Prepare for volatility

Last week, I wrote to expect a short-term rally, which was a tactical trading call (see The "Merde" rally?) but I wasn't convinced that any rally would be the start of an intermediate term move upward for stocks:

My inner trader wants to buy risk in anticipation of an oversold rally. My inner investor tells me to watch the market action in likely ensuing rally to gauge the strength of the bulls as this is just another phase in the choppy up-and-down market action that we have been witnessing in the past few weeks.

The market action on Thursday and Friday makes me more unconvinced that this is the start of either a sustained bull or bear move. We have a lot of macro cross-currents between now and year-end and navigating them will be a challenge for any investor. In some cases, we have economies that appear to be outperforming but likely to start to underperform later in the year. In other cases, you have the reverse - economies burdened with negative news but whose headlines are likely to improve later. The difficulty is that the timing of all these twists and turns will be highly uncertain. Moreover, it is unclear which headline the markets will focus on during this period of uncertainty.

To summarize my outlook, I use my framework of the Three Axis of Growth, namely Europe, China and the United States. I preface my analysis with the comment that, as an investor, I am agnostic on the question of whether an economic policy is the correct one or not. Rather, I focus on the likely effects of that policy on the markets:

• Europe: News flow and headlines are negative and likely to get more negative. However, investors shouldn't discount the effect of a political response, which would serve to kick the can down the road yet one more time and the markets would rally in relief.
• China: Uncertainty reigns, but the market perception of the likelihood of a hard landing is receding, at least for now. The change in leadership later this year is likely to usher in a period of stimulus, which would provide a bullish impetus to the markets.
• US: American equities remain the global leadership, for now, but economic momentum is faltering and the Fed may not have the political capital to act between now and the November elections. Moreover, the US faces a fiscal cliff in 2013. Markets typically look ahead six months or more. When does the markets start to discount the negative effects of that fiscal cliff?

Another European summer of discontent
After the positive news about a "fiscal compact" and LTRO, which saved the eurozone from disaster late last year, the headlines from Europe is starting a negative cycle. The equity markets are reflecting that heightened anxiety as a glance at the DJ Euro STOXX 50 shows that it is in a well-defined downtrend. The bad news for investors is that the negative news isn't so bad that we are poised for a rebound. I would wait until the index declined into the support zone before nibbling away at positions.

Across the English Channel, the FTSE 100 is declined and is now testing the 200-day moving average. I interpret this as another sign of market stress over the eurozone.

Jeff Miller of A Dash of Insight put some perspective on why you shouldn't blindly react to the headlines and panic over Europe [emphasis added]:

Most of the commentary we see has three steps:

1. Some problem in Europe
2. Cockroach/contagion/domino
3. Disaster for the world

This type of commentary ignores any policy reaction, and also often insults the leadership of European nations, the IMF, and the ECB.

[snip]
I suggest that investors read very critically when a story suggests causal relationships that lack specificity or quantification. Be even more suspicious when the story ignores policy responses. And finally, how about some quantification concerning Europe's impact on the US economy?

My own conclusion -- familiar to regular readers -- is that the European story is an ongoing process of bargaining and compromise. US observers are far too ready to impose their own value judgments on other countries and cultures. The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress. The exact nature will change and I still expect new entrants.

Marc Chandler at Brown Brothers Harriman wrote an excellent piece entitled 10 points on the comity of Europe that made a similar point. The article is well worth reading in its entirety, but here are some highlights:

1. EMU itself is a culmination of two trends: 1) the integration of western Europe since the 1950s and 2) efforts to keep Germany wedded to the fortunes of Europe. The elite, and it is an elite project, knows no alternative strategy.


2. Because there is no Plan B, there is no mechanism to formally eject Greece or any other member. Polls indicate a majority of Greeks want to stay in EMU.

5. EMU is an institutional expression of the comity of Europe. These nation states have lived with each other for longer than the US has been around. It is very much like a family, even if dysfunctional (what family isn’t?). They did not get to chose each other. Their histories are intertwined. There is a great desire for peace and prosperity. It is difficult to prove that integration has made peace on the continent, but is sure looks that way.

Miller and Chandler make the point that the European elites will find a way to defuse the crisis, because of the long history of Europe and the political commitment involved. Already, the consensus is starting to shift:

6. The ECB’s Draghi and EC’s Rehn came out in favor of a growth/investment pact prior to this past weekend’s election results. This changed the political discussion. German officials recognize the shift and have sought to get ahead of the curve. Some suggest that this is always what was intended. Austerity was phase 1 and growth/investment was phase 2. The debate is now really over the content of a growth/investment pact, not whether one will be forthcoming.

While European stocks are reflecting the anxiety about another eurozone crisis, the bond market isn't overly concerned. Consider, for example, the yield on the Italian 5-year note. Yields are below the crisis levels of last October and November and below the heightened anxiety levels of last summer, indicating that the bond market is not worried about contagion from Greece and Spain.

The yield on 5-year Irish paper shows a similar picture. No anxiety at all.

