Rudi's View | Mar 07 2012
This story was originally written on Monday, 05 March 2012. It was sent to paying subscribers on that day in the form of an email.
By Rudi Filapek-Vandyck, Editor FNArena
If my observations are correct, the gap between supportive market factors and price action for global equity markets is widening to the extent it's probably time for longer term investors to retreat to the sidelines and adopt a more cautious approach.
While I do not foresee a return of the kind of mayhem that dogged risk assets in August last year, I do sense that the overall bias has now shifted to the downside. As things stand right now, I expect any "correction" -if and whenever it occurs- to be a mild one.
Long term investors who continue to focus on high quality, "all-weather" performers that are lowly priced and have firm dividend support can ignore this message as any market retreat is unlikely to have much of an effect on these share prices. Examples are Transurban ((TCL)), ASG Group ((ASZ)) and Ardent Leisure ((AAD)).
Global equity markets have put in a strong rally since mid-December following relief in the European saga (ECB's liquidity injections plus a "solution" for Greece) and better-than-anticipated data from the US economy. Renewed buying interest has fed into improving technical indicators. As things stand right now, some technical indicators remain positive and the more bullish biased chartists continue to predict risk assets, including US equities, will soon break-out to the upside.
This would suggest my observed gap between "fundamentals" and "technicals" has no value whatsoever and risk assets can possibly rally higher at any given time. However, I think investors can draw a timely lesson from what happened in the silver market last month, when technical resistance was "broken to the upside" and the subsequent wave of technicals inspired buy orders pushed the price of silver in one fell swoop from $34-something to $37/oz.
Just like that.
We are now a few weeks later and silver is back at $34 (see price chart below).
The lesson for equity markets, in my view, is that "sentiment" and "technicals" can only take "momentum" so far. Rallies need "fundamentals" to provide ultimate back-up. Right now, I believe that, contrary to general market commentary, the fundamentals underneath this rally are weakening, not strengthening.
1. Economic Data
Let's start with the most obvious of observations: economic data have become less supportive. This is not immediately apparent when relying on general commentary, but then most commentators feel they have to adopt a positive bias.
Wall Street firms like Citi and UBS construct their own proprietary index for economic surprises as history shows there's usually a strong correlation between an uptrend in surprises and a rise in risk appetite, as we've just witnessed over the weeks past. However, indices at Citi and UBS are now clearly showing divergence. The indices are stalling and the respective analysts are concerned as it appears the trend is about to "roll over".
2. China
Chinese data so far are suggesting a slow and gradual pick-up in activity post Chinese New Year. This has been taken as a positive by markets, but… usually the return of overall momentum for the Chinese economy is more pronounced.
In other words: a little bit of strength this time around is relatively disappointing. It brings back memories of last year when commodity analysts at UBS, while staring at a weaker than usual monthly manufacturing PMI, concluded the Chinese government had successfully de-coupled economic momentum from its previous sharp seasonal cycles.
I questioned this logic at the time. As it turned out, the Chinese government had achieved no such thing and underlying momentum for the Chinese economy weakened noticeably in the following months. Is history about to repeat itself in 2012?
One can assume that if things go pear-shaped in China, the authorities will be ready to re-stimulate the economy, but investors better not forget the order of events: first momentum proves weaker than expected,…
In addition, it should be clear to all but the blind the current administration in Beijing will continue its anti-bubble policies towards Chinese property markets. This month's National People's Congress, if anything, confirms the bias has shifted, and is likely to remain, towards "prudent" policies, which suggests tighter not looser monetary conditions.
3. Linear Thinking
Even some of the more optimistic economists around the globe are now conceding economic data and forward looking indicators have been distorted in the past three months on the back of milder than usual weather in the Northern Hemisphere. This means there is going to be some sort of payback at some point. But when?
Above all, however, I am always surprised by how the majority of economists and market commentators instantaneously adopts a linear approach whereby a better economy yesterday automatically means we'll also have a better economy later in the year. This becomes even more so when leading economic models do not subscribe to such a trajectory. Of course, these models, like anything else, are not necessarily flawless (they're not), but it does suggest that what we are experiencing in terms of economic and corporate profits momentum is closer to a peak than a bottom.
Note for example the Economic Cycle Research Institute (ECRI), both leading and infamous on Wall Street depending on what source you ask, publishes a weekly leading indicator which just surged to its highest level in six months. However… ECRI also maintains most economies around the world, including the US and Australia, peaked in the final quarter of 2011, suggesting the underlying momentum is downwards, not upwards.
A similar picture appears on a forward looking indicator from highly regarded IHS Global Insight. This economic forecaster publishes a monthly indicator in cooperation with newspaper USA Today and the February update suggests, in line with ECRI, the US economy is currently experiencing a "peak" in momentum, not the start of a new uptrend. According to the USA Today/IHS Economic Outlook Index, GDP growth in the US will be around 2.5% in the first two quarters of calendar 2012, but the second half will see deceleration to 1.6% by year end.
Problem number one is the latest update for this index dates from February 6 and while 2.5% looked pretty accurate at the time, it no longer does today with economists' revisions suggesting a number closer to 2% growth. I expect the next update, sometime this week, to reflect this lower momentum. With Q4 2011 GDP printing 3%, I'd say watch out for economists talking up the overall strength in the US economy.
Economists at JP Morgan had a genuine shock last week when the latest round of monthly manufacturing PMI surveys around the globe translated into a general fall in underlying momentum. Making matters worse was not only did JPM's proprietary index weaken from January's rise, but various forward looking indicators in these surveys looked worse. This, at the very least, points to loss of momentum.
4. Banks and governments
Yes, I know, we've all got excited (at least most of you, traders and commentators out there) after the European Central Bank injected no less than an extra EUR1trn into the European banking system, but most of these funds have been used by these banks to improve in-house liquidity and to take a punt on peripheral government bonds with effectively "cheap money". This is why interest rates on government bonds for Italy and Spain have fallen.
The problem is, however, that apart from keeping European banks solvent, and from relieving governments in troubled countries from immediate market pressures, and from stimulating global risk appetite, these liquidity injections have not done anything for European businesses or the economy. Equally worrisome is that US data are suggesting the banks over there are again tightening their loans to large firms. This is in particular worrisome because part of the investment community is worried that profit margins for US companies have now peaked, which would suggest slowing momentum ahead despite an apparent improvement in the economic picture.
Corporate profits in the US as a percentage of GDP are at an all-time high. This is not a short term concern. The last time this occurred was in 2006 and equities continued their rally for another year, before selling off. The peak before that dates from 1998 and back then the final stage in the world's "irrational exuberance" had yet to take off, but there will be some consequences in the near term. History suggests there is a close relationship between capital expenditure (capex) and corporate profit growth. Can we expect something similar for new jobs?
At least one commentator recently pointed out it was quite remarkable how well financial markets had behaved in light of all the talk about inevitable austerity in Western economies which will, of course, keep a lid on overall growth.
He then continued: wait a minute! We haven't seen any of it as yet?!
This is correct. Apart from the European periphery, government austerity is still something that lies ahead. The general expectation is that whoever gets elected as US President later this year will immediately have to deal with the government's debt ceiling, and ultimately, of course, with reducing the debt and reducing overall government expenditures.
All politicians around the world, not just in Europe, have done is kicking that can (of worms) further down the road. But we'll be talking about it again at some point. How about in a few months' time?
5. Crude oil
Someone smart at UBS has put together a chart that correlates the movements in the price of crude oil with the investment banker's proprietary index of global risk appetite. Guess what? The correlation since December is so high it's almost impossible to distinguish which is which on the chart. This perfectly illustrates the conundrum for risk assets this year. More exuberance from investors only makes sense if the price of crude oil de-couples from positive sentiment, but exactly how is this (ever) going to happen?
In conclusion: underlying support for continuation of the rally in equities and risk assets in general has weakened and it might potentially already have turned the corner. Some of the issues I mentioned are likely to gain more prominence later in the year, but some of these issues might start impacting as early as this month.
(This story was originally written on Monday, 05 March 2012. It was sent to paying subscribers on that day in the form of an email).
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