FMX | Connect – www.fmxconnect.com - (Reported 11/01/2010)
Excerpt from MARKET MUSINGS & DATA DECIPHERING
WHILE YOU WERE SLEEPING
The risk-on trade is on again with equity markets strengthening to kick off the week, at least outside of Japan (don’t look now, but the Topix index is down six days in a row). The MSCI Asia Pacific index jumped 0.9% and the region’s FX rates also firmed considerably. The U.S. dollar is predictably weaker as its correlation with the stock market, historically negligible, continues to tighten up, and corporate bond risks are ebbing.
The catalyst today was the news that China’s manufacturing PMI index rose to 54.7 in October from 53.8 (the news that U.K. home prices fell 0.9% in the latest Nationwide survey, the steepest decline since January 2009 and the fourth slippage in a row, barely caused a ripple today). Bonds for some reason are either consolidating or rallying modestly in the face of these large moves in reflationary assets, like commodity prices — silver just crossed above $25 an ounce for the first time in three decades but somehow bond yields in France, Germany and Italy are down 3-4bps so far today. Maybe somebody is keeping an eye on the European debt problems (see more below) — as Irish/German yield spreads gap out to a record high of 455bps.
Below we highlight the three major U.S. developments this week. In Canada there is also a potential biggie as the federal government is expected to announce its decision on the takeover bid for Potash Corp.
BIG WEEK AHEAD IN THE U.S.
We have the mid-term election results on Tuesday, the Fed announcement on Wednesday and October nonfarm payrolls on Friday. So to say that this will be a critical week for the markets would not be an exaggeration. There is little question that the GOP will take the House with a 1994-type landslide; however, the Senate is a much tougher call. The real question is how President Obama is going to respond, especially since he has lost much of his policy team and as such seems rudderless.
The bottom line is that when things are good, as they were in the Reagan years of the 80s and the Clinton era of the 90s, gridlock is good. However, when there are lingering and deep economic and social problems, then sorry, gridlock stands in the way of solutions. See more on this file in the E.S. Browning column in today’s WSJ (Stocks Face Dark Side of Gridlock in Capital).
The reality is that the GOP will not support more fiscal initiatives and so we are likely about to see a pronounced slowdown in the pace of economic activity because outside of government intervention and inventory accumulation, catalysts for growth are few and far between. Unlike what happened in the soft-patches of the mid-1980s and again in the mid-1990s, the economy today is just a shock away — even a negative fiscal shocks — from slipping back into contraction mode. (As an aside, here’s one form of “stimulus”, adding over $30 billion at an annual rate to household cash flow to deadbeat debtors from living rent free in their foreclosed home. See the Mark Whitehouse article on this topic in today’s WSJ). There is a reason why Obama’s approval rating on the economy is all the way down to 38% (from 46% at the start of the year).
As for the Fed, surveys show that market participants expect the Fed to buy between $80-100 billion in bonds, with the ultimate sum ranging from $250 billion to $2 trillion. The risk of disappointment, or a classic case of sell the fact after buying the rumour for the past two months, is very high, especially with the stock market at the high end of the 2010 range and investor sentiment readings back close to extreme levels.
The risk that the markets are not fully appreciating is what happens if the Fed becomes very aggressive and heavy asset purchases causes further weakness in the U.S. dollar, which then touches off a currency war (the Bank of Japan also has its finger on the QE trigger) followed by a trade war? The case for gold as a hedge against this more-than-remote possibility is pretty strong (see the article on Shayne McGuire who runs the Texas Pension Retirement fund on page B1 of the weekend WSJ — A Gold Bull and His Prediction: $10,000 An Ounce). Alternatively, if the Fed comes in light, say with a $250 billion package, which would be the equivalent of a 25 basis point rate cut. Whoopee! As if the U.S. economy is suffering from a lack of low interest rates right now.
The consensus forecast on Friday’s U.S. nonfarm payroll report is 60k, but as Alan Abelson points out in his Barron’s column, the legendary John Williams believes that an outright decline deserves to be a base-case scenario. That would certainly shock a complacent stock market. Bonds would rally strongly in this scenario, especially at the long end of the Treasury curve. As an aside, if there is a possible inflation accident waiting to happen, it is in Emerging Market bonds, not Treasuries (see Asia’s Emerging Inflation Risks on page B16 of the weekend WSJ).