The yield on Spanish paper has risen, but they are at levels below the high anxiety days of last October and November.

Trust the bond market over the stock market. The bond market has to finance the European sovereigns and their banks and signs of stress will show up there first. Don't extrapolate the effects of the dire headlines in a straight line. The bears should be aware of policy reactions. That's why I believe that while the headlines are headed south, they will reverse course in a few months and start to go north again. For investors, timing that turn will be a challenge.


Is China stabilizing?
Moving eastward, there seems to be some degree of stabilization in China. The Shanghai Composite staged a brief but unconfirmed breakout from a wedge, which would be bullish. Although the latest trade figures were highly disappointing, the market reaction, which saw the Shanghai Composite close flat and marginally up on the day, was gratifying for the bulls.

Next door in Hong Kong, the picture looks less bright. The Hang Seng Index has violated an important technical support level Friday. I would wait for signs of follow through before turning overly bearish, however.

To understand China, you also have to understand the concept of how important "face" is to the Chinese. China's political leadership is scheduled for the change that occurs every 10 years late this year. The new leaders will loathe to step into a situation where the political and economic outlook are rapidly deteriorating - they will lose face. Expect a substantial stimulus package later this year to boost the economy. Already, the authorities are taking steps in that direction as the reserve requirement was cut by 0.50%.

As with Europe, timing that turn will be a challenge.


When will Americans realize they face a fiscal cliff?
Moving the spotlight across the Pacific to America, US equities today remain the global leaders. The chart below of the SPX against ACWI (MSCI All-Country World Index) shows that US equities continue to outperform other global bourses.

Not all is well in America. I wrote about the prospect of a short-term bounce last week here and here but the rally has been rather weak. JPM's problems notwithstanding, I believe that the rally will still materialize. The two things I will watch for in US equities are the ability of the SPX to hold support in the current support zone and for the index to rally above its 50-day moving average.

Moreover, the US faces a fiscal cliff. There have been many warnings, such as this one from The Economist. Here is some analysis from Pragmatic Capital on the reasons behind the fiscal cliff:

1. The Alternative Minimum Tax (AMT), currently at 28% for those filing jointly with incomes of $74K or greater, will drop down to $45K. That means that middle class families making over $45K will not be able to use deductions (medical, etc.) to pay less than 28% in taxes – a substantial tax increase on the middle class.

2. The so-called “doc fix” provision, which is currently keeping the government from implementing a 25% cut on physician payments by Medicare, will expire unless Congress acts.
3. The Payroll tax cut will expire at the end of 2012, increasing from 4.2% back to 6.2%.
4. The Super Committee’s inability to reach a decision last year will force mandatory cuts (sequester) in the US government’s discretionary spending. A great deal of that will hit the defense industry.
5. Unemployment benefits for workers who have exhausted the standard 26 weeks of benefits will be phased out.
6. Numerous temporary research and development tax benefits to corporations will expire.
7. The 2001 and 2003 tax cuts are set to expire. This includes tax rates on those making over $250K as well as qualified dividends and in particular the 15% rate on long term capital gains. People are wondering why we are having a string of large IPOs this year (including may private equity backed IPOs), even in a less than friendly IPO environment. Part of the reason is that the current cap gains tax rate may be the lowest that the owners will be paying in the foreseeable future.
8. At the end of the year the infamous debt limit will hit again, potentially forcing further cuts. 

To give you some sense of how steep the the fiscal cliff is, it could amount to as much as $600 billion, or 4% of GDP:

According to Goldman Sachs, the total of amount of dollars the US government will be taking out of the economy is about $600 billion. Clearly some of these provisions may be modified or extended. But given the sharply divided Congress and the contentious election year, the political impasse is likely to continue. A large portion of these tax increases and austerity measures may take effect. These changes will potentially be a positive for the US budget deficit, but for an economy that is still fragile and somewhat dependent on government stimulus, it will certainly generate a material drag on the GDP growth.

A 1-2% GDP contraction amounts to a run-of-the-mill recession. A 4% contraction puts the economy into economic depression territory. When does the stock market start to discount these risks?



Can the Fed ride to the rescue?
Moreover, high frequency economic data is going south, as exemplified by the last two disappointing NFP releases. Take a look at the Citigroup Economic Surprise Index, which charts the degree that economic data come in at above or below expectations. The index peaked in January and February and has been falling ever since and has fallen below the zero line, which is the level where economic releases come in at expectations. Moreover, ECRI has reiterated their recession call.

If the economy is deteriorating. What about QE3? Don't forget that this is an election year. The Fed will hesitate to intervene unless there is unequivocal evidence that the economy is falling apart, e.g. the stock market craters by 20%. So don't count on the Fed to be proactive and ride to the rescue.

Yes, the Bernanke Put still lives, but this insurance policy has a rather high deductible at the moment.

In short, while the US market is still the leadership right now and global investors should give their US allocations the benefit of the doubt, the outlook will deteriorate into year-end. Timing that turn will be another challenge.


