11 Sep 2014

Macro Strategy Update

The Equity Rally Remains Intact

In recent days, volatility has increased largely on the downside. The results of the various European elections, although largely expected, led investors to sell off risk assets due to fears that the Euro system will unravel. Persistent disappointment in US employment numbers added to the bearish sentiment. Notwithstanding these latest events, we still do not see enough evidence to suggest rising recession risk in the US or increasing global contagion from Europe. The rally in equities from the October 2011 lows remains intact.

Amidst the political upheaval in Europe, the key issue for investors lies in the bond markets. Will the policies and threats of anti-austerity politicians lead to a sell-off in bond markets? This would only serve to cause immense stress in the banking system and send risk aversion sharply higher.

As mentioned briefly in the previous flash updates, markets are quite open to less austerity and more growth. When pro-growth policies were suggested, bond markets were quite positive - they did not send Spanish or Italian yields soaring. Yields also did not rise when anti-austerity advocate Francois Hollande won the French elections.

The IMF is also taking a more moderate stance on austerity as they see its limited effectiveness in such recessionary times1. This is a significant development as the IMF have raised a US$1 trillion war chest2 to combat the Eurozone problem.

Finally, it is positive to see the Bundesbank signaling a softening stance on inflation3. First, it gives the ECB more flexibility to deal with the crisis in terms of expanding its balance sheet. Secondly, tolerance of higher inflation in Germany equates to a rebalancing of the European economy as cost competitiveness in Southern Europe improves. Wages in Germany are set to rise even as Spain and Italy experience substantial wage declines in the face of high unemployment. The end result is that countries like Spain improve their competitiveness and start growing again. A rebalancing of economic growth is required within the Eurozone.

For now, bond markets appear to be priced in moderation to austerity measures, hence yields are off their 1-yr lows. As current yields are below the panic highs seen last year, they are also signaling that investors are not unduly worried that the debt economies will totally abandon fiscal discipline. It is too soon to conclude that the situation in Europe is escalating. Until bond yields start spiking, the odds of a financial crisis are low.


Current 1-year high 1-year low
Spain 3.60 6.09 2.19
Italy 2.97 7.66 1.75

Figure 1: 2 Year Government Bond Yields are behaving

It is interesting that the media continues to talk about Greece as a systemic threat to the world. The recent elections is an inconclusive signal as to whether Greece stays within the Eurozone or that bailout terms get amended. Nonetheless, any impact of Greece leaving the Euro may be short lived. After the debt restructuring, Greek debt is now concentrated in the ECB and Greek banks, as well as some opportunistic hedge funds. The threat that a Greek exit would destabilize the European banking system is now much lower than before. This is why TED spreads remain steady in the face of all the recent European woes, as opposed to the scene in 2011 when supportive measures like the ECB's LTRO were not yet in place.

Image courtesy of Stockcharts.com

Figure 2: TED spreads drifting lower

The other issue investors grapple with is the strength of the US economy. Persistent disappointment with the employment data appears to have reinforced the notion that economic recovery is not as robust as expected. First, despite the "disappointing" jobs report, investors should note that the leading indicators are still signaling a recovering economy. Growth of temporary help services is strong, while average hours worked continue to rise. Rising optimism in small businesses is also helping the labour market.

Figure 3: Temporary help services

Figure 4: Hours worked rising

Figure 5: Small business hiring plans rising

While the uptick in weekly unemployment insurance claims is a concern, it remains to be seen whether the trend has indeed changed since the latest reading has actually improved.

Figure 6: Unemployment insurance claims

Second, the all important US consumer is in pretty good shape. Consumer discretionary stocks remain in a strong uptrend despite fears of a weaker economy, poor job prospects and the European contagion. The uptrend remains intact and it had even made a new high recently during the time when the S&P500 index started the correction phase.

Image courtesy of Stockcharts.com

Figure 7: Consumer discretionary stocks outperforming

Thirdly, the odds that US housing is about to contribute to the economy are starting to rise. An index of homebuilding stocks has broken out of its three-year resistance and has been outperforming the market even during the recent market weakness. Strength in this index could signal a revival in housing starts and greater discretionary consumption. Even if a revival in housing activity does not push economic growth higher, it should prolong the current cycle.

Image courtesy of Stockcharts.com

Figure 8: US homebuilders powering ahead

Conclusion and Portfolio Positions

Although we are seeing a re-run of events in Europe, there are stark differences in terms of ECB's financial support and policy makers' openness to ease up on austerity. Hence, despite entering a seasonally weak period, the signs are just not there yet to take a defensive position. We advocate staying invested. There are no changes to our portfolio positions.



References
1. IMF shows new flexibility on fiscal austerity. May 7, 2012. Reuters.
2. G20 doubles IMF's war chest amid fears on Europe. Apr 20, 2012. Reuters.
3. Bundesbank would accept higher inflation to rebalance euro zone. May 10, 2012. Irishtimes.com

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