6%.

Structural factors are also in favour of commodity investments. In a recent interview, Jim Rogers said that the outlook for raw materials will stay rosy for several years. Indeed Rogers said that a growing number of people in emerging markets are adopting western lifestyles, with a consequent increase in raw material consumption. By contrast, he also said that little has changed for production capacity over the past 10 years.

But there are several reasons for caution before investing in commodities. First, the correlation between commodity and stock markets has risen sharply in recent months. As the table below indicates, the correlation between the S&P500 and CRB indexes has increased from 0.2 in the last 15 years to 0.52 in the last two years to 0.8 in the last year. The correlation between the S&P500 and WTI is also rising, while there is a steadily weak correlation between the S&P500 and WTI.

Moreover, the recent uptick in commodities has reflected the US Dollar’s weakness and not a bullish demand, as clearly shown by WTI. Indeed oil prices have moved up despite an increase in oil inventory and even though refineries running below their historical average.

Investors willing to invest in commodities should also consider the structure of the market. Some academic studies, including "Momentum strategies in commodity futures markets" by Miffre and Rallis, have shown that investors are highly likely to gain positive returns with futures in backwardation than in contango.

Although the above-mentioned theory is not unanimously accepted (other studies have shown that the returns of the futures curve are uncorrelated from the curve slope), the fact that the whole of the 20 major commodity futures we considered, with the exception of those on precious metals (gold, silver, platinum and palladium), are in contango signals that obtaining positive returns is no easy task at this point in time. A study by Standard & Poor's is a clear example. It gives evidence that those who invested in the Natural Gas futures have seen the value of their investment drop from 100 in January 1994 to 2.63 in September 2009 notwithstanding the 125% increase in the futures in the same period because of the position roll-over. Even those who invested in oil futures have seen their earnings more than halved during 2009 in the face of a falling dollar (for European investors) and of the repercussions of the futures roll-over.

For these reasons, investments in commodities should be made by well diversified instruments as the ETFs that cover a general index, while single commodity futures should be used only for trading and not for investing.

Investing in securities in the Basic Resource sector index may represent a viable alternative to commodities. Indeed, although Gorton and Rouwenhorst have shown that commodity-producing companies have underperformed commodity futures, this could have been triggered by the sharp increase in inflation in the years 1970s to 1980s - which was clearly unfavourable to the stock market.

However, this trend has reversed since 1987, with the DJ Euro Stoxx Basic Resources index significantly outperforming the CRB. Since 1987 the Basic Resources index has gained 238%, compared to +38% of the CRB. We believe that this trend will persist into the coming months unless a sharper turn to the upside in inflation, which would damage the entire stock market, materializes.

Government bond outlook: overweight short/medium term bonds in Euro

2009-10-17T11:38:00.002+02:00

International financial markets have endured intense volatility over the last few weeks. Indeed, leading international equity indices have continued to follow the upward trend began in March, with the Dow Jones Industrial back above the 10,000 level for the first time since October 2008. Even currency markets have seen a lot of action, with the Euro moving back past the 1.49 mark against the US Dollar - a level last seen in August 2008. But the financial market excitement has not spread to major international bond markets, which appear to be going through a phase of apparent calm notwithstanding the recent signs of economic improvement. Accordingly, Central Banks will likely implement an exit strategy beginning in mid-2010.

Yields on the short and long end of the curve have been relatively unchanged both in the US and in the Euro area over the past few weeks. In the US, the 10-year Government bond yield remained below 3.5%, while the 2-year note yield continued to hover around the 1% level.

The bond market has been substantially quiet this week notwithstanding the dollar’s fall against major international currencies and the jump in gold prices to the historical high of US$1066oz. This is clear evidence that bond investors do not fear a dangerous increase in inflation, as the uptrend in gold prices and the US Dollar might indicate. Indeed, inflation expectations for the years ahead have been moderate, as the trend followed by the inflation-indexed securities (Tips) has shown. The implicit inflation estimate for 10-year Tips stands at 1.8%, well below the 2.2% historical average. With a real rate of 1.5%, the Tips also indicate that the market does not expect the U.S. economy to make a comeback to robust growth in the coming years, contrary to what the recent equity market rebound would suggest.