Prepare for volatility ahead
So where does that leave us for the rest of 2012? In one word: Volatility.

I wrote last week that I expected a short-term rally. This was a tactical trading call for a rally that was likely to last 2-4 days. Today, the relative performance of SPY (equities) against TLT (US long Treasury bonds) show that stocks have violated a relative support level against bonds, but look highly oversold.

The relative performance of the defensively oriented Utilities sector against the market shows a similar bearish picture, but the sector appears to be extended on a short-term basis and ripe for a consolidation/pullback.

Longer term, we are faced with huge cross-currents from around the world. Investors have to contend with the following questions going forward:

1. When do some of these trends reverse and turn around?
2. Given all these cross-currents, which headline will the financial markets focus on?

These are the challenges we face. Be prepared for greater volatility and more choppiness in the markets.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Another sign of a short-term bottom

I recently wrote that gold and gold stocks could be setting up for a short-term trading bottom (see A bottom for gold and gold stocks?) and followed up with a post that the market may be seeing a short-term reversal at these levels (see The "Merde" rally?). Now comes another sign that a trade-able bottom in risky assets may be near.

The chart of the gold stock ETF GDX below shows that it experienced an outside day yesterday on high volume, which is an indication that we could be seeing signs of a trend reversal.

While there is still a high degree of headline risk, consensus sentiment is becoming overly bearish, which is contrarian bullish (see Mark Hulbert's article Major correction unlikely), and the stock market is now overpricing tail-risk in Europe. Notwithstanding the problems posed by Greece, the message from the bond markets of France, Italy and Spain is one of relative calm.

Who would you rather believe, the stock market or bond market?



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The "Merde" rally?

There is a silver lining in most dark clouds. When the stock market and other risky assets got clobbered over anxieties about Greece today, the silver lining is that a short-term bottom may be forming.

The chart below of SPY is just a bellwether whose analysis could be extrapolated to many other risky assets. The ETF formed a reversal day by selling off but rallying near the end of the day to a level where it roughly opened, and the action occurred on relatively high volume. Moreover, the selloff successfully tested a key short-term support level. For technicians, this action is, at a minimum, an indication of market indecision in the face of bad news - a positive sign. It could be more bullishly interpreted as capitulation selling.

An overreaction to Europe and Greece
As for Greece, things aren't necessarily as bad as it sounds. Foreign Policy wrote that the surprise showing by SYRIZA, the leftist party that polled in second place in the election, doesn't necessarily mean that the scenario of a catastrophic Greek exit from the eurozone is necessarily around the corner [emphasis added]:

Even if SYRIZA earns the mandate and manages to somehow seize the reins of power, the changes in Greek policy will hardly be "radical," as the Coalition of the Radical Left's name misleadingly implies. The party's young, charismatic leader, Alexis Tsipras, has made it clear that he has no intentions of withdrawing Greece from the eurozone, let alone the European Union. Instead, we should expect a more nuanced approach to economic revitalization, which would likely include an aggressive renegotiation of the bailout terms currently in place between Greece and the "troika" composed of the EU, the European Central Bank, and the IMF, as well as a demand for more public investment in lieu of loans.

If I were to stretch the point a little further, even Foreign Policy's new term to replace "Merkozy" as a characterization of the new Franco-German partnership could also be interpreted bullishly as a contrarian magazine cover indicator:

A short-term Merde bottom?
I previously posted that a short-term bottom may be forming for gold and gold stocks, which is another high beta risky asset:

These readings are suggestive of a tradable short-term bottom in gold and gold stocks is coming up, but a long or even intermediate term bottom may have to wait. Given that gold prices are deflating in the wake of the French and Greek elections, that short-term bottom may be fast approaching.

We may be seeing that short-term trading bottom now. My inner trader wants to buy risk in anticipation of an oversold rally. My inner investor tells me to watch the market action in likely ensuing rally to gauge the strength of the bulls as this is just another phase in the choppy up-and-down market action that we have been witnessing in the past few weeks.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A bottom for gold and gold stocks?

Mark Hulbert wrote last week that his measures of gold timer sentiment was very washed out, which indicated the possibility of a bottom for gold and gold stocks soon:

Consider the average recommended gold market exposure among a subset of the shortest-term gold market timers tracked by the Hulbert Financial Digest (as measured by the Hulbert Gold Newsletter Sentiment Index, or HGNSI).

When I wrote about gold sentiment two months ago, this average stood at 16.7%. Today, in contrast, it is at minus 14.8%, which means that the average gold timer is now allocating about a seventh of his gold-oriented portfolio to shorting the market.

Hulbert wrote that he hadn't seen these kinds of sentiment readings since March 2009:

In fact, except for a couple of days in late March when the HGNSI dropped marginally lower to minus 15.7%, its current level is the lowest it’s been since March 2009, more than three years ago.

And that’s really quite amazing, given that gold at that time was trading only slightly above $900 an ounce.