BIG MONEY!
For a sign of the times, see Bye-Bye Bear on the front cover of Barron’s (and the Bears, Beware! warning used as the title for the 2010 Big Money Poll); quite a comment for an S&P 500 that has moved within a 1,000 and 1,200 band for the last 10 months.
Then swing to Michael Santoli’s article, Setting Up for a Year-End Rally — that is certainly a consensus view right now. The comment (which I’m sure is directed at me) that the ECRI leading index is “a favourite of eco-bears only when it’s plunging” misses the point that the damage has already been done and we have an economy right now that continues to skate on some very thin ice, even if outright contraction is avoided. There was no mention that at a 0.6% annual rate in Q3, real final sales came in 30 basis points shy of consensus estimates.
In any event, the survey of the Big Money Poll from Barron’s shows that 62% of portfolio managers see equities as the top performing asset class in the next 6-12 months — versus 15% for precious metals, 6% for cash and 3% for bonds. You don’t have to be much of a contrarian to understand what it means to have twice as many investors more bullish on cash than on bonds. It’s otherwise known as a herd mentality. Fully 72% are bearish on Treasuries, only 5% are bullish (versus 60% and 15%, respectively, for equities) and yet 62% believe bonds are in a bubble. How can bonds be in a bubble and at the same time be so detested? One of life’s greatest inconsistent thought processes at the current time!
Not only that, but 70% see little chance of another economic contraction. And, 70% favour the stock market on expectations of better jobs data, a stronger economy and rising profits. To top things off, BusinessWeek runs with this article to boot — Stocks and Bonds Are Bullish on the Economy (come again?) on page 47. At least we know where the surprise will be, if any!
DEFLATION, NOT INFLATION, IS THE PRIMARY RISK
The risk is to treat last Friday’s U.S. GDP report with a cavalier approach. There was really nothing benign about it. It is abundantly clear that the economy is in a spot of trouble. Weak exports and fiscal retrenchment mean no exogenous boosts at a time when real final sales growth is slowing and now barely positive. A chronic large gap in the labour market will result in decelerating, if not falling organic personal incomes, putting consumption at risk at a time of a rising trend in the savings rate. Indeed, real personal disposable income growth throttled back to a mere 0.5% annual rate in Q3.
Investment will be tepid, at best, in view of the high degree of excess capacity and the overall weakness in housing and commercial real estate activity. The best days of the inventory cycle are behind us. With all this in mind, one would expect the base-case scenario to be one of economic contraction and price deflation with regard to final goods and services. The New Abnormal that dots the editorial page of the weekend WSJ (A16) is well worth a read.
Notwithstanding the boomlet in commodity markets, and heightened inflation expectations in the TIPS market, curiously before the Fed has even announced anything, the economic data still support the overall notion of deflationary momentum. The personal consumption expenditure price index excluding food and energy (core PCE) came in at a tepid 0.8% annual rate last quarter and this took the YoY trend down to +1.3% from +1.7% at the turn of the year.
There is no more significant source of inflation than the U.S. labour market and we found out on Friday that total employment costs slowed to just +0.4% in Q3 and the YoY trend is extremely tame, at +1.9%. Wages came in at +0.3% sequentially and just +1.5% on a YoY basis.
We can understand the temptation to believe in the inflation story because of what the CRB index has been doing, but our advice is to resist that temptation and remember what we were talking about, quite unexpectedly by the way, six months after oil hit $140/bbl back in 2008. Deflation.
In many cases, pricing power is hard to achieve and so the bump in commodity costs serves as a margin squeeze as opposed to a sustained source of final stage inflation. For real-life examples as opposed to the data, what did the NYT have to say about Colgate’s profit results? This — “Colgate's revenues in the United States, which produces 19% of its sales, grew 2%, while the company sold 3% more products. Price cuts reduced earnings in the United States by 1.5%.”
NOTICE THE WORD "PRICE CUTS"?
And, what the NYT had to conclude about 3M’s results? That it “reduced the top end of its full-year forecast and said rising raw materials costs and other pressures were cutting into margins, sending the company's shares sharply lower.” Margin compression at a time of low single-digit nominal GDP growth does not equate to a $95 operating EPS stream for 2011.
Further on this file of compressed margin pressure, S&P 500 revenue growth is already slowing down, notwithstanding the fact that 80% of the universe is beating their beaten-down profit estimates. The cost-cutting wave certainly did go much further than anyone expected but as the legendary Herb Stein once remarked, “anything that can’t last forever, by definition, won’t.” At some point, the well will run dry on the cost-cutting front and slowing revenue growth will take over — on track for +5.5% YoY in Q3 from 6.1% in Q2 and the consensus now for Q4 is sitting at +4.9%. As an added signpost of how this has proven to have been a revenue-less recovery, the top-line growth since the profits rebound began just over a year ago is running at barely more than half the average pace recorded in the 2002-07 cycle.
For all the talk about profits recovery, sales are still 11% lower now than they were in the spring of 2008. And, if you are wondering why it is that the stock market has still done little more than range trade in 2010, it is because earnings estimates are no longer rising as they were in 2009 — they are falling. The bottom-up consensus now sees 12.9% earnings growth for 2011 from 14.2% a month ago and 20.9% back in the spring. Have a look at the Paul Lim column on page 8 of the Sunday NYT business section — Raising a Caution Flag on Corporate Revenue.
THE RETAIL INVESTOR SHUNS THE NEW FED-LED BUBBLE
The Fed may be successful yet again in triggering an asset bubble and kicking the stock market into a liquid sugar-high, but it may have some difficulty getting the wealth-effect on spending it so desires if the general public continues to reduce its exposure to equities.
Even with the very best September since 1939, perhaps Ma and Pa Kettle remember that the secular bull market did not commence for another decade (1949 that is). And that best September since 1939 followed on the heels of the worst August since 2000 and it is this intense volatility that is really turning people off the stock market (of course, we followed that up with the best October since 2003 no less!).
What we saw in October, even as the hedge funds and proprietary trading desks were buying, was that the retail investor was busy taking profits as they pulled $11.2 billion from equity mutual funds — the fifth month of redemption in a row (bringing the year-to-date net selling to $29.3 billion). The economists and strategist have labelled this as a bubble in bonds and bad timing even though households are, in the aggregate, underweight fixed-income securities in their asset mix and the simple fact that bonds have out-returned stocks handsomely this year as they have done in two of the past three.
Bond funds took in $24.2 billion (even $2.2 billion into muni’s) and $212.7 billion year-to-date. And, in this secular income theme, which has a demographic overlay to it, hybrid funds also took in nearly $2 billion in September.
PROBLEMS RE-EMERGING IN FRANCE
It really says something about the shape of the U.S. economy that the U.S. dollar could remain so soft at a time when debt problems in the European periphery are mounting again. Portugal is still having difficulty getting a 2011 budget plan through its legislative process. Hence, we saw a huge widening in bond yield spreads last week — the Irish-German differential at one point hit a one-month high of 462bps.
CANADIAN GDP A TREAT
While most of the excitement last Friday was focused on the U.S. data flow, Canadian GDP managed to come in as expected, rising 0.3% MoM in August. If we assume a modest increase in September, our tracking for third-quarter GP is at 1.5%, basically in-line with the Bank of Canada’s latest forecast of 1.6% (but below consensus estimates of around 2%). We continue to expect the BoC to remain firmly on hold well into 2011.
The 0.3% increase is encouraging especially after the 0.1% decline in July. However, we believe that the Canadian economy faces many headwinds, including the housing market, high personal debt and its exposure to a slowing global economy. From the details of August report, it is clear that some areas of strength won’t be repeated going forward. Construction output rose 0.4% generally (and residential construction was up 0.8%, in particular). Given that housings starts fell 1.3% in September (after falling 2.9% in August), we expect a reversal here. Manufacturing was also strong at 0.4% but given the recent strength of the Canadian dollar, output could be much weaker going forward.
David A. Rosenberg
Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919
Source: Market Musings & Data Deciphering
http://www.fmxconnect.com/
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