Restrained inflation and economic growth expectations for the years to come are a source of considerable concern for U.S. Government bonds going forward. In fact, should inflationary pressure increase or economic growth be stronger than expected, Treasury yields would rise sharply and lead to capital losses. Moreover, for non-US investors, the US Dollar trend is another risk factor for the U.S. bond market. A continuation of the US currency downtrend, in fact, would ensure that the returns yielded by the coupons would not be able to offset the accumulated currency translation losses.

As things stand, we do not recommend investing on U.S. Treasuries but awaiting a trend reversal in the US dollar, which is undervalued against all major international currencies according to OECD statistics on Purchasing Power Parities (PPP) as we have indicated here and here. In so doing, considering also that there is much likelihood that the Fed will embark on monetary tightening in 2010, investments should be first channelled toward the very short end of the curve, which is less subject to capital depreciation when interest rates increase. Investments would subsequently shift toward the long end of the curve should inflationary pressures be contained. The table below shows that a sharp steepening of the yield curve (the spread between the 3-month T-Bill and the 10-year T-Bond is about 330 bps) has historically been followed by a rise in short-term yields and a fall in long-term yields. Although a sharp decline in 10-year yields in the face of an economic recovery does not seem to be on the cards now, yields may return to fall after an initial rebound as investors start discounting an economic slowdown.

The European bond market outlook looks rosier, particularly due to the single currency strength against the greenback. Indeed, inflation in the Euro area would remain more moderate than in the U.S. should the international economy recovery heighten inflationary pressures, hence delaying and limiting a monetary tightening by the ECB.

Indeed, even a possible reversal of the Euro’s uptrend will likely have a limited impact on the near-term inflation and monetary policy prospects. Based on a study by some OECD economists ("Standard shocks in the OECD Interlink model" by Dalsgaard, André and Richardson), a 10% decline in the Euro would push up inflation by 0.4% in each of the following two years - not particularly worrying given the now restrained inflationary pressures. A reverse scenario, i.e. the emergence of deflationary pressures should leading international economies fail to pull themselves out of the crisis, would enable the bond market to post positive performances.

As the ECB is likely to raise rates in small and not too frequent steps, short and medium term bonds are to overweight in a bond portfolio. Indeed, long term bonds would face greater risks in the face of heightened inflationary pressures. Only a deflationary scenario, which is highly unlikely to materialise any time soon, would lead investors to invest on the long end of the curve.

Carry traders bet on Central banks

2009-10-10T11:19:00.004+02:00

In our latest post Fed, ECB and BoE: exit strategy far from certain we anticipated that an exit strategy from the expansionary monetary policy that major central banks have pursued over the course of the past two years, although not imminent with respect to the Fed, the ECB and the Bank of England, would be implemented soon by many western economies. We also suggested that the Norwegian Central Bank would likely be the best candidate to raise interest rates, following the Bank of Israel’s rate hike last September. But, considering the whole of the G20 countries, last week the Reserve Bank of Australia (RBA) unexpectedly increased rates from 3% to 3.25% - a hasty move for some economists. The RBA decided that it was time to start removing the expansionary monetary policy it had been implementing since September 2008, with rates down from 7.25% to 3% in just a few months. With GDP declining only in Q4 2008, the Australian economy has not entered the recession of the past two years and the recovery of Asian economies, its major trading partners, has led the RBA to estimate that economic growth could be pretty close to trend growth in 2010. Further rate increases may therefore be implemented over the coming months: according to Morgan Stanley, rates will likely be raised to 3.5% by the end of 2009 and to 4.5% by mid-2010.

The RBA surprise move impacted on the currency market, where the Australian Dollar gained substantial ground against both the Euro and the U.S. Dollar, thanks to the sharp increase in carry trades (i.e. borrowing in a low-yield currency and investing the funds in a higher-yielding currency to gain from the difference). Contrary to economic theory, carry trades have historically yielded high returns for extended time periods but have entailed serious losses during financial turmoil. In a study published in July 2009 "The Revenge of purchasing power parity on carry trades during crises", Briere and Drut, two economists of the Université Libre de Bruxelles, have shown by using the cross currency exchange rates of the eight major developed economies (the U.S. dollar, Euro, Yen, English Pound, Swiss Franc, Australian Dollar, New Zealand Dollar and Canadian Dollar) that carry trades yield higher returns than those offered by a strategy built on the Purchasing Power Parity (PPP), but only due to the performance posted during normal market phases.

