14 May 2010

Macro Strategy Update

Watch The Real Economy

Amidst the European debt crisis over the past two weeks, investors failed to notice some fundamental improvement in the global economy. A decent set of numbers from the US has reduced the odds of a double dip. Investors finally dipped their toes back into the asset backed securitization market without government intervention. Surprisingly, the European economy (minus Greece) is doing well, thanks to a weak euro. Add in a trillion euros, equity markets can rally further.

In our assessment of the European debt crisis, we highlighted the different economic environment investors and policy makers are facing today compared to 2008. Currently, business activity and confidence are rising, allowing the financial system to withstand financial shocks better. The actions taken by the EU/IMF and more importantly, bond purchases by the ECB, only serve to buttress the economy.

A key complaint that the bears have is that the entire recovery is based upon government support and that is not sustainable (as seen in the Greek crisis). However, we see a glimmer of hope where government support was recently withdrawn. In the asset backed securitization market, US government guarantees were withdrawn in March but companies still managed to raise funds via this market, selling credit card and auto loans 1. Even the securitization of residential mortgages came back to life with Redwood Trust closing a US$238 million prime jumbo deal without government guarantees 2. Sensible risk taking is back.

The US labour market is also showing signs of life. Some may dismiss the 290,000 jobs created last month as a blip due to government hiring of census workers. However we would point out that of the 290,000 jobs created, only 20% was due to government hiring. The private sector added 231,000 jobs, with the all important services sector contributing 72% of new private sector jobs.

Skeptics may also argue that the birth/death model, used in estimating new company formation, may have over-estimated the number of jobs created. We would point them to the household survey that indicates the number of people who are in the labour force have been rising. Furthermore, leading indicators are also showing signs of improvement, with overtime, work hours and weekly earnings rising. This gives us confidence that the job market in the US is improving, making the economic recovery sustainable.


The credit cycle in the US is also on the right path towards recovery. The latest loan officer survey shows another quarter of improved confidence among bankers. This augurs well for bank lending, which is key to a sustainable recovery.

Source: Federal Reserve

Even in Europe there are signs that the ongoing recovery is on track. According to the Purchasing Managers Index (PMI) surveys, European manufacturing has been expanding. Even afflicted countries like Spain, Ireland and Italy have seen their manufacturing sector grow3. Businesses are reporting higher new orders, largely due to a weaker euro. The latest first quarter GDP estimates from Germany, France, Italy and Spain also confirm the PMI results. Business confidence is high, and with the massive bailout to stabilize the financial system, the odds are good that growth in the European countries can continue, albeit at a slower pace than the US.

Hence despite the drama over the European crisis and the thousand-point decline in the Dow, the evidence does not suggest that the up cycle is over. Economies are growing, some accelerating. Monetary authorities continue to be on the defensive while skeptical views continue to plague markets. We believe the decline in equities is a bull market correction. Investors should focus on what is happening in the real economy, which will be a boost for markets once the dust from Europe settles.



1. American Express Issues Credit Card-Backed Securities. Bloomberg News April 28, 2010
2. Redwood Trust Announces Closing of Prime Residential Mortgage Securitization. Company press release April 28, 2010
3. Euro-zone April PMI jumps, led by Germany. MarketWatch May 3, 2010

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