13 April 2012

Macro Strategy Update

No Trend Change

Volatility has returned to equity markets in recent days. Spooked by a weak Spanish bond auction and poorer than expected jobs data from the US, investors are beginning to question the sustainability of the recent stock rally. The bears are out again in the media, predicting another bear market and an economic recession in the months ahead. Is this the start of a trend change?

The first thing to remember is that markets hardly ever rise in a straight line. Secondly, any market correction helps to remove excess optimism or just enable it to catch its breath. This is often a necessary factor for an upward trend in equities to continue. Third and most importantly, we need to look at the hard economic data for signs of a material slowdown in economic activity which may portend a change in direction of the financial markets.

At this time the available data does not suggest such a slowdown. The large-cap S&P 500 index has begun to correct, after an almost straight line upward movement since December 2011 (see Figure 1). Unlike most other markets which have been consolidating since March, large cap stocks in the US continued to enjoy investors' favour until the recent disappointing jobs report which sparked a market sell-off.

Image courtesy of Stockcharts.com

Figure 1: S&P 500 correcting after a solid run since December 2011

Last Friday, The US Department of Labor reported that 120,000 jobs were created in Mar 2012. This contrasted with the consensus expectations of 201,000 which thus seemed to indicate that the US jobs recovery was not as strong as previously thought and hence the markets sold off. However investors should remember that one data point does not necessarily make a trend. You need more data-points pointing in the same direction before saying that a new trend has been established. If one were to look at the data on the average no. of hours worked per week, it had edged down slightly but was compensated by a rise in average hourly earnings. Furthermore, the data on temporary help services, a key leading indicator, was unchanged (see Figure 2)

Figure 2: Temporary help services taking a breather last month.

Investors ought to note that recoveries never occur in a straight line. During the last economic expansion from 2003 to 2007, growth in non-farm payrolls was erratic, ranging from below 50,000 to more than 300,000 jobs created (Figure 3). So it should not be a surprise that the current economic expansion is heading along similar patterns. More importantly, we see weekly unemployment claims continue to drop, signaling ongoing improvement in the job market (Figure 4).

Figure 3: Change in non-farm payrolls

Figure 4: Jobless claims continue to fall

The same story goes for the PMI data (Purchasing Manager's Index). Although US PMI for manufacturing and services expanded, some of the sub-indices like New Orders grew at a lower rate, disappointing investors. Again, it is not realistic for one to expect PMI data to expand at such a fast rate all the time, just as the previous cycle shows (Figure 5). There will be ups and downs, but as long as we see more expansion than contraction, the economy is growing.

Figure 5: US PMI for manufacturing

Another key indicator which we look at is the corporate profits of the entire US economy, including small and unlisted companies. Rising profits precede capital spending and hiring. Earnings are still growing (Figure 6) and until we see a contraction, it is too early to call for a recession. The first quarter earnings season has started with aluminum giant Alcoa reporting better than expected results, sending the stock up 5% in after-market trading1. How the listed companies will be reporting should give a good indication of business conditions both in the US and around the world.

Figure 6: US non-financial business profits after tax still rising

In Europe, Germany continues to perform well, at least relative to the other European economies. Although the latest PMI showed a contraction in manufacturing activity (PMI fell to 48.4 from 50.2), Ifo surveys still point to growth (Figure 7). The ZEW Indicator of Economic Sentiment also increased for the fourth consecutive month2, confirming the strength of the German economy. With February exports growing 1.6% from the previous month compared to expectations of a decline, investors should begin to expect better performance from the German economy.

Figure 7: German's Ifo survey points to growth

Markets may have been spooked by the recent weak Spanish bond auction, which sent yields higher and European bank shares tumbling. The more important point investors need to take note is the probability of a contagion. Back in 2011, before the ECB stepped in to be the lender of last resort, a rise in government bond yields threatened the European banking system and, to a certain extent, the global banking system as well. Today, with ECB's LTRO program, the risk of contagion is lower. That is why TED spreads remain stable despite rising bond yields (Figure 8).

Image courtesy of Stockcharts.com

Figure 8: TED spreads steady even as Spanish, Italian yields rise

One major thing going for the bulls is falling oil prices. The risk premium in oil prices due to the Iranian situation appears to be falling after Iran appears to be willing to attend negotiations. Crude oil prices have fallen to almost as low as $100 in recent trading. This would be a welcome boost to business and consumers globally.

Image courtesy of Stockcharts.com

Figure 9: Oil prices falling

Conclusion

Markets are still undergoing a correction, as investors reassess the global economic outlook. We may get a couple of disappointing economic data, i.e. weaker than expected, but the key is to watch the trend. As long as the trend remains positive, investors should remain invested. So far, we are optimistic that trends would remain positive. It is interesting to note that market advances in the last 2 days seems to be validating our views as well.

Portfolio Positions

No change to our portfolio positions at the moment.



References
1. Alcoa Posts Surprise Profit After Aluminum Orders Climb April 11, 2012 Bloomberg News
2. ZEW Indicator of Economic Sentiment - Positive Outlook Confirmed March 13, 2012 Centre for European Economic Research

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