In fact, during a financial crisis, when the Vix (Volatility Index on the S&P100 options) rises by one standard deviation above the long-term moving average, carry trades lose ground while a PPP-based strategy earns positive returns. A study by the Bank for International Settlements (BIS) published in the Quarterly Review of December 2007 ("Risk in carry trades: a look at target currencies in Asia and the Pacific") illustrated the profitability of carry trade operations with reference to some Asian countries (Indonesia, India and the Philippines).

As the Australian Dollar trend showed last week, identifying the next central bank to tighten, widening the interest rate differential with other currencies, is likely to ensure a good performance to investors. As for the eight currencies analysed by Briere and Drut, the outlook for the Norwegian Krone appears to be rosy. Not only is the currency key rate already higher than that of the U.S. Dollar, Swiss Franc and Japanese Yen (the three main financing currencies), it should also benefit from the interest rate hikes that will be likely implemented in the aftermath of the October 23 meeting. Another candidate to become a buying currency in carry trades is the New Zealand Dollar, as the interest rate level (2.5%) should remain higher than in other countries, although economists at Morgan Stanley have recently estimated that a rate increase by the New Zealand Central Bank should not materialise before Q3 2010. By contrast, the Central Bank of Canada rate hike, which Morgan Stanley expects in Q1 2010, will likely have a modest impact on exchange rates. With rates at 0.25%, in fact, only expectations of a severe monetary policy tightening could drive up the Canadian dollar.

However, as we said before, carry trades will remain profitable as long as the ongoing positive phase of the market continues. A deterioration in financial market conditions, which would be evidenced by a sharp increase in the Vix above the 30 threshold, would make it necessary to focus on the currencies with a greater undervaluation against the PPP, in line with the findings of Briere and Drut. The table below illustrates the over/under valuation of the G10 currencies against the U.S. Dollar on the basis of OECD data. The U.S. Dollar appears to be undervalued and the Swiss Franc, the Norwegian Krone and the Australian Dollar are among the most overvalued G10 currencies against the US Dollar. According to a Deutsche Bank report released in 2007 ("Currencies: Value Investing" by Bilal Hafeez), which indicated that a strategy based on the sale of overvalued G10 currencies on the basis of the PPP and on the purchase of the most undervalued currencies translated into positive performances between 1980 and 2006, the Swiss Franc, Norwegian Krone and Australian Dollar would be the three currencies to short, while the U.S. and Canadian Dollar and the Pound would be the currencies to buy.

Fed, ECB and BoE: exit strategy far from certain

2009-10-05T14:17:00.002+02:00

Despite signs of caution coming from last week’s macroeconomic data, major international economies are likely to have recorded positive growth rates in Q3 and to continue to trend upward in the coming quarters as the Fed acknowledged in the statement released after the September 23 Fomc meeting (“Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn”). Therefore, there are increasingly stronger expectations that leading international central banks will start to plan an exit strategy following the sharply expansionary monetary policies implemented over the course of the past two years. Looking ahead, the financial market trend, currency and bond markets in particular, will depend on the timing and strength of the announced end to government assistance. But the removal of ultra-expansionary monetary policies has already begun with the decision of the Bank of Israel to raise interest rates from 0.5% to 0.75% on September 7. The Norwegian Central Bank seems to be one of the most likely candidates to follow the route taken by the Bank of Israel. In the statement released after the September 23 meeting, Norway’s Central Bank said that it was considering lifting rates, currently at 1.25%. The decision to increase rates will be likely made at the next Norwegian Central Bank meeting (scheduled October 28), when the Monetary Policy Report 3/09 (the last for this year) presenting new growth and inflation projections for the quarters ahead is due for publication. As shown in the chart below the upward phase of the interest rate cycle could be very marked, considering that the previous expansionary phase was much stronger than indicated by the model used as a benchmark by the Norwegian Central Bank and built along the lines of the Taylor rule. Interest rates might reach 1.75% by year-end from the current 1.25% and hit 2.25% in mid-2010.

Nevertheless, all leading western Central Banks are highly unlikely to implement exit strategies for some considerable time - the only exception being Israel and Norway. According to some Fed, ECB and Bank of England officials, the three central banks appear to be in no hurry to hike rates. First, Central Bankers want to make sure that the economic recovery is solid and broad-based for not running the risk of addressing a fresh economic contraction once the monetary stimulus is halted (the much-feared W-shaped scenario). Second, they acknowledge that the banking system has yet to pull itself completely out of the crisis of the past two years. What is more, a new inflationary spiral should not materialize any time soon. Benchmark for the behaviour of central banks will once again be the Fed, which has already started ending the government assistance granted during the most acute phase of the financial turmoil.

