30 November 2011

Macro Strategy Update

It's all about Europe

The stress continues to build up in European credit markets. Spanish and Italian bond yields continue to surge even as Germany locked horns with France on ECB’s role in stopping the sovereign debt crisis. Markets are now asking if the October lows in stock markets will hold.

European bond yields have surged in the past weeks. Even Germany had a weak bond auction which had the positive effect of scarring the Germans to be more earnest in seeking a permanent solution to the Euro crisis. Embattled Italian 2-year bond yields rose to 7.7% from 5.0% within a month. Similarly, Spain saw her two-year borrowing cost climb from 4.0% to 6.1%. Given the low rate of growth these economies are achieving, such high borrowing costs begin to look unsustainable.

Meanwhile, rumours that Italy will be bailed out continue circulating – the latest being that the IMF is planning a €600 billion loan to help Italy tide over the next 12 to 18 months at half the interest rate she is currently paying. While it may be a good idea, just like the EFSF, it is easier said than done. The IMF’s lending capacity1 is currently around US$385 billion (€284 billion). External help will be required if Italy needs a bailout. This probably explains why Christine Lagarde is currently on a trip to Latin America – to seek funding.

Meanwhile, the ECB’s emerging lending facilities are being tapped feverishly, at levels not seen since early 20092. Lacking access to more stable forms of funding, European banks are likely to curtail loan growth, compounding the business cycle downturn in the Eurozone. Flash PMIs from Europe continue to show contraction in business activity, although the rate of decline was slower within the service sector. Germany’s Ifo business survey continues to show a sustained downturn despite a small uptick this month. It appears difficult for Europe to escape a recession - the question is how deep and how long it would be.

Now that Italy is taking centrestage, it seems increasingly likely that either the ECB will have to expand its balance sheet significantly (just like the FED and the BoE) or Germany will have to take on a greater share of support for the Euro project. The meeting to finalise the EFSF framework and leverage structure is likely to add on to the volatility in markets if no concrete or quick solution is agreed upon. At the end of the day, markets and investors need clarity on the solution to Europe’s problem. The longer it takes for the Europeans to come up with a rescue plan, the more costly it will be to salvage the situation and restore confidence in the banking system. Judging from how bank shares are performing right now (Figure 1), the markets are signalling their lack of confidence in a concrete solution coming any time soon.

Figure 1: European financials continue to underperform the market.

Across the Atlantic, we are not too optimistic about the US economy despite a spate of strong numbers. Retail sales (especially over the Thanksgiving weekend) were stronger than expected even as the labour market remains tepid. Income growth (Figure 2) has failed to match up with the performance of retail sales, raising the issue of sustainability. Not surprisingly, consumer borrowing has been on the rise (Figure 3). While this is normally a good sign, given the precarious situation banks are in and the frail conditions in financial markets, a reversal in consumer credit can hit the economy hard when it comes.

Figure 2: Real disposable income growth weakening.

Figure 3: Consumer credit rising.

Conditions in the credit market are currently stressed. TED spreads show no sign of easing despite strong numbers from the US economy (Figure 4). The preference for Treasuries over banks is increasing and this does not bode well for future credit growth. Likewise, investors continue to favour investment graded bonds over junk bonds (Figure 5). The state of credit markets appears to be deteriorating and S&P's downgrade of the largest US lenders yesterday (including Goldman, BofA and Citi) does not bode well for the economy.

Figure 4: TED spread continues to rise despite better than expected economic data.

Figure 5: Investment graded bonds outperforming junk bonds.

Hence, despite continued growth in US corporate profits (Figure 6), the likelihood that it has peaked is high. It does not help that energy prices have been rising of late, possibly due to increasing tensions in the Middle East (Figure 7).

Figure 6: Third quarter profits continue to rise.

Figure 7: Energy prices rising again, breaking the downtrend since April 2011.


For now, the markets are fixated by events in Europe and seem to be gyrating wildly with each piece of news or speech from European leaders. Yet there is a sense that the situation needs to be urgently resolved one way or the other. Many are looking to the EU Summit on 9 Dec as to when a solution would finally be announced. Markets could either rally sharply or fall into an abyss depending on what will be announced. Hopefully European leaders will finally act rationally and decisively. The alternative is too frightening for the world to contemplate.

We have rebalanced our cash portfolios to where the equity portion is weighted in our core United G Strategic Fund. The fund manager is taking advantage of the recent market bounce to reduce equity exposure to 50%. Should there be a sense that the situation is going to deteriorate further, he would bring the overall equity exposure much lower to protect capital values. Now is the time we need to be nimble so as to quickly jump into a rally or avoid being dragged along should the markets test the October lows.

1. IMF's Financial Resources and Liquidity Position 2009 - September 2011.
2. Europe’s Banks Relying on Money From E.C.B. 22 November 2011 New York Times

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