Submitted by Rodrigo Serrano of Rational Capitalist Speculator
Weekly Bull/Bear Recap: October 10-14
Risk markets seem to be at a crossroads. Both bulls and bears can point to a myriad of factors to bolster their case. I'd like to provide a quick rundown of the strongest points for both sides.
For the bulls, the U.S. isn't in a recession according to economic data over the past two weeks. Consumer spending, according to the most recent Retail Sales report, has rebounded. Better yet, previous months were revised higher. The consumer remains incredibly resilient in the face of a very tough macro environment. Auto sales surprised to the upside. The jobs report showed continued growth in the labor market into September. ISM manufacturing and non-manufacturing metrics pointed towards expansion. The 4-week average for jobless claims fell to its lowest levels since August. Even better is the fact that gas prices continue to fall, which may provide further respite for the consumer in the weeks ahead. Another arrow in the bull's quiver is the pervasive bearishness. Despite recent bullish data points many, including myself, remain convinced that recession is practically inevitable. This persistent skepticism would be called a "wall of worry". It's certainly in place. I have set hedges should the markets power higher, cognizant that they love to inflict the maximum amount of pain on everyone. Indeed, looking at how the market pierced the 50-day moving average like an Aaron Rodgers throw through the wind signals to me that risk markets are just itching to rally from here. The S&P 500 is testing resistance in the two and a half month-old channel.
Across the pond, we also got surprisingly good news. On the economic front, Industrial Production for France, Spain and Italy was overwhelmingly positive, in fact Industrial Production for the entire Eurozone was positive. Germany also reported strong trade data and PMIs don't show a Eurozone economy falling out of bed. Even more importantly is the perception that Europe's leaders finally "get it". Plans are taking shape regarding a comprehensive "durable" solution to perhaps the largest headwind facing the global economy today. If continued progress towards a viable solution is presented, markets would rally further in my view.
However, I feel that looking at our current environment from a more bearish perspective will prove to be prudent, starting with the Eurozone. True, we are getting continued progress towards a comprehensive bank recapitalization; but details remain very murky. Disagreement still prevails among the Eurozone's largest members. France wants to use the EFSF to recapitalize French banks, while the Germans are adamantly against such action. The French have a huge interest in Germany picking up the tab because should they need to bailout their own banks, their coveted AAA rating would more than likely be stripped. This would result in Germany, Finland, Holland (the other AAA members) shouldering a larger portion of the bailout. A pivotal question remains unanswered: are these fiscally strong countries (and their taxpayers) willing to pony up for the bailout? The other, perhaps even more important and one that most are ignoring, is how will this "fiscal transfer" from the fiscally strong to the weak take place when the German Constitutional Court has already deemed such action a "dangerous subversion of German democracy" (ie illegal)? I also forgot to mention that the newly approved EFSF is already deemed too small by the markets. Officials are looking for ways to expand the EFSF's firepower without the approval of parliaments. As Erin Burnett would say; "Seriously?". Another concern I have is that while engaging in a recapitalization program would result in near-term relief, it does nothing to solve the underlying issues causing this problem in the first place. A recapitalization program is akin to throwing more money into the black hole. Trade imbalances would persist. Germany would continue to be a surplus country, while the periphery would continue to produce deficits. Eventually another bailout would be needed. This fact isn't lost on the sovereign bond market. Spreads in Italy, Spain, Belgium, France, and Greece actually rose this week, a big non-confirmation in this recent rally in my view.
On the U.S. front, we have some important leading indicators pointing lower. Lakshman Achuthan, managing director of ECRI, has recently stated how a double-dip recession was inevitable. You also have some disconcerting data out of the manufacturing sector. The Pulse of Commerce Index has been plunging as of late. It's becoming disturbingly clear that the usual "Christmas build", an expansion of manufacturing activity in preparation for the Christmas shopping season, is absent. While retail sales did rise in September, other indicators are not confirming this newfound bullishness.
Last but certainly not least is China. China bulls have been repeatedly wrong about the inflation situation there. I remember seeing articles since early last year on how inflation was set to come down shortly, resulting in additional wiggle room for officials to loosen policy and a re-acceleration of growth. Well, it turns out that inflation has been sticker than the bulls could ever have imagined. Trade data also showed a significant slowing. PMI surveys are straddling the 50 yard line. Credit spreads are widening in alarming fashion. True, China is a black box and it's damn near impossible to get a clear reading on their economy, but news there is progressively getting worse, not better.
Overall the investment environment remains quite turbulent. The last 2 months have been an absolute meat-grinder. Both bulls and bears are frustrated. There are seemingly mixed signals everywhere. Both sides can make their cases. Economic data is improving, yet the Eurozone acts as an anchor. Which route should an investor follow? It pays to be nimble or just stand aside and wait for a breakout. I have one final thought relating to news of China investing in bank shares. Should China's banks deteriorate as the bears (includes me) suggest and a bailout be needed, it would stand to reason that they would dip into their large cache of foreign reserves. Wouldn't that involve selling Treasuries to build up liquidity? Could a banking crisis there actually lead to higher interest rates here as they free up liquidity to bailout their banks? Something to consider.
Key Event Summary
+ The Eurozone is hitting an important inflection point. Economic data has suddenly surprised to the upside. Global growth is making a comeback as the twin-headwinds, the Japanese earthquake and higher oil prices, dissipate. Germany and France pledge to deliver a solid solution to the debt crisis. All countries pass the EFSF Expansion legislation. Berlusconi survives his confidence vote, a vote of confidence in ultimate integration. The rescue plan is coming into better focus. Europe is getting its act together and that is great for the bulls. There’s a huge wall of worry for the market to climb.
+ It’s about time equity markets recognize the clearly stronger than expected economic data in recent weeks. The economy isn’t in recession and will reaccelerate in the months ahead (just look at September retail sales!). Markets are beginning to rally as high levels of bearishness constitute a high “wall of worry” for markets to climb. Did you know that relative to interest rates, the U.S. stock market seems to be discounting 2012 S&P profits of around $60 a share? (Source: Question 6 of “10 Questions for the Bears”) Earnings will surprise to the upside —case and point: Google. The global recovery is set to pick up after a Eurozone solution is presented this month.
+ This week, the 4-week average for Jobless Claims fell to the lowest level since August and is a positive for the labor market. The job market remains resilient. With the Europe situation moving forward, financial conditions will improve and job growth will accelerate in the months ahead.
+ A true green shoot, the Yuan remains in an uptrend. This would help in their fight against inflation and increase their purchasing power for global products. The global economic restructuring remains in progress. This can also be seen with recent U.S. international trade data. Growth in exports remains in healthy double-digit levels. Exports as a % of GDP has blown past the recent high in 2008. The restructuring is taking place in the U.S. economy. Furthermore, the global economy isn’t headed for a protectionist wave as 3 trade agreements with Columbia, South Korea, and Panama were approved by Congress.
+China is putting its piggy bank to work, buying beaten down banks. For the bears, who warn of a hard-landing due to mal-investment and a banking crisis, Chinese officials are clearly showing that they aren’t afraid to dip into their roughly $3 trillion in foreign reserves to bailout their banking system. They are also initiating “targeted easings” to address liquidity issues in their economy.
+ Japan’s August Machinery Orders surprise to the upside. This report is a leading indicator for Japan’s industrial sector and signals that the global recovery remains resilient to all the current headwinds. Need more proof? China is increasing its purchases of copper signaling that they don’t think prices will stay low for long due to higher demand. Australia announces a decrease in their unemployment rate to 5.2% for the month of September from 5.3% in August.
- Regarding the Eurozone, the bulls fail to “read between the lines”. An important crisis summit in the Eurozone is pushed back due to continued disagreement between Germany, France, and the ECB. The act of countries with deteriorating credit quality expected to contribute to the bailout is circular in nature and is nothing more than a shell-game. A “50% Haircut on Greek Debt” gets a cold reception from investors. The ECB finds itself torn on interest rate policy choices. Greece comes no where near its targets, yet in a sign of desperation, the troika still approves the next tranche. This puts Greece in the driver’s seat; so it pays to focus on what’s going on there (hint: not good). Trichet has some words of warning. Sure, Slovenia approves the EFSF (at the expense of a collapsing government), now what? The banks are against recapitalizations and recaps are not a solid sustainable solution to the crisis anyways. While equity markets rally, bond yields in Spain, Italy,rise for the week. France is now making some noise with the Oat/Bund spread at Euro-era records (quite the disconnect). Furthermore, you have continued red-flags of increased danger of recession in the region…
- …and the world for that matter. Indonesia signals an end to its tightening cycle as weak demand leads to a surprise rate cut of 25 bps to 6.5%. Singapore cuts its growth forecast and eases monetary policy. China’s property bubble is popping, its financial system is struggling amidst massive amounts of mal-investment, and inflation remains sticky to the upside. The country’s copper inventories are revealed to be double the estimate. Exports/Imports are weakening and the U.S. Senate approves protectionist legislation, designed to more effectively pressure China into raising the Yuan, it seems to be having a negative effect though. Trade war? Furthermore, questions arise on the current viability of the famed “Decoupling” theory. UK manufacturing falls 0.3%, a third consecutive drop, while unemployment is becoming a serious issue. Fitch downgrades UK banks and places 12+ more on credit watch negative.
- A leading indicator of manufacturing is plunging and is pointing to a significant slowdown in manufacturing activity in the coming months. Remember that manufacturing has been the driver of this otherwise very weak recovery. ECRI, 10th decline in a row.
- NFIB Small Business Survey points to continued weakness in the overall economy. While the index did increase, the rise is weak compared to the 6 monthly declines that preceded it. Owners continue to cite “poor sales” as their biggest problem. Probably because we’re in a balance-sheet recession with pre-crisis debt obligations weighing heavily on households’ post-crisis incomes and asset values. A weak small business sector translates to a continued tepid job market. A weak job market translates to weak spending and weakened consumer confidence.
- The FOMC is in chaos. We have a clear divergence of opinion and prescription for our current economic malaise. The fed straight up doesn’t know what else to do. Furthermore, fiscal stimulus isn’t forthcoming, setting up for a big disappointment when the Fed unleashes QE3 and investors realize that they are powerless.
- A “little” trouble brewing for the banks?