To understand what the Fed Fund rates outlook might be like we used, as in the case of the Norwegian Central Bank, a benchmark model derived from the Taylor rule: inflation expectations (based on PCE deflator projections), output gap and Fed fund rates in the previous quarter are the independent variables included in the model output. On the one side the chart below shows that rates should be negative in the face of the high level of spare capacity within the system (the Fed solved the problem by implementing a quantitative easing programme), on the other side it shows that interest rates should start to increase in Q2 2010. Based on the GDP and inflation forecasts presented in the Fed Monetary Policy Report to Congress in July, Fed Fund rates might rise to 0.5%/0.75% by the end of the first half of 2010 and to 1.5% by year-end 2010.

More moderate and more distant in time should be the rate hikes that will be likely implemented by the ECB, whose meeting on October 8 is expected to provide limited disclosure of the outlook for monetary policy in the short term. The chart below, which compares the trend of the Refi rate with the that of the rate prescribed by the Taylor rule using the latest ECB estimates for the coming quarters, illustrates that rate interventions should not be needed before end 2010. A quicker removal of monetary policy stimulus is unlikely due to the euro’s uptrend, particularly against the dollar. The continued rise of the euro, in fact, is already playing a restrictive role for the Euro area and a hasty rate increase by the ECB would end up pushing the single currency even higher. It is therefore not surprising that Trichet said that a strong dollar is very important for the economic system, suggesting that exchange rate movements will play a key role in monetary policy decisions throughout 2010, as we indicated in our posts Does the ECB really need an exit strategy? The Euro/Dollar exchange rate factor and How long will the Eurozone (and the ECB) cohabit with an overvalued Euro? Why the Euro's fall is key for Eurozone economy.

More uncertain are the monetary policy prospects for the Bank of England. Governor Mervyn King voiced concerns about the economy and inflation despite a higher-than-expected rise in consumer prices in recent months. The weakness of the Pound may have helped keep inflation at a higher level than estimated by the Bank of England, whose inflation projections in the latest inflation report for August showed that, after a temporary increase in the first half of next year, the CPI should stay moderate until the end of 2010. Should this be the case, the Bank of England would find it hard to lift rates although this seems to be necessary using the Taylor rule based on the inflation report estimates. Under the report, inflation would come in at 2% at the end of a two-year time horizon with rates steady at 0.5%. By contrast, inflation would stay below 2% should rates be increased. Therefore, a rate hike in 2010 will materialize if inflation is higher than predicted by the BoE, leading to an upward revision of the inflation report estimates due in November. Nevertheless, the Monetary Policy Committee meeting scheduled October 8 should offer little new information to markets.

Which return from US equity market?

2009-09-27T20:01:00.000+02:00

Following the huge uptrend since last March, the outlook for the S&P 500 and other leading international stock indices appears to be clouded in uncertainty. A major short-term negative for the S&P 500 is that the recent strong rally has brought the index to an overbought level (as an example, its latest close was 15% higher than the 200-day moving average). The S&P 500 has never experienced such a sharp increase (+58%) in such a limited time period. However, even though we believe that an equity market correction is a near-term possibility, we would not lighten up positions or exit the equity market until a clear trend reversal takes place as we would not try to sell at the top of the market but to remain invested in the trend direction.

But institutional and long-term investors had better focus on the equity market medium/long-term prospects than on the S&P 500 short-term swings. Projecting the equity market performance for the 10 years ahead is key for determining how to allocate a portfolio between equity funds and bond funds. Although this is no easy task, we will try to predict the S&P 500 moves for the next 10 years using the John Bogle’s (founder of Vanguard Mutual Fund Group) model we find on the Mark Boucher’s book "The Hedge fund edge".

Under the model, we should take the dividend yield at the beginning of the projected decade to forecast stock and bond returns in the following 10 years, add the average annual earnings growth for the past 30 years and compute what rate of return would have to develop over the subsequent 10 years to achieve that average P/E at the end of the term and add this final number to the previous table. As we can see in the chart below this model has a good track record for projecting the S&P rate of return. We are looking for an average annual return of 8% for the S&P500 from now to 2019 with a range between 3.5% and 12.5%. Even though this rate of return is lower than past returns, we believe this is enough to recommend investors assigning a neutral weight to the equity market in their institutional portfolios. Indeed, with the 10-year US Government bond at 3% the S&P 500 is likely to post the extra-performance needed to invest in equities.

