Monday, October 31, 2011

Defying gravity

Something has changed within me
Something is not the same
I'm through with playing by the rules
Of someone else's game

Too late for second-guessing
Too late to go back to sleep
It's time to trust my instincts
Close my eyes: and leap!

It's time to try defying gravity
I think I'll try defying gravity
And you can't pull me down!

- Defying Gravity lyrics, from Wicked

The rally in risky assets in reaction to the EU Grand Rescue Plan was awesome to behold as the risky assets seemed to defy gravity despite grave concerns expressed by analysts over the details of the plan. The rally has unleashed a tsuanmi of positive price momentum. However, medium term concerns from cyclical indicators, measures of risk aversion and macro concerns over the sustainability of the eurozone "fix" leaves me to believe that we are undergoing a consolidation phase with an upward bias in the next few months.

I would be inclined to become more cautious about the outlook for equities and other risky assets in the 1Q and 2Q of 2012. My Inflation-Deflation Timer Model agrees with this assessment and has moved to a "neutral" from a "deflation" reading, which would orient the model portfolio from a bond heavy tilt to a more balanced weighting between stocks and bonds.

In the meantime, enjoy the spectacle of stocks defying macro-risk gravity.

Powerful momentum
To see how powerful the momentum is, you just have to look at the chart of the SPX. It shows that the index not only rallied through a downtrend line, but through resistance at the 1260 level and the 200 day moving average. Does this mean that the tide has turned and it's now up, up and away from now on?

Charts from a number of major equity averages around the world seem to suggest that bullish view. The FTSE 100 shows a similar pattern of a rally to test the 200 day moving average.

Even the Euro STOXX 50 shows a pattern of a turnaround. It broke through a downtrend line and the index is now in a minor uptrend, though the rally hasn't quite reached the 200 day moving average yet.

Moving eastward, even the Hang Seng Index has shown a pattern of strength by rallying through an important multi-year resistance zone.

Cyclical red flags
While the short-term momentum has been impressive, cyclical indicators are not sounding the all clear signal just yet. The resource-heavy and cyclically oriented Canadian equity market is showing a pattern of a rally through a short-term downtrend, but the longer term downtrend remains intact.

Commodities are also telling a similar story of a counter-trend rally within a longer term downtrend.

The Shanghai Composite isn't looking as healthy as Hong Kong or the other major equity averages around the world as it is struggling at the site of the 50 day moving average as well as a major resistance zone.

Inter-market analysis confirms my cyclical concerns. The relative performance of the Morgan Stanley Cyclical Index against the market also shows a pattern of a counter-trend rally within the context of a longer term relative downtrend.

Risk appetite returns, but...
Measures of risk appetite are also telling a similar story of a retracement within a longer term downtrend. Consider, for example, the performance of the NASDAQ Composite against the large cap NASDAQ 100. The ratio rallied through a relative downtrend line, but it has barely retraced much of the technical damage done when the risk aversion trade began in July. This chart suggest to me that the current rally has further to go, but a more realistic expectation would be a period of sideways consolidation with an upward bias. Longer term, this trade has the potential to go down further.

The relative performance of JNK (junk bonds) against IEF (7-10 year Treasuries) also show a similar pattern of rally through a short-term downtrend, but the longer term downtrend remains intact.

Macro concerns
On the macro-economic front, grave concerns remain. I detailed in my last post some of the concerns over weakness of the eurozone rescue plan (with new comments in brackets):
  • European banks could send Europe into a deep recession. I wrote before that banks are asked to recapitalize to the tune of €100 billion, but the total market float of these banks is about €200 billion. Any plan that raises that much equity in such a short time will crater bank stocks. Bank CEOs have the alternative of getting to their 9% target by calling in loans, which would create a credit crunch that sends Europe into a deep recession.
  • How good is the EFSF monocline insurance guarantee? Individual EU states are only guaranteeing their contribution the EFSF and have not actually funded their portion of the contribution. So when the EFSF insurance scheme “guarantees” the first 20% of a Spanish bond, part of the guarantee comes from Spain. If Spain were to get into trouble, can investors depend on the Spanish guarantee? In that light, how big is the real size of the EFSF monoline insurance scheme? [In addition, the WSJ also asked a very good question about regulatory risk surrounding the EFSF: "If Greek CDS don't trigger, why would EFSF?"]
  • EFSF insured bonds create a two-tiered bond market in Europe. What will happen to currently outstanding bonds of troubled countries should there another credit event with, say, Portuguese bonds? [That appears to be less of a concern as the EFSF has indicated that credit protection will be detachable from the new bonds issued with such protection.]
  • Greece is still struggling under the burden of an enormous debt. Even with the “voluntary” haircut, Greek debt will be 120% of GDP, which is above the 100% 90% of GDP benchmark that most analysts Rogoff and Reinhart consider to be a sustainable level for sovereign debt. Will Greece have to come to the table again for relief in the future?
  • Could Portugal be the next Greece? The Portuguese debt burden does not appear to be sustainable and many analysts believe that Portugal is the next Greece. This deal only grants relief to Greece and does not put a sufficient ring-fence around the other peripheral countries. The current prescription of more austerity is only likely, in the short-run, to exacerbate budget deficits and send fragile EU member state budgets like Portugal and Italy over the edge. [Already, Portugal is showing signs of unraveling and going down the Grecian path.]
  • What does the EU do when Portugal or Ireland asks for debt relief? When they rescued their banks in 2008-9, the Irish understood that they would be offered the same deal as Greece if there was a deal to be done on debt relief. Already, the Irish are seeking some form of debt relief. How will the EU respond?
Add these concerns to the European worry list:
  • Pressures are showing up again in the bond market. The Italian bond auction on Friday did not go well. 10-year yields surged to new highs at 6.06% and they sold only €7.93 billion of bonds, which was under the €8.5 billion maximum.
  • The EFSF's AAA credit rating depends on the French AAA. The WSJ reported that Standard and Poors has affirmed the EFSF AAA rating, but that rating depends on the credit rating of contributing member states, several of which have been downgraded recently. This puts incredible pressure on France to retain its AAA rating.
  • Will ISDA declare the *cough* "voluntary" haircut to be a credit event? The beleaguered ISDA has a hard decision to make. It certainly walks like like a duck and quacks like a duck, but will it declare the "voluntary" haircut to be a default credit event and trigger all the credit default swaps sold on Greek debt and throw the global financial system into turmoil? Fitch has already weighed in stated that they believe that the "voluntary" 50% haircut and debt exchange would constitute a default. Macro Man has likened the discussion with the ISDA to the Monty Python dead parrot. Here is an excerpt (for full details click on Macro Man link above):
"I wish to complain about this CDS what I purchased not half a year ago from this very investment bank"
"Oh yes, the Hellenic Republic... What's wrong with it?"
"It's not paid out, that's what's wrong with it."
"No, no, it's just voluntary, look."
"Look my lad, I know a dead product when I see one, and I'm looking at one right now"
"No, no, it's not dead, it's just voluntary."
"Yeah... remarkable product, Sovereign CDS... beautiful name, innit?"
"The name don't enter into it. It's not paid out."
"Nah, nah... it's voluntary"
To put it all into context, here is what STRATFOR, writing before the Grand Rescue Plan was announced, thought about how Europe would resolve its Greek problem:

All roads lead to *ahem* Rome. I guess that's why George Soros thinks that the current rescue plan will hold together between "one day and three months".

The trouble doesn't stop in Europe
Meanwhile, there are signs of trouble in China. Consider:
Last but not least, we have a looming recession in the US. In addition, the Super Committee to reduce the budget deficit appears to be deadlocked, and Merrill Lynch analyst Ethan Harris believes that inaction may prompt a credit rating downgrade of US debt by either Fitch or Moody's.


Don't forget the policy response
To investors who see these macro risks as dire warnings of a calamity, I would say, "Don't forget to think about the policy response."

I wrote that central bankers are planning a party and I believe that's what the markets are beginning to discount. Elements of the Federal Reserve are pushing for QE3 in the form of MBS purchases and there appear to be good reasons to undertake such a step.

Incoming ECB head Mario Draghi also signaled a subtle change in ECB policy last Wednesday by supporting the continuation the program of sovereign debt purchases, which was supposed to be temporary and discontinued when the EFSF comes into being. This represents the first step in a slippery slope to ECB quantitative easing, and even permabear Albert Edwards believes that ECB will eventually be forced to embrace QE. One key test of the direction of the Draghi ECB is its interest rate decision this Thursday.

In China, the authorities are getting ready for a policy of selective stimulus by cutting reserve requirements. The Chinese have maintained a policy of either stomping on the accelerator or stomping on the brakes. This latest move is a signal that they may be taking the foot off the brake and they are starting to step on the accelerator again.

While I recognize that the macro risks are enormous, but do you want to take the chance and step in front of a trillion or two of central bank stimulus?

Sideways consolidation with an upward bias
If asked to give an opinion as to future market direction, I would have to say that your stance would depend on your time horizon. Given the tremendous bullish momentum shown by equities last week and the technical damage done to the bearish case, my inner trader would say that in the short-term, his best guess is a sideways consolidation with an upward bias. The bull case is underpinned by the fact that we are moving into a period of positive seasonality and the likelihood that the markets start to discount the possibility of Fed and ECB intervention.

Watch the FOMC statement and Bernanke press conference this week for language that tilts towards another form of QE, or under what circumstances they would become more stimulative. Also watch the ECB decision Thursday. If either central bank shows signs of further accommodation, then the news could spark off another melt-up in equity prices.

My inner investor, on the other hand, believes that in the medium term, the eurozone Grand Rescue Plan is deeply flawed at many levels. Moreover, if the Fed does not signal that it is tilting towards greater accommodation by its December meeting, then the markets could be in for a rude shock should the economy start to slide into a recession. Early next year, Portugal could blow up and become the next Greece. Ireland may kick up a fuss and demand debt relief. There is also the dynamics of the French presidential election in the spring, which could create further volatility in the markets.

Those are things to worry about in 1Q or 2Q. Meanwhile, enjoy the rally.

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.

1 comment:

Mitch said...

In regards to your comment on China - it will be interesting to see how the defaults in the informal banking sector among SMEs will translate to market stability in other smaller sectors of the Chinese economy, and how that will effect support and buoyancy of small firms versus SOEs in China. We are also interested in how Africa will fare in 2012 given its increased ties with East Asia and the assumption of increased investment, especially with the political changes in North Africa and the attempts at more cohesive economic integration in East Africa, joined with favorable business conditions prevailing over large parts of West Africa (although we predict that Nigeria may have a recession in 2012). As always, it seems, the global climate is tenuous.

Mitchell Langley
Frontier Strategy Group