Monday, September 10, 2012

Party on! (but watch out for the cops)

In my last post, I wrote that dissecting the market's reaction to news was in some ways more important that the news itself (see Watch what the market does, not what pundits say). The preliminary verdict of the market from Friday's NFP release is clear, party on!

The signs of a cyclical turnaround were already in place. Now we have central bankers, first the ECB (and most likely the Federal Reserve next week), throwing a giant party.

The signs of a cyclical upturn were there if you were watching. The chart below of the relative returns of the Morgan Stanley Cyclical Index against the market bottomed out in late July and began turning up in August.

Likewise, commodity prices displayed a similar pattern of ending a downtrend and starting to turn up.

Indeed, JP Morgan economists (via Business Insider) have written a note indicating that global growth is bottoming and on the verge of an turnaround:
With this week’s August PMI release and new information on July activity, the DFM-Eco index estimate of current quarter growth rose to 1.8%. Interestingly, the rise in our nowcaster is driven by July activity readings that were stronger than what was anticipated by the July PMI. The index estimate is now in line with our bottom-up forecast (2%) that looks for a stabilization of global growth this quarter.

With growth bottoming, attention now turns to assessing whether private sector behavior and policy stances are aligned to deliver the modest lift built into the forecast. Our forecast does not expect much in the way of growth, with global GDP expected to accelerate only a touch to a still-subpar 2.4% annualized pace in pace in 4Q12. In this regard, the recent data have been mixed, raising more “maybes” than certainties. The news from consumers remains upbeat. Our estimates of current quarter global consumption growth was lifted again this week as July readings were firm and auto sales reports for August surprised to the upside. Although less broad-based, it appears that the pace of global inventory accumulation has slowed.

A rally on the horizon
Now we have the extra "juice" provided by central bankers to jump start the global economy. The anecdotal evidence from trading desks was a rush for risk. I had heard from multiple sources that, in the last few weeks, institutions had begun to fret that they had too little beta and were looking for to buy more risk.

Bloomberg reports that Lazlo Birinyi is forecasting more stock market gains as the bears capitulate:
More gains are likely as bearish investors give up and start buying, according to Laszlo Birinyi, president of Birinyi Associates Inc. in Westport, Connecticut.

“They realize it isn’t working,” Birinyi, an equity trader for Salomon Brothers Inc. in the 1980s, said in a telephone interview. “The excuses of no volume and earnings aren’t going to be good -- that’s not happening, and maybe it’s time to join the party.”
The European market action late last week was convincingly bullish. Equities melted up on Thursday in response to the ECB announcement and the follow-up strength on Friday was equally impressive. The combination of overly bearish positions in institutional portfolios and a sea change in risk appetite suggests to me that this rally is sustainable until at least the American elections in early November.

Wait for an entry point
I had expressed the opinion that the leadership was going to come from Europe (see An asset inflation signal) and I have been fortunate in my timing so far. For investors who missed the initial surge, I would be inclined to wait for a pullback before initiating (or adding) to European positions.

Consider the chart of the Euro STOXX 50 below. We just saw a bullish 50/200 day moving average crossover, otherwise known as a golden cross, on the index. Despite this intermediate term bullish signal indicating an uptrend, the short-term picture shows that the index is nearing trend line resistance from which it is likely to pull back. These conditions are indicative of some near-term weakness that could form the basis of a better entry point in the next couple of weeks.

I also indicated that the source of inflation was coming from Europe and referred to the CRB Index priced in euros. An alert reader wrote me to watch the euro-denominated gold price as well. While the USD denominated gold price, seen below, recently staged an upside breakout from a downtrend, which is constructive for bulls...

...the euro denominated gold price appears far more bullish as it is challenging resistance at its all-time highs. As with these key tests of resistance, I would expect that it would initially fail at resistance on its first try, which would be a useful entry point for the risk-on trade, and more likely overcome resistance on later tries.

A true turnaround or more "kick the can"?
As well, consider these relative performance charts of peripheral country equity markets compared to Germany. The IBEX (Spain) vs. DAX (Germany) chart, shown below, shows that Spanish stocks have rallied through the short-term relative downtrend to German stocks, but the long-term relative downtrend remains intact.

You can see a similar picture for the MIB (Italy) vs. DAX (Germany):

I have two conclusions from these charts. First, there is considerably more room for the peripheral markets to rally against the safe haven markets, such as Germany. This indicates that there is more room for the risk-on trade to run, which is consistent with the stories I heard from the trading desks (see above).

The longer term picture is more clouded. However, I had written about labor cost convergence in the eurozone as a long term positive (see An inflection point for Europe?) and Gavyn Davies highlighted the same issue in an FT column:
Spain remains the critical case. The ECB’s willingness to provide liquidity to a country like Spain is probably greater than the IMF’s willingness to help countries in earlier crises, but it is still limited by two factors. The first is Germany’s capacity to acquiesce to higher Target 2 credits. The second is the ECB board’s willingness to accept greater exposure to the Spanish sovereign on its balance sheet. Either of these factors could mean that the ECB’s tolerance for providing greater liquidity might not last for as long as is necessary for Spain to become self financing in private markets.

How long might that be? As in the case of previous IMF crisis interventions, that will depend on the market’s view on Spain’s competitiveness (or implied real exchange rate) within the euro area. The good news is that Spain has in fact improved its competitiveness markedly in recent years, as a result of the reductions in labour costs which have accompanied the recession and structural reforms in the labour market:

These improvements in Spain’s real exchange rate are probably greater than the markets have realised. The current account deficit should be eliminated in 2013. Admittedly, that deficit would soon re-emerge if Spain brought its unemployment rate down to more normal levels from the current 25 per cent rate, but Spanish labour costs are still improving quite rapidly, relative to the eurozone average, on an ongoing basis. This is encouraging, because it implies that the ECB’s provision of liquidity might not need to be as open ended in as the market currently fears.
If the eurozone can indeed conquer these long term challenges, then watch for a similar kind of convergence between the periphery equity markets and Germany. The long term relative downtrend should not pose a problem.

On the other hand, should the ECB's actions be another kick the can down the road exercise, then the rally in European equities will prove to be ephemeral.

In the meantime, the ECB (and likely the Fed) is throwing a big party. So don't worry and party on, but don't forget to watch out for the cops should the merriment get out of hand.

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.

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