Norges Bank drives Norwegian Krone outlook

2009-09-23T14:44:00.002+02:00

As widely expected, the Norges Bank decided to leave the key policy rate unchanged at 1.25% at today’s monetary policy meeting. Nevertheless, in the statement released after the meeting, the Central Bank announced that the Executive Board had considered the alternative of increasing the key policy rate.

The Bank highlighted that activity in the global economy and Norway’s economic growth had been stronger than initially projected in the Monetary Policy Report 2/2009 (published on 17 June). Core inflation now stands at around 2.5% in spite of the appreciation of the Norwegian Krone and above-estimate but still poor economic growth. With international financial markets recovering some ground and Norwegian house prices nearing to the 2007 historical high, the Norges Bank will likely begin removing its ultra-expansionary monetary policy in the short term. Following today’s monetary policy assessment, it is highly likely that the Central Bank will raise rates at the October 28 Monetary Policy Meeting, with a 50bp rate hike as a clear possibility. The Monetary Policy Report due for publication the same day will provide further hints about the prospects for the monetary policy.

An increase in the interest rate will therefore result in Krone appreciation in the medium term. With both the Fed and the ECB likely to hold the key policy rate steady for some months, the interest rate differential will become more favourable to the Norwegian Krone going forward. The country’s economic activity is also likely to improve sharply due to the fiscal stimulus that is being implemented. The productivity differential against the Eurozone will therefore widen. The Norwegian Krone would be a strong buy should oil prices resume an upward trend.

Governor King pushes Pound downwards

2009-09-22T10:05:00.004+02:00

If the publication of the Bank of England’s August quarterly Inflation Report halted the upward trend in the Pound against the Euro, highlighting the country’s negative economic and inflation outlook, Governor Mervyn King’s speech to lawmakers last week contributed to further depressing the UK currency. King said that the Bank of England may soon decide to cut the deposit rate (i.e. the rate at which the liquidity that commercial banks deposit with the Central Bank is remunerated), which now stands at 0.5%. Some economists advanced the hypothesis that the UK will likely adopt the negative rate policy first implemented by Sweden’s Riksbank in July. Nevertheless, the chances of this happening look slim (the BoE's next Monetary Policy Committee Meeting is scheduled for 8 October).

Overall, King's words have intensified fears about the British economy over the coming months, indicating that the monetary policy may remain accommodative for a long time. "The strength and sustainability of the recovery is still very uncertain and the balance of risks to the inflation target of 2% remains downward" said King.

Governor King did not appear to be worried about the country’s short-term economic prospect (the inflation report suggested that a short-term rebound in economic activity is "inevitable" due to the strong expansionary policies pursued by the whole of international central banks and governments), but about the medium-term outlook, as recovering the ground lost during the crisis that hit the country over the past two years will not be easy task.

A harmful signal on the economic outlook came from a report recently published by Ernst & Young Item Club. According to the study, housing prices should fall during the first half of 2010 despite recent signs of improvement, then stabilise in the following two years and subsequently start picking up as the wider economy strengthens and credit conditions ease. But the 2007 record high prices should not be achieved before 5 years.

The sharp rise in unemployment, which climbed to the highest since 1995, will continue to weigh on the real estate sector and on the economy as a whole, and will trigger an increase in the savings ratio due to growing concerns about the labour market outlook. With government spending likely to be put under control in the near future in the face of the large deficits expected for 2009 and 2010, exports appear to be the only hope for a return to growth. Considering also that deflationary pressures are much feared by UK central bankers, a further weakening of the Pound would be welcomed by the BoE, as we stressed in the article published last August 17 A weak Pound is welcome, BoE's Governor King indicated.