Does this mean that gold and gold stocks are set to bottom? Not yet, according to my long-term measures of greed and fear. Consider, for example, the silver-to-gold ratio. Silver has long been regarded as a high-beta play on gold. The chart below of this ratio shows that while sentiment has descended from levels indicating excessive bullishness, they are not at levels consistent with a long-term bottom yet.

Here in Canada, we also have a good measure of speculation levels in resource and junior resource stocks. The chart below shows the ratio of the TSX Venture Index, which is comprised mainly of junior resource companies, against the more senior and established TSX Composite. This relative return ratio also tells the story of falling speculative fever, but readings are not at levels consistent with capitulation bottoms. (Note that the scale of this chart is 13 years, which is the amount of history available, compared to the silver/gold ratio above that has a 20 year history.)

What about the ratio of gold stocks to gold? The chart below shows the HUI to gold bullion ratio.  While we are nearing levels where a meaningful bottom can be established, readings are not at screaming buy levels yet.

Mark Hulbert qualified his analysis with the following caveat [emphasis added]:

How long must traders wait for gold to begin to respond to these positive sentiment conditions? Assuming the market responds the way it typically has done in the past, the wait could be as much as several more weeks.

I say that because of econometric tests I have run on the HGNSI over the last three decades. Its greatest explanatory power in predicting the market’s subsequent direction existed at the three-month horizon.

These readings are suggestive of a tradable short-term bottom in gold and gold stocks is coming up, but a long or even intermediate term bottom may have to wait. Given that gold prices are deflating in the wake of the French and Greek elections, that short-term bottom may be fast approaching.

My inner trader tells me that I could buy here, but I need to carefully define how much risk I am willing to take. My inner investor tells me that there is value at current levels and I can accumulate positions, but there may be better entry points down the road.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Draghi's "growth pact" = Internal devaluation

As we await the results of the French and Greek elections, there has been a considerable change of focus in the eurozone from the paradigm of all-austerity-all-the-time to growth strategies. The villians, according to those who push back at the "fiscal compact", is Angela Merkel and, to a lesser extent, Mario Draghi.

What I don't get is that many analysts have failed to understand (see the post by Yves Smith as one example out of many) is that Draghi has said repeatedly said that the long-term plan has two components:

1. "Good austerity" in the form of lower taxes and lower government spending. But the Grand Plan isn't all austerity, all the time. The second component addresses the problem of the competitiveness gap between northern and southern Europe, which means:
2. Structural reform, which is the European version of the step China took to "smash the iron rice bowl" in order to create labor flexibility for all, not just the young but all of the current employees in their cushy jobs and gold-plated pension plans. Draghi went on to characterize structural reform as the old days of the European social model being all gone.

He talked about this in late February when he revealed the Grand Plan for the eurozone. He positioned structural reform as a "growth compact" when he spoke to the European parliament in late April. Last week, he went further when the Telegraph reported that ECB president Mario Draghi calls for binding 'growth pact':

The president of the European Central Bank (ECB) said it was of "utmost importance" for leaders to impose fiscal discipline but also to generate growth by "facilitating entrepreneurial activities, the start-up of new firms and job creation".

He echoed demands for a "growth pact" from leaders including the French presidential hopeful, Francois Hollande. But rather than protectionist policies advocated by some, Mr Draghi said his ideal growth pact would be based on free labour markets and structural reforms that would be "agreed collectively, not unlike the fiscal [pact]".

He said political commitment would be "the most important" part: "Collectively we have to specify the future of the euro; where do we want to be in 10 years' time?"

The "growth compact" in micro and macroeconomic terms
I feel that the market still doesn't really get Draghi's "growth compact". Let me try to explain it in micro and macroeconomic terms. In microeconomic terms, it addresses the barriers to business formation in many Club Med countries. Simply put, it's hard to fire people. The "growth compact" is an Anglo-Saxon, or Thatherite, solution to make it easier to terminate employees. This is what Draghi meant when he stated in the WSJ interview that "the European social model has already gone". His reasoning is illustrated by his response that the current arrangement is inherently unfair to the youth of Europe [emphasis added]:

WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.

The Anglo-Saxon reasoning goes, if it is easier to fire people and make them work harder or take away their gold plated pensions, it creates more opportunity for growth and business formation.
 
In microeconomic terms, the "growth compact" is structural reform, pure and simple. In macroeconomic terms, the "growth compact" means an internal devaluation by the peripheral countries in the eurozone, which is a fixed exchange rate regime. The Greeks, Italians, Spaniards, etc., just have to work harder and get paid less.
 
 
Projecting the gains under a "growth pact"
What are the possible gains under such an internal devalution? FT Alphaville reports that Morgan Stanley’s Joachim Fels and Elga Bartsch took a stab at the problem:

Morgan Stanley projects that the Club Med countries (which include France) could gain about 15% of GDP growth over 10 years if they adopted these structural reforms. This amounts to an average of 1.5% of GDP a year, which is considerable when you consider that the long-run real growth rate in Europe has been hovering around 2% per annum.

