9 February 2012

Macro Strategy Update

Still Bullish, After Considering the Negatives.

The party came earlier than expected. Risk assets were up in the month of January, with emerging market equities and industrial metals leading the gains. What was supposed to be a tough start to 2012 turned out to be so bullish that bearish strategists have reversed their views and turned optimistic1. Now that there are supposedly more bulls than bears, is the contrarian play that we mentioned last month over?

A good contrarian play requires well thought out assumptions that run contrary to the current consensus. Back then, we were positive on the ECB's LTRO, which has effectively stabilised European sovereign yields and avoided another Lehman-like event. This reduction in macro risk eventually led to a fall in risk premiums and an upwards re-rating in risk assets.

The value of a contrarian play has declined now that investors are more convinced that Europe will stabilise. Nonetheless, it does not mean that risk markets cannot rise further. Going forward, we are likely to see momentum investing at play as more investors become convinced that the world is not ending; better-than-expected economic news forthcoming will drive investor confidence even higher.

We now need to consider the factors that could derail the rally in risk assets. Europe continues to hog the headlines, although its impact on equity markets has been rather muted. Greece has the potential to cause a sharp fall in investor confidence with its bailout and debt restructuring talks still in limbo. Judging by how European financial stocks continue to show stability, and how Italian and Spanish yields continue to stay low, it is likely that any fallout from Greece would be temporary and, more importantly, contained. In fact, it is highly likely that Greece will default on some of her debt, which has already been priced into the markets given that two-year Greek bonds are now yielding 197%!

So far, European financials have been performing strongly on both absolute (Figure 1) and relative bases (Figure 2). This suggests that investors' confidence in the survival of European financial institutions is rising despite the Greek problem. The market is signaling that Europe will not be a macro risk to investors for the time being.

Figure 1: European financials breaking out of its downtrend.

Figure 2: European financials outperforming the market.

Any weakness in the US economy is also a factor that investors should consider. The FED extended its ultra low interest rate policy in its latest monetary policy meeting, despite a spate of positive economic news. Before that, rates were expected to be held at zero to a quarter point till mid-2013. At the latest meeting, it was decided that this policy would likely be maintained till late 2014. Some observers see this as a sign of weakness in the US economy. However, as of now, the economic news flow has been fairly positive. Both the manufacturing and services PMI are growing strongly. The new orders indices (Figure 3), which is typically a good leading indicator, is showing strong momentum.

Figure 3: Strong new orders indices portend future growth.

What investors need to look out for is any surprising news from the housing sector. So far, the markets are signaling some good news. While home prices (Figure 4) are not expected to bottom any time soon, housing starts seem likely to recover. Job creation in the residential construction sector (Figure 5) has risen for the fourth consecutive month (on a year-on-year basis), a positive sign of revival in home construction. Should this trend be sustained, it could be a significant boost to the US economy. So far, the market seems to be confirming this signal as the housing related equity index continues to post strong gains (Figure 6).

Figure 4: US home prices continue to fall.

Figure 5: Jobs in housing construction rising.

Figure 6: Housing related equity index rising strongly since October 2011.

Finally, rumours of war in the Middle East continue to drive energy prices upwards. High energy prices act as a tax on consumption, retarding economic growth. Although oil prices have stabilised in recent weeks (Figure 7), investors continue to worry about Iran's threat to close the Straits of Hormuz, a key oil shipping choke point.

Figure 7: Oil prices stabilising since mid-November 2011.

While it seems probable that Israel would strike to halt Iran's nuclear program (and in turn provoke Iran to close the Straits), the odds of that occurring are slim when we consider the bigger picture. Iran's nuclear program has encountered several setbacks - mainly due to the assassinations of its nuclear scientists. Since 2010, four scientists involved in Iran's nuclear program have been killed2. While this is a setback on their nuclear ambitions, this alone is not good enough a reason for Iran to close the Straits; especially since neither Israel nor the West has ever claimed responsibility. As long as Iran's nuclear program is delayed, there is little reason for Israel to engage Iran directly despite the rise in rhetoric as reported in the media.

Conclusion

For now, while we are mindful of the above mentioned risks to investing, markets are not signaling any change in trends. In the near term, equities are overbought and are susceptible to a healthy correction. However, indicators from the equity, bond, commodity and currency markets suggest that risk taking is back on as the signs are rather pervasive and persistent. This signals a healthy momentum behind the current rally.



References
1. Global Strategists Are Abandoning Bearish Views. 3 February 2012 Bloomberg News
2. Was Israel behind Iran nuclear scientists' assassination? 12 January 2012. CS Monitor

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