Last week the Euro/Pound exchange rate marked the 0.9 level for the first time since May (+3%). Leading international bank strategists expect this trend to persist into the coming months. As an example, Hans-Guenter Redeker, a currency strategist at BNParibas, has recently set his Euro/Pound target price at 1, while Steve Barrow, a currency strategist at Standard Bank, has set a target price of 0.95. As in the case of the US Dollar, the main reason for the decline in the Pound is the change of its role during carry trade operations - from investment to financing currency due to low interest rates. With the monetary policy expected to remain expansionary in the UK much longer than in other major western economies and with the Pound unable to act as a safe haven currency during fly-to-safety phases, the British currency is to be preferred to the US Dollar in carry trade operations despite slightly higher interest rates. The Pound is likely to stay weak in the foreseeable future.

Betting on US Dollar as weapon of defence

2009-09-20T16:33:00.004+02:00

Over the past few weeks the Euro/Dollar exchange rate has continued to move upward to exceed the 1.47 threshold for the first time since September ‘08. By contrast, better than expected US economic data during the summer was not enough to reverse the Greenback’s downtrend. Above-estimate news from the Euro area, with the German and French GDP improving by a surprising 0.3% q/q in Q2, cannot help explain the strength of the single currency. There is continued uncertainty surrounding the Eurozone economy, such as the poor health of some major economies including Italy and Spain. Moreover, the outcome of the new referendum on the Lisbon Treaty to be held in Ireland by November 2009 is another factor of uncertainty about the outlook of the European Union.

Two reasons appear to justify the Euro/Dollar uptrend. First, the short-term interest rate differential should continue to remain favourable to the Euro for several months, as both the Fed and the ECB are likely to leave interest rates unchanged for several months. In our opinion, there is still a long way to go before an exit strategy is implemented.

Second, the upward trend in the Euro/Dollar seems to be closely connected with the fall in the risk premium on international financial markets. Indeed the Dollar downtrend began last March, the month when the S&P500 saw its lowest since 1997. The negative correlation between the US Dollar and equity markets is due to the strong expansionary monetary policy pursued by the Fed: with the Fed Fund rate at 0% the US Dollar has become the new financing currency in carry trades, taking the Yen’s place. Several academic studies have shown that carry trades are profitable in the case of a downtrend in the market risk premium. The drop in the Vix below the 25.00 level, the narrowing of the spread between low-rated corporate bonds and US Government bonds and of the spread between emerging markets Government bonds and U.S. Government Bonds and limited volatility in the foreign exchange market are all symptoms of how the trend in market risk premiums is supportive for carry trades.

The U.S. Government might welcome a continuation of the carry trade aimed at weakening the dollar, provided that the move does not spark a strong reaction from the government of China, which sits on a mountain of dollars. A weak dollar, in fact, would have a great impact on the U.S. economy. First, it would boost exports and enhance American companies’ competitiveness. Second, as indicated by Hiromichi Shirakawa, a chief economist at Credit Suisse Tokyo, a weak dollar would increase the returns on U.S. investments abroad, increasing the wealth of businesses and households. Finally, a devaluation of the US Dollar would lessen deflationary pressures.

With the interest rate differential weighing on the US Dollar, carry trade operations using the dollar as the financing currency expected to continue due to the uptrend in market risk premiums and the U.S. Government that seems to view favourably the dollar’s devaluation, despite claims to the contrary, the current situation seems to favour a further appreciation in the Euro/Dollar in the short term.

Nevertheless, investors holding positions in the equity market should not bet on a further appreciation of the Euro/Dollar. Indeed, the strong correlation between the exchange rate and the equity market in recent months has given evidence that investing in the Euro/Dollar would not impact positively on a portfolio diversification. By contrast, building positions in favour of the US Dollar against the Euro could turn out to be a more viable solution.

First, the interest rates differential should not penalize the US Dollar as long as it did with the Yen, the carry trade financing currency ahead of the US Dollar. In fact U.S. interest rates (once clearer signs that the country has pulled itself out of the recession of the past two years emerge) will likely rise more quickly and achieve a higher level than those in the Euro area, although this scenario should not materialize before 2011.

Second, due to the recent upward move, the Euro/Dollar is overvalued by over 25% according to the Purchasing Power Parity (PPP) calculated by the OECD. 20% deviation from the fair value has historically been followed by a correction phase. As shown in the chart below constructed using the German Mark as a proxy for the Euro in the years ahead of its introduction, strong deviations from the fair value calculated by the PPP were followed by counter-trends to correct previous excesses. Therefore we are now looking for a Dollar revaluation in the medium term. This would not occur should inflation rise more markedly in the US than in the Euro area and therefore align the PPP with the Euro/Dollar’s present value.