28 October 2011

Macro Strategy Update

It's just a bear market rally

Rising markets tend to attract investors who were once fearful. Equities have staged a remarkable come back since October 1 (Figure 1). Wall Street strategists are increasingly bullish as US economic data appears to be holding up. Emerging markets are also benefiting, judging from the increased fund flows into emerging market equity and debt funds. According to EPFR Global, emerging market equity funds enjoyed their best week in terms of inflows since early May1. Emerging market debt also attracted cash after four consecutive weeks of declines. Nonetheless, we continue to view this as just a bear market rally.

Figure 1: Global equities rising since October 1

There are good reasons to turn bullish. In fact, we indicated that a bear market rally was in the making two weeks ago. Positive signals were received from European financials which reduced the European debt crisis risk. Globally, financial stocks were able to break out of their short term down trend (Figure 2).

Figure 2: World financial index breaking out of a short term down trend since mid-October.

It helps that the economic news flow has turned positive for the world largest economy. A slew of data over the past two weeks has lowered the odds of a recession in many observers' mind. PMI data is holding up for both manufacturing (Figure 3) and services (Figure 4), while consumption remains on the uptrend (Figure 5). This has led to Wall Street economists revising their growth forecast upwards2.

Figure 3: ISM Manufacturing PMI has improved.

Figure 4: ISM Services PMI still strong.

Figure 5: Retail sales healthy.

Unfortunately, these data points are more coincident rather than leading. It is still too early to declare that the US has avoided a recession. Overtime hours in manufacturing has peaked and is on the decline (Figure 6). A continued decline in overtime hours clocked indicates less work orders, usually a sign of falling economic activity.

Figure 6: Average weekly overtime hours in decline.

Moreover, the economic situation in Europe is worsening. The Eurozone PMI is in decline, with the latest flash reading at 47.2 for both manufacturing output (third month of contraction) and services (second consecutive contraction reading). Europe's second largest economy, France, is beginning to contract (composite output index at 46.8 versus 50.2 last month) while the German manufacturing powerhouse contracted for the first time in 27 months. Germany's weakness has also been confirmed by the Ifo Business Climate survey which showed business expectations falling. Europe is seriously at risk of a recession.

More importantly, we continue to receive recessionary signals from the market. Industrial metal prices, a key indicator of economic activity, may have stabilised after a summer swoon but they have yet to turn up (Figure 7). Until we can see a renewed uptrend, it is difficult to envisage a sustainable rise in economic activity.

Figure 7: No signs of an upturn in industrial metal prices.

Even the high yield bond market shows few signs of growth coming back. The junk bond market has recovered in recent weeks, in line with equity markets. However, we continue to see a preference for the least risky bonds within the high yield bond space. BB-rated bonds recouped half of their losses while CCC-rated only managed to recover a third. Clearly fixed income investors are taking this opportunity to re-jig their portfolios towards defensive securities.

The preference for safety is also seen in a rising TED spread (Figure 8). The credit market is choosing the US Treasury over commercial banks when it comes to lending money. This does not bode well for growth as liquidity is being withdrawn from the economy.

Those counting on Germany to bail out Europe may be disappointed if Berlin continues to drag her feet in resolving the European crisis. When the German economy is growing, it is easier to sell a bailout plan to voters. However, Germany’s dependence on a frail Europe looks set to weaken her own economy. With exports accounting for 40% of GDP, and with five of the top ten trading partners located in the Eurozone (Table 1), a marked slowdown or a recession looks increasingly likely for Germany. If that is the case, Angela Merkel may find it tougher to support an enlarged European Financial Stability Facility.

Figure 8: TED spreads continue to rise despite a rally in equities since October.


Investors are advised to treat the ongoing rally in equities as a bear market rally. The global economy continues to face significant headwinds even as Europe struggles to produce a credible and sustainable solution. Watching key technical resistance is an important risk management tool for those who are in the market. Enjoy the rally while it lasts.

1. Investors buy high-yield bonds, emerging mkts -EPFR. Reuters News 21 October 2011.
2. No U.S. Recession as Forecasts Improve. Bloomberg News 10 October 2011
3. Siemens shelters up to 6 billion euros at ECB. 20 September 2011, Financial Times.

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