The commodity market is saying global growth is slowing. But, there is hope, as BofAML's David Woo notes, the US equity market is saying US consumers are still going strong; and the FX and European sovereign markets seem to believe Mrs. Watanabe is about to embark on a global shopping spree. However, like us, Woo thinks it is unlikely that these markets will all turn out to be right. At the same time, we agree completely with Woo's assessment that markets may be under pricing three macro risks: the ability of Beijing to ease policy aggressively in the face of strong home price appreciation may be limited; the positive wealth effect of US housing recovery may not be enough to offset the contractionary impact of fiscal tightening; Japanese money may stay at home longer than expected. As he concludes, "something will have to give and a major re-alignment of the markets, the odds of which are rising, will probably not be either smooth or benign."
Via BofAML's David Woo,
The circle that cannot be squared
It is probably an understatement to say that lately it has become more difficult than usual to read markets. Many relationships/correlations across markets that are often taken for granted are weakening or even breaking down. Nevertheless, emerging from price action are three distinct macro themes that appear to be shaping market consensus and guiding investment flows:
1. The global economy is slowing down. Industrial commodities have been sliding for the past two months, with the LMEX metal index down 14% since mid-Feb and now at levels of last summer during heightened concerns about both Europe and China (Chart 1). Despite recent strong US stock market gains, cyclical sectors have been underperforming the more defensive sectors since March.
2. US consumers are still going strong. The US stock market has been the best performing major stock market this year and consumers have led the rally. Even with the correction this week, S&P 500 consumer staples and consumer discretionary are still up 16% and 12% year to date, respectively. Indeed, Q1 was only the second time since 2000 that in a rising stock market both consumer discretionary and consumer staples outperformed the S&P 500.
3. Mrs. Watanabe is about to go on a global shopping spree. Since the BOJ meeting on April 4, emerging market currencies have staged an impressive rally and peripheral debt spreads have tightened (Chart 3). Market expectations that aggressive BOJ monetary easing will push yield hungry Japanese investors into the arms of risky assets have driven up, almost indiscriminately, the prices of global high yielding assets.
To the extent that these themes reflect market expectations of reality, there seems to be three different versions of reality right now. The commodity markets are trading on the first version, the US equity markets are trading on the second, and the FX, EM and peripheral debt markets are trading on the third. Who is right and who is wrong?
In our view, it is unlikely that all three markets will prove to be right. In this respect, we are concerned that the current market equilibrium may not be a stable one. Something may have to give and a major re-alignment of the markets, the odds of which are rising, may neither be smooth nor benign. We believe markets are under pricing this risk.
1. Global slowdown difficult to refute
The body of evidence suggesting that the global economy is slowing is growing almost every day. The latest manufacturing PMI warns that the recession in Europe may be deepening (Chart 4) just as the Eurozone unemployment rate hit a new decade high of 12%.
The weaker-than-expected Q1 Chinese GDP data only reinforces what soft electricity production data and railway freight volume have been telling us for a while (chart 6).
This time around, things may turn out differently as the strong momentum behind recent home price appreciation may hold back policymakers from easing quickly and with decisiveness.
2. Moment of truth for US consumers
The prevailing optimism towards US consumers reflects the view that rising home prices will offset the impact of fiscal tightening. We have argued that whether this will turn out to be the case will depend critically on what happens to consumer confidence. Michigan consumer expectations fell in April to the lowest level since the fiscal cliff crisis. Furthermore, with the household saving rate having fallen to just 2.6% in February - the lowest level since December 2007 - household consumption could be more vulnerable than usual to any sudden confidence shock.
In our view, the market continues to underestimate the headwinds associated with the implementation of the sequester. Our US economist team estimate that this will amount to about $50bn worth of fiscal tightening over the next six months. If we were to assume that this will primarily take the form of reduced wages/salaries of government employees and contractors and that most of the hit will occur in Q2, this could result in a very dramatic shock to household income (Chart 10).
3. Mrs. Watanabe to save the world?
Japanese policymakers have taken the world by storm in the past three months. Their determination to reflate the Japanese economy at all cost is both unprecedented and impressive. While only time will tell whether or not their shock-and-awe policy will be successful, many investors now believe the BOJ’s aggressive easing will have global repercussions by sending Japanese investors in search of higher yielding assets away from home. This may be a reasonable assumption but the question is how quickly this will happen. In our view, there are at least three reasons why this could be slower than generally expected:
1. Japanese money to flood global markets like it did in 2005-7, Japan’s deteriorating trade balance will have to first turn around (Chart 13).
In our view, this is unlikely to happen quickly.The two main factors behind the dramatic deterioration of Japan’s trade balance since 2010 were a surge in Japan’s energy imports and the slowdown in the EU and China. The recent depreciation of the JPY will have very limited impact on either. Indeed, Japan’s trade deficit could worsen in the short-run as the result of the price inelastic nature of energy demand.
2. The fact that the BOJ’s aggressive easing has so far failed to reduce the volatility of Japanese markets will also limit the appetite of Japanese investors for foreign assets. Indeed, adjusted for FX vol, US Treasuries and core European bonds have never been so unattractive for Japanese investors over the past ten years (Chart 15).
3. foreign assets as a share of total assets of Japanese pension funds and life insurance companies rose in 2010 and 2011 even while the JPY was strengthening (Chart 18).
Q4 data suggest that foreign assets as a share of total assets was just shy of the 2007 all time high. Given the JPY has since depreciated 20%, it is reasonable to assume that Japanese pension funds and life insurance have never been so overweight foreign assets as they are now.
Risky assets have had a mini-correction this week. What is interesting, however, is that the risk premium of cyclical assets remains quite low, suggesting that investors see the correction as a one-off repricing.
We see this as offering a cheap insurance against the possibility of a synchronized global slowdown.