10 July 2012

Macro Strategy Update

Q&A on Latest Developments

Equity markets, after recouping some of their losses in June, are now at a crossroads. The EU summit was generally viewed as favourable although unsurprisingly, details were lacking. With major central banks in aggressive easing mode (People's Bank of China, European Central Bank, and Bank of England all acting in concert on Thursday), investors are confronted with more questions, rather than answers. In this update, we shall attempt to answer some of these questions.

Did the EU summit solve Europe's problems?

No. The biggest positive takeaway from the summit was that policy makers now understand that breaking the vicious cycle between sovereigns and banks is key to stabilising the continent. That is why there was an agreement to have the ESM inject capital into banks directly, as opposed to the ESM (European Stability Mechanism) providing funds to governments, and in the process increasing their debt burden further. It was also agreed that the ESM can buy government bonds, after fiscal conditions have been met.

If no, what else remains?

First we need to identify the issues. One, southern European economies are not competitive. Two, they are burdened with too much debt. Three, there is fear in the market that the eurozone will not survive, contributing to a banking crisis. Since undergoing a deep recession to restore competitiveness is not a choice for the Europeans, their economies are likely to undergo a prolonged period of low growth punctuated with recessions. Borrowing more to spend on growth compounds the second issue, too much debt. Going forward, it is likely that Spain or Italy will have to restructure their debt to more sustainable levels. The problem is major holders of government bonds are banks. The potential for sovereign debt restructuring causes banks to reduce risk on their books by cutting down on lending, which further depresses economic activity. This is why the ESM's mandate has been changed to aid banks directly.

However, changing the ESM's mandate does not solve the eurozone crisis. Currently at 500 billion euros, it is quite likely that this amount is insufficient to support Spain and Italy. Ideally, since European governments are not able to contribute anymore to the ESM, leveraging on the ECB's ability to create unlimited amount of euros is essential to bulk up the size of the ESM's firepower. While the idea of granting a banking license to the ESM has been floated, there is no solid support for the idea yet. Once the ESM is able to borrow unlimited amounts from the ECB, Europe will effectively be inflating away their debt problems.

As for euro bonds, that is a long term solution only after we get fiscal union. It is unlikely to occur in the next twelve months.

Are the EU policy makers on the right track?

Yes. Despite news that Finland and The Netherlands appear to be backtracking on the EU summit statement, Europe is moving closer towards a permanent solution. Effectively there were no losers or winners at the summit. Southern Europe got their growth pact and a change in the ESM's mandate. Northern Europe received greater central authority. Although not clearly highlighted in the media, the actual injection of capital into banks by the ESM will occur only after a central European bank supervision authority is established. Funds to buy sovereign bonds also come with fiscal conditions and economic monitoring by Brussels. Thus, in essence, EU leaders agreed on the way to handle the crisis.

What are the potential obstacles?

For starters, the ESM is not operational yet. There may be delays due to individual countries ratifying the establishment of the ESM, now that the mandate has been broadened. Germany's constitutional court is also looking into the legality of the ESM.

The lack of details is another obstacle to resolving the crisis. The Euro Group, comprising the finance ministers of the EU, has been tasked to work out the details of the ESM. The size and flexibility of the ESM is crucial to stabilising Europe. Another issue is bank supervision by a central authority. Unless the EU can come up with a plan that all can agree on, the ESM's hands are tied.

What are markets signaling regarding the European crisis?

European equities have seen significant recoveries. Spanish and Italian stock markets are leading while European banks are outperforming the market. This signals that the worst case scenario (a breakup of the euro) has been averted. However, Spanish and Italian yields remain high. Until the ESM opens for business and Spain and/or Italy applies for aid, these two countries may have to endure higher yields a little longer unless the ECB steps in. That said, the fact that Spain and Italy continue to have access to bond markets is a sign that time is still on their side.

With poor manufacturing PMI data, is the US entering a recession?

While the headline numbers are scary, it is important to note that the decline from 53.5 to 49.7 was largely due to the new orders component collapsing (60.1 to 47.8). Uncertainties regarding Europe probably caused the sharp decline. On the other hand, the services PMI showed better resilience, down from 53.7 to 52.1, still in expansionary mode.

Investors should also note that housing in the US continues to recover. Although home prices continue to decline, the pace is slowing. Importantly, housing activity is rising. Construction and sales are up, and their sustainability is confirmed by housing-related stocks at a three-year high (Figure 1). This should sustain the US economy and prevent it from slipping into a recession.

Image courtesy of Stockcharts.com

Figure 1: US Housing Related Equity Index

China is slowing significantly. Is a hard landing on the cards?

After a series of weak data, the Chinese authorities are now pursuing both fiscal and monetary easing. Projects that were previously put on hold are now being approved by the NDRC (National Development and Reform Commission). Premier Wen is also relenting on property development, after prices have fallen over the past year. Aggressive cuts in reserve requirements and interest rates serve to stimulate bank lending. Beijing has also probably directed state owned banks to increase lending. One must remember that China is still a command economy, control in key sectors like finance and infrastructure is retained by the central government.

With Europe in recession, can China rely on exports to stave away its problems?

We need to remember that the Chinese economy is not dependent on exports as most people would like to believe. Yes, many goods are made in China, but the value add is very low as it only involves assembly. Capital investment remains the key driver of the Chinese economy while net exports count for very little. Back in 2009 when the world was reeling from the financial crisis recession, China grew its economy by 8.7% even as exports fell 16%. When the Chinese leadership is intent on sustaining growth, especially in a political transition year, growth targets can be met or exceeded.

Are there any risks to China?

One thing that the Communist Party cannot control is food prices. Until recently, the decline in food prices meant that inflationary pressures have eased, giving policy makers more room to stimulate the economy. The recent spate of bad weather in the US, which drove agricultural prices skywards (Figure 2), can potentially throw a spanner in the works. If prices do not ease soon, we could soon find inflation rising again in the next quarter or so, limiting policy makers' ability to stimulate growth.

Image courtesy of Stockcharts.com

Figure 2: Agricultural Index Rising Sharply

What are the implications for investors?

The likelihood of a strong policy response is high given that it is time for leadership change in many major economies. Even the IMF is calling for more measures to stimulate growth. Markets are likely to respond favourably to a reduction in uncertainty out of Europe and measures to promote growth in the US and China. The fixed income markets, where investors are more concerned with the return of capital than the return on capital, is signaling better times ahead, as junk bonds and emerging market debt make new highs (Figures 3 & 4).

Image courtesy of Stockcharts.com

Figure 3: High yield bonds making a 1-year high

Image courtesy of Stockcharts.com

Figure 4: Emerging market bonds making a 1-year high

Portfolio Positions

No changes recommended at this time.

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