Martin Wolf of the FT showed some analysis in a presentation on May 3, 2012 to the National Economists Club and Petersen Institute for International Economics. My conclusion, in the context of the "growth compact", is that the Club Med countries should try to become more like Ireland.

Note how unit labor costs in the troubled peripheral countries have been rising relative to Germany - all except for Ireland. These structural reforms that make it easier to hire and fire people, or internal devaluation, could get unit labor costs down below German costs and make Greece, Spain, etc., look more like Ireland.

Also note from the first chart how low Morgan Stanley has projected Ireland's  gains from structural reforms are, indicating that Dublin has already made the hard choices. This also means that Ireland will be the poster child for the growth pact and structural reform. The preliminary indications appear to be positive. This CNBC report discussing the upcoming Irish referendum on the fiscal compact shows that business are re-locating to Ireland "attracted by its relatively low corporation tax and increasingly cheap workforce":

Some of the forward-looking indicators for the Irish economy have been more positive. Tax revenues for March are 370 million euros ($486 million) ahead of target in the year to April 2012, driven by healthier corporation tax revenues as companies move to Ireland, attracted by its relatively low corporation tax and increasingly cheap workforce.

Nevertheless, I would expect that the trajectory of Irish growth will be scrutinized intensely to see if the harsh medicine is working.

A more realistic scenario
If all eurozone countries were to adopt the structural reforms that Draghi advocates and the Morgan Stanley analysis is correct, Germany would also gain 12.5% in GDP growth per annum. The spread between Spain and Germany is only 2.5% over 10 years, or 0.25% a year - hardly worthwhile.

Let us assume a more realistic scenario. Supposing that the peripheral countries were to adopt some form of structural reform, but only get two-thirds of the gains projected by Morgan Stanley, i.e. about 10% instead of 15% over 10 years. Assume, at the same time, that the Germans rest on their laurels. Indeed, former IMF chief economist Simon Johnson wrote in Bloomberg that German Unions Seeking Higher Pay Could Save the Euro [emphasis added]:

The solution involves a move straight out of the gold-standard playbook, with a modern twist. Since monetary union began, Germany has had substantial productivity gains and only moderate wage increases, making it highly competitive. Eurostat reports that German wages rose 2 percent a year from 2000 to 2009, while Spanish wages increased by 4.7 percent a year in the same period -- more than twice as fast. Because the currencies are the same, Germany’s competitiveness has made it tough for Spain and the other weaker states to sell their products in the euro area.

But the cavalry may show up in the unlikely form of German trade unions, which are seeking big wage increases this year. Recent demands by German workers range from 3 percent to 6 percent. As Bloomberg News reported, IG Metall, Europe’s biggest labor union with about 3.6 million workers, is demanding 6.5 percent more pay at a time when inflation is about 2 percent.

This isn’t crazy. German unemployment is at its lowest level in two decades. German exports have been doing well around the world. To some monetary purists, talk of higher wages suggests that the European Central Bank’s policy is too loose for current German conditions. But this is really taking an idealized version of the gold standard too far.

The point is to have relative wages and prices adjust -- higher for Germany and lower for its European trading partners. If German incomes rose, German consumers would have more disposable income with which to buy imported goods. And lower labor costs in other European countries would make their goods and services less costly, giving them a leg up against Germany’s export machine.

If the people in charge -- mostly Germans at this point -- insist that the adjustment must come entirely through a fall in the absolute level of wages and prices in countries with current-account deficits and large amounts of debt, then Europe is in for a difficult, and perhaps lost, decade.

But if part of the adjustment can come through higher German wages -- recognizing productivity gains and consistent with continued prosperity -- the path forward will be easier.

In other words, German wages go up while Club Med wages go down. Both Germany and the peripheral countries take actions to bear the cost of this internal devaluation.


The big question
Here is the big question. Assuming that the peripheral countries enact these structural reforms that make them more Anglo-Saxon. Would that create sufficient incentives for big employers like Alstom, EADS, BMW, Siemens to locate plants in Valencia, Thessaloniki or Lisbon, instead of looking at Poland or Slovakia as they do now?

I don`t know. What I do now is that the ECB has always had an agenda, or wish list as outlined by this analysis:

The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.

To the extent that member states are willing to go along with the ECB, it has shown an inclination offer the carrot of supporting the harsh adjustments necessary with easy monetary policy and unconventional policies, such as LTRO. On the other hand, it has the stick that, if a member state were to falter, the ECB has the option of leaving that government to the mercy of the bond market wolves.

Draghi realizes that these prescriptions are harsh and that`s why he used the analogy of crossing the river in this report:

Structural reforms are essential to restoring competitiveness but will also cause pain in the short term, the ECB president said.

"Structural reforms hit vested interests," he said, adding that they "change profoundly the society." These changes are themselves "a source of pain," he added.

"We are just in the middle of the river that we are crossing. The only answer to this is to persevere and for the ECB to create an environment that is as favourable for this as possible," Draghi said.

Notwithstanding the news flow over the pending elections, the fight over austerity and structural adjustments is by no means over, regardless of the electoral outcome.

My bet, in the long run, is still on Draghi and Merkel. In the short run, however, anything can happen.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.



None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Stay long USD assets

Sometimes it's useful to sit back and examine the technical leadership of the market to see where the strength is coming from and to understand the message of the market. Instead of the usual analysis of technical leadership from a sectors or market cap perspective, I thought that I would do something slightly different and look at the global picture of international stock leadership.

The bottom line? The current macro outlook is highly uncertain, suggesting that the near-term path for equities will be choppy and volatile. The charts are showing continued leadership by US equities and the US Dollar. All other global regions are underperforming. Under these circumstances, I would stay with the strength and concentrate the bulk of any equity exposure in the US and overweight USD assets in a global portfolio.


Where is the leadership?
The chart below shows the relative performance of US equities, as represented by SPY, against ACWI, or the ETF for the Morgan Stanley All-Country World Index. Since all prices are quoted in US Dollars, the currency effects have all been filtered out of the analysis. As you can see, US equities have been in a relative uptrend against ACWI for about a year:

What about Europe? The market is telling us that it is indeed concerned about the eurozone, as its equities have been underperforming for over a year.

The other large developed country in EAFE is Japan. The performance of Japanese stocks is nothing to write home about. They are either flat to weak against ACWI, depending on you interpret this chart.

Emerging market equities have not been a pretty picture. The relative performance of these stocks show that they appear to be rolling over on a relative basis.

Until the BRIC countries, and China in particular, begin to show some sustained strength, I would underweight these stocks in a global portfolio. There is a glimmer of hope, as Bloomberg reported that Analysts who called 2010 bottom in China stocks now say buy.

Finally, a look at the US Dollar Index shows that it remains in an uptrend that began last summer. Currently, it appears to be testing the bottom trendline of the uptrend, but I would give the USD bulls the benefit of the doubt for now.

What about the fiscal cliff?
Recently, Fed Chair Ben Bernanke warned Congress about taking sufficient action so that the US doesn't go over the fiscal cliff. Bloomberg reported that he said:

If no action were to be taken by the fiscal authorities, the size of the fiscal cliff is such that there’s no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy.

Other analysts, like Nouriel Roubini, David Rosenberg and Citi's Steven Wieting have warned about the impending fiscal cliff that the US faces. No doubt the risks are gargantuan and my inner investor is highly concerned about an overly high concentration in USD assets under these circumstances.

My inner trader tells me that, for the markets, these things don't matter until they matter. Stay with the relative performance trend and then pull back when you see the trend break.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Green shoots in China?

In the past few weeks, the markets have shown concern that China may be on the verge of a hard landing. My reading of the charts indicate that those concerns are starting to recede and there may be signs of "green shoots" out of China. Bear in mind the following two caveats to my analysis:

• "Green shoots" are fragile and can easily be trampled underfoot; and
• "Green shoots" are indications of stabilization, not signs that a roaring bull market is about to begin.

First, a chart of the Shanghai Composite shows that the index has rallied through an intermediate term downtrend (solid line) and that market is in the process of a sideways consolidation. In fact, it could be argued that the Shanghai Composite is starting to form a wedge pattern (dotted lines). Depending on which way the pattern resolves itself, it could point to the future trajectory of Chinese growth.

China is an enormous consumer of commodities. In this post (see Time to take some risk off the table), I pointed to the dismal behavior of commodity sensitive currencies as a sign for caution. Now, commodity sensitive currencies such as the Australian Dollar has rallied through its downtrend. A period of sideways consolidation is likely at this point.

The Canadian Dollar, which is another commodity sensitive currency whose economy has greater leveraged to the American economy than the Australian economy, recently staged an upside breakout from a trading range.

Commodity prices are also showing a tender green shoot, though that one is far more fragile. The CRB Index below shows that commodity prices have staged an upside breakout from a short-term downtrend (solid line), but the longer intermediate term downtrend (dotted line) remains intact.

The liquidity weighted CRB Index is more heavily weighted towards the energy complex. A look at the equal-weighted CRB Index, called the Continuous Commodity Index or CCI, shows that the CCI has staged an upside breakout through the intermediate downtrend. The most likely scenario is that commodity prices undergo a period of sideways consolidation.

To be sure, these "green shoots" are early signs of recovery which can easily be trampled. The strength in commodity prices may be a false start, as Izzy at FT Alphaville pointed out that it could be just more inventory accumulation and not the result of actual physical demand.


Constructive on China
My current framework for the analysis of the global outlook is to examine the Three Axis of Growth, namely the United States, Europe and China. For now, I believe that the message of the markets from China has changed from bearish to a fragile stabilization. No doubt the aforementioned markets will retrace some of their gains, but chances are good that the risks of a hard landing are receding.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Draghi and Merkel defend the Grand Plan

Angela Merkel has said in the past that there is not magic bullet that can save the eurozone, but that it's a process which takes time. The "process" that she refers to is the Grand Plan, which I wrote about before, as outlined by Mario Draghi. It consists of:

1. "Good austerity" in the form of lower taxes and lower government spending. But the Grand Plan isn't all austerity, all the time. The second component addresses the problem of the competitiveness gap between northern and southern Europe, which means:
2. Structural reform, which is the European version of the step China took to "smash the iron rice bowl" in order to create labor flexibility for all, not just the young but all of the current employees in their cushy jobs and gold-plated pension plans. Draghi went on to characterize structural reform as the old days of the European social model being all gone.

