27 July 2011

Macro Strategy Update

Debt problems manageable for now

Since the last update, the macro picture continues to be challenging for investors. After temporarily resolving the Greek debt issue, investors now face the prospect of either a US debt default or a credit rating downgrade. All these occurred even as earnings season got underway, with 70% and 83% of the S&P 500 companies reporting beating estimates on profits and revenues respectively1. For now, it is unlikely that these debt problems will derail the market.

The EU announced a plan to give additional funds to Greece and cajoled private banks to share the burden of bailing out Greece. The role of the European Financial Stability Facility (EFSF) was expanded to help contain potential financial contagion, now that Spanish and Italian yields have spiked upwards (i.e. prices of these bonds have fallen). The fund can now extend credit lines to countries facing financial stress and also buy bonds from the secondary market in the near future.

Still, we do not see such measures as a permanent solution to the European debt crisis. Without currency depreciation to improve economic competitiveness, the afflicted countries will need to undergo serious domestic price deflation to regain an economic edge. This only increases the odds that Greece may need another round of support as austerity measures fail to reduce the deficit (as tax revenues will continue to fall short) and interest rates remain high. This is signaled by how European financials and the euro have been underperforming even in the face of the EU announcement.

Figure 1: Index of Dow Jones Europe Financials vs Dow Jones Europe

Figure 2: Index of Euro vs Swiss Franc

The recent bond auction by Spain and Italy also attest to the anxiety in markets2. Although they were rather successful bond auctions (Spain attracted bids of 3.23 times), yields remained elevated. Thus we continue to view the European debt situation as contained until a recession threatens the ability and willingness of Germany and France to fund the crisis.

The other challenge for investors is the US debt situation. Currently the focus is on the issue of default. While the media has made it out to sound catastrophic, thanks to fodder given by the politicians, it is unlikely that financial markets would collapse even if an agreement could not be reached on August 2. Government shutdowns have happened before in 1995 and 1996. Both were temporal in nature till concessions were made. The US government avoided default by redirecting funds from non-essential government services to pay off debt obligations.

The impact of a credit rating downgrade is more long term in nature. Rating agencies have cited the negative medium term prospect as a reason for placing the world's largest debt issuer on negative watch. We seriously doubt US politicians can come up with and agree on a credible plan over the next week to reduce the deficit on a long term basis since elections, both presidential and congressional, are around the corner. A downgrade from AAA to AA need not be catastrophic since it does not necessarily lead to a sell off in Treasuries by money market funds. Firstly, money market funds do not invest in long term Treasuries, which are currently affected by the credit watch. It is the short term credit rating that matter and credit rating agencies are not targeting that. Secondly, unless the US is downgraded to junk status, which is eight notches below the current rating, money market funds are still allowed to hold on to US Treasuries3.

Investors may worry that interest rates may rise when a bond credit profile weakens, but demand for US Treasuries is unique. As the world's largest and most liquid market, many central banks have parked their reserves in the US debt market. This is why despite rising record deficits, interest rates in the US continue to be low.

Figure 3: One year US Treasury Yield

Hence we think even if US credit rating is downgraded, interest rates would not spike up and it would not have a material impact on the economy since the US Treasury market is the place to park excess funds. Japan, the world's second largest debt market, is a good example. She lost her triple A rating ten years ago and rates have been even lower since4.

So it is more important to focus on the real issues, which is growth and earnings. The data is expected to show continued slowdown in economic activity but nonetheless, growth remains. Perhaps this is why economic sensitive sectors like the consumer discretionary and industrials continue to trend higher. Industrial commodities, a key indicator of economic growth is also trending higher.

Figure 4: Consumer Discretionary Select Sector Index

Figure 5: Industrials Select Sector Index

Figure 6: Industrial Metals Index

Nonetheless, we continue to exercise caution when it comes to investing. Financials continue to be weak and CCC-rated bonds are underperforming the high yield market. Signs like these should not be ignored when stocks are up 103% since March 2009. We remain positive but we would exercise restraint when it comes to investing in risk assets at this time.

1. S&P 500 Second-Quarter Earnings on Track for Record. 25 July 2011. ETF Trends
2. Spanish, Italian Borrowing Costs Soar. 26 July 2011 Wall Street Journal
3. Frequently Asked Questions About Money Market Funds and Credit Ratings on U.S. Treasury Securities. Investment Company Institute
4. The US Can Lose Its AAA Rating Without the World Ending. July 25 2011. Wall Street Journal

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