Driver – Why deteriorating Franco-German relations matter…

Over the last five years most asset price moves were based on policy decisions. They always necessitate compromise, and that’s why ideology is so counterproductive in these circumstances. Last year the conflict between Republicans and Democrats threatened to put the US back into recession. Now it is the conflicting views of France and Germany that are threatening the whole European project. That matters greatly, but so far the liquidity addicted markets don’t care.

For the European crisis to be solved, there is no other way than to have some sort of fiscal union (call it mutualisation or solidarity if you prefer), and that necessarily means democratic representation (control), which means some transfer of sovereignty from states.  There are no doubts about that, hence the bigger question is what are the odds that this is going to happen? It is not a macro question but mostly a sociologic one, so it is quite tough to say, but unfortunately I fear that they have been diminishing.

 

1/ Where do we stand?

The insult by the French socialist party to Merkel (selfish intransigence) is a very significant event showing how bad the relationship has turned. It is quite shocking actually, a political party and its leaders are insulting personally Merkel. The fact that amongst the persons doing so, there is the third official in the French state (Claude Bartolone – president of assembly) is even worse! That’s a good evidence of the fact that the beliefs of the French socialist party are particularly affected by Merkel’s policy and by the crisis. More important for markets it confirms that the whole “conditionality” concept (austerity against financial help) which is still so far at the core of the framework for crisis resolution in Europe is now irrelevant.

Despite that, the markets seem quite happy to see the struggle against austerity start – with Italy and France fighting against Germany. Of course, I am not saying that short term austerity is a good policy, it is a major policy error. Particularly in the case of Spain or Portugal which have already made significant reforms. They now need growth and austerity is killing them. I believe that if Germans continue to insist on short term austerity, it is not because they read Rogoff and Reinhart, and didn’t hear about the mistakes. It is maybe simply because they don’t trust yet the pre-commitment of their European partners to reform tomorrow. In other words, the problem for Germany is how conditionