14 August 2012

Macro Strategy Update

Climbing the Wall of Worry

As much as the world feels like it is tethering on the edge of the next crisis, things are actually not as bad as it seems. The euro remains intact while the US economy continues to chug along. Equity markets are holding up better this year than in 2011 (figure 1). The call to stay invested worked despite the high volatility. Now that the rally off the June lows is into its third month, it is perhaps time to relook at our current investment stance.

Image courtesy of Stockcharts.com

Figure 1: Global equity performance

European Situation

The call for the euro's demise was premature. Each time the situation deteriorated, EU policy makers came to the rescue. This has been our position on Europe, that policy makers have no choice but to maintain the eurozone structure as the benefits outweighs the costs. Northern Europeans benefited from open markets while southern Europeans enjoyed cheap financing. To keep the eurozone going, this arrangement has to continue, with northern Europe providing the financing support through bailouts, ECB financing and potential Eurobonds in the future. This will ensure that southern Europe remains in the eurozone and be able to implement the necessary reforms. Steps taken are in the right direction but the pace is likely to be slow enough to create the occasional anxiety.

In the short term, markets have taken positively to the ECB's talk of ensuring the future of the euro. While we did not see any further policy moves at the latest meeting, comments by the ECB president Mario Draghi was enough to send short term yields on Spanish bond crashing (from 6.6% to 3.5% for the two-year government bond). With his comments, Mr Draghi has thrown the ball to the politicians, expecting the northern Europeans to work on starting the ESM with southern Europeans applying for bailouts (and increasingly cede more fiscal authority to Brussels).

Regarding Germany's Bundesbank's opposition to the ECB's plan to purchase short term bonds on the secondary market, investors should not be too concerned since it is the lone voice of opposition to the plan and will likely be out-voted in the ECB's governing council. Once the ESM begins operations, likely in late September, the ECB can initiate their bond purchase program whenever help is requested. Thus, for once, when a EU nation asks for financial help, it could actually bring down uncertainty in markets.

US Situation

We have also been saying that the US is unlikely to slip into a recession despite weakening data. Our main reason was the recovering housing sector. Housing, unlike manufacturing or the services sector, is rather difficult to outsource. Any improvement stays within the country. A housing market where new housing starts are increasing will generate jobs and contribute to growth via capital spending. Discretionary spending is also likely to rise as a result of more houses built and sold. So far, the housing index continues to show improvement, which will likely translate to better times ahead for the housing sector. This provides support for economic growth in the US and balances out the growth shortfall in Europe.

The data so far do not suggest a higher probability of recession in the US. While manufacturing remains weak according to the PMI survey, it is getting less bad. July's number was 49.8, up from 49.7. Services, on the other hand, is expanding at an accelerated rate, up from 52.1 to 52.6. Jobless claims have been improving while jobs in temporary help services increased. While there are reasons to be concerned about the health of the US economy, especially the manufacturing sector, that alone is not sufficient to drag the economy down. The most realistic scenario, in our opinion, is that the US economy will grow at a rate not high enough to ward off recession fears.

Under such a scenario, markets can rally from oversold conditions when investor sentiment is negative and doomsday scenarios are avoided but longer term gains will likely be more challenging. This will require renewed economic growth to sustain either earnings growth or a reduction in risk premium to sustain multiple expansion.

We maintain our positive view in the short to medium term. The risk-on trade remains intact with strength seen in growth currencies like the Aussie and Canadian dollar (figure 2), junk and emerging market bonds (figure 3). Financial stocks are also rising together with housing equities (figure 4). Importantly, TED spreads (figure 5) have finally begun to fall, after drifting for the good part of the year.

Image courtesy of Stockcharts.com

Figure 2: Growth currencies rallying.

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Figure 3: Risky bonds rallying.

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Figure 4: Financials and housing stocks rising.

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Figure 5: TED spreads falling.

Unlike the perma-bulls, we do not think this is a new bull market. Rather, it is an extension of the bull market that started in 2009, which means that we are likely at the late stage of this up cycle. Perhaps this is also why certain cyclical sectors like industrials and materials are beginning to underperform the market, which is usually indicative of late stage cycles.

Technically, the market is not over extended yet. Daily and weekly momentum indicators are positive, and there are no overbought signals (figure 6 & 7). Given that the investment community remains cautious at best, the wall of worry remains high and allows markets to climb higher for longer.

Image courtesy of Stockcharts.com

Figure 6: Daily technical indicators positive.

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Figure 7: Weekly technical indicators positive

Conclusion

We do not see any reason to change course and will continue to maintain our current portfolio positions. No changes recommended for now.



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