Now that austerity is starting to bite in many European countries, Draghi went before the European Parliament's Economic and Monetary Affairs Committee in Brussels and defended the Grand Plan. He went on to call structural reform a "growth compact".

Restoring fiscal health is "an unavoidable policy measure to regain market confidence" Draghi said, stressing that governments need to "persevere."

However, "to deny that fiscal consolidation has some short-term contractionary effects would not be correct," the ECB chief said, conceding later that these effects are now starting to "reverberate."

Structural reforms are essential to restoring competitiveness but will also cause pain in the short term, the ECB president said.

"Structural reforms hit vested interests," he said, adding that they "change profoundly the society." These changes are themselves "a source of pain," he added.

"We are just in the middle of the river that we are crossing. The only answer to this is to persevere and for the ECB to create an environment that is as favourable for this as possible," Draghi said.

He said competitiveness disparities within the Eurozone are a key underlying cause of the crisis and that "the way out is to implement structural reforms that free some of the energies."

At about the same time, Bloomberg reported that Angela Merkel defended Draghi's Grand Plan as not being all-austerity-all-the-time:

Chancellor Angela Merkel backed European Central Bank President Mario Draghi’s call to focus on spurring economic growth, as German officials rejected charges they are fixated on budget austerity to fight the debt crisis.
Europe needs growth “in the way that Mario Draghi, the president of the European Central Bank, said it today, that is in the form of structural reforms,” the chancellor told a conference of her Christian Democratic bloc in Berlin today.

It's a combination of austerity and growth compact:

“We’ve had a fiscal compact,” Draghi said. “What is most present in my mind now is to have a growth compact.”

Given Draghi's current view that the eurozone is "just in the middle of the river we are crossing" and "the only answer to this is to persevere", it appears that the voices against austerity, like French presidential candidate and frontrunner François Hollande, have a fight on their hands. Note how different his version of a "growth plan" differs from the Merkel-Draghi Grand Plan, according to this FT story:

Mr Hollande’s proposed growth plan would comprise four elements: the creation of commonly issued eurobonds “not for the mutualisation of debt but to finance” infrastructure, industrial investment and employment; additional financing of investment by the European Investment Bank, the bloc’s long-term lending arm; the imposition of a financial transaction tax by those EU member states willing to use it to find development projects; and the more efficient use of EU structural or regional development funds.

In the days to come, there will a lot of theatre and inevitable compromises. The theatre will be entertaining, but don't forget that Hollande is committed to Europe and he doesn't want to go down in history as the one who blew up the EU. Expect him to compromise from his election rhetoric, but I would not be surprised if Merkel also compromised on the issue of eurobonds.
 
All is not lost. Consider the upcoming election in Greece as an example. Despite the pain that the Greeks are feeling, the latest polls show that they don't want to leave the eurozone:

A poll by the MRB company showed that 26.2 percent of respondents intend to vote for a party opposed to the unpopular EU-IMF rescue in the May 6 ballot.

In response to another question, 66 percent said Greece should stay in the eurozone but adopt an alternative recovery plan, while 13.2 percent said the country should drop the euro altogether.

So unless anti-Europe leaders take power, the eurozone is unlikely to fall apart.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

How serious is this selloff?

Yesterday, global stock markets sold off mainly on the Hollande and Holland news. European stocks are in a well-defined one-month downtrend.

US equities descended to test an important technical support level.

However, when I look at the FX and bond markets, I can't see the same level of investor angst that seems to exist in the equity markets. For example, if Europe is such a mess, why is the EURUSD exchange rate holding up so well?

Also consider the CADUSD exchange rate, which is sensitive to commodity prices and a measure of risk appetite. The loonie remains in a trading range relative to the greenback.

There are no signs of panic in the bond market either. High yield, or junk, bonds continue to perform reasonably well in light of the difficulties experienced by the stock market. Why isn't risk aversion showing up in this market?

In conclusion, until we get signs of a significant decline in risk appetite from the foreign exchange and bond markets, this bout of stock market weakness is just another phase in a sideways and choppy market.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Not enough panic to buy yet

Now that we are nearly at support on the Spanish IBEX 35 Index, my inner trader tells me it's too early to be buying. We need to wait for more pain and panic to materialize. My inner investor says that signs of value are starting to show up in a number of natural resource sectors and it's time to start accumulating positions in resource cyclicals.


Spain a contrarian buy, but not yet
Soon after I wrote my last post (see Why I am buying the pain in Spain), Macro Man and I seemed to be on the same page when he wrote that Spain is unlikely to crash:

To TMM [ed. TMM=Team Macro Man] it would appear that the only scenario that supports selling right now is one where Spain crashes, doesn't receive assistance, defaults and the euro and then Europe break up. Now call us picky but though that indeed is one potential outcome there are a lot of other scenarios and most of them involve some internal resolve, even if it does involve printing your amount of money. Elections may change the leaders of some countries but as the UK Con/Lib coalition is finding out, they are but the tip of the iceberg of the machine that is government. There is enough mass below the waterline that knows where its true interests lie to stymie any threats to them. Yes Minister indeed.

In fact, they were piling into the Spanish trade:

Having piled back into equities last week the current mood should be considered as red flags to us and we really ought to run with the pack, chop the longs, swing short and whip up the doom. Instead though TMM have decided to do the reverse and have broken the glass on the cabinet containing their Kevlar Gloves and bought some Spanish stocks of international appearance ( braced for comments). Hold on tight !!

Recall that my original premise for buying Spain is to wait for a period of maximum pain and panic (see How much more pain in Spain?). The defining moment was the 2009 lows, which would be a level of technical support for Spain's IBEX 35 Index.

Now that we are nearly there, I don't think we've seen sufficient pain and panic in the markets for Spanish equities to be a contrarian buy yet. My inner trader thinks that TMM should be following his initial instincts to "run with the pack, chop the longs, swing short and whip up the doom."

Consider this chart of European stocks, which exhibited a break of an uptrend, but the index is not showing any signs of panic yet.

What about the euro? The EURUSD exchange rate is holding in nicely, thank you very much.

So are 10-year Treasury yields. No signs of panic there either.

Is the market about to hit an air pocket?
I am starting to see the signs of a change in leadership. While my Asset Inflation-Deflation Trend Model remains in at a weak neutral reading and I am not in the business of anticipating model reading changes, my best wild-eyed guess for the stock market is a gut-wrenching correction, followed by an explosive rally as the Bernanke Put and Draghi Put kicks in.

Consider the relative return charts below. The top chart shows the relative return of the Morgan Stanley Cyclical Index compared to the market. Cyclicals are underperforming and they have been in a relative downtrend after topping out in early February. By contrast, defensive sectors such as Consumer Staples and Utilities have been bottoming out relative to the market this year and recently started to outperform.

These are the signs of a change in leadership pointing to a deeper correction in stocks.


Value in resource sector
Despite the negative near-term prospect for cyclicals, I am seeing signs of value showing up in the deep cyclical sector, particular in the resource sector. Canada's Globe and Mail featured an article detailing that while energy companies were going like gangbusters:

Alberta’s oil patch is roaring. Oil prices are flying, pipelines are pumping millions of barrels a day, and companies are engaged in a rollicking spending spree.


Every 2½ weeks, companies shovel another billion dollars into oil sands projects. Drilling rigs across the province are tapping big new pools of oil. And firms desperate for skilled workers are scouring the globe to help them get on with ambitious growth plans. Western Canadian oil output is expected to surge by more than a third to 3.6 million barrels a day by 2018.

Their stockholders were missing out on the party:

Alberta’s energy frenzy has all the makings of a hollering rodeo party. But there’s one group conspicuously missing out on the action: investors.


In the midst of a boot-stomping boom, oil and gas has been among the country’s worst-performing sectors of the stock market. Since the global economic crisis, benchmark oil prices have soared from below $40 (U.S.) a barrel to above $100. Many Canadian energy stocks, however, have been left in the dust.

Indeed, this chart of the XOI, or Amex Oil Index, against the price of WTI shows that energy stocks are historically cheap against oil. Arguably, the graph doesn't show the true picture as XOI is shown against WTI, which has been trading at a discount to Brent, which is becoming the de facto benchmark for the world price of oil.

We see a similar picture with gold mining stocks. The Amex Gold Bugs Index, or HUI, is trading at a huge relative discount to gold bullion and the relative relationship is approaching the post-Lehman Crisis panic liquidation and capitulation lows.

The slope of the recent price action of the energy stock/oil and gold stock/gold ratio, however, tell the story of controlled selling rather than the panic selling that characterize a capitulation low. That's the same picture that I see in the IBEX 35, the Euro STOXX 50, Treasury bond yields and the EURUSD exchange rate.


A market crash is unlikely
Longer term, however, I expect that asset prices to be well-supported by the Bernanke Put and Draghi Put. Consider the Italian MIB Index as a bellwether of market fortunes. While there is downside risk, tail risk is likely to be mitigated by the Draghi Put and the near-by presence of major technical support that stretch back to the mid 1990's.

As the table below shows, this week is a big week for Spanish equity market, as most of the Spanish banks are expected to report earnings. Bad news could provide a catalyst for another downleg, which would be a set up for the good contrarian to start buying.

In summary, my inner trader tells me that there isn't enough panic here for him to step up to buy, but my inner investor, who has a longer time horizon, tells me that it's time to start nibbling away at long positions in distressed sectors, such as Spain and resource stocks, at current levels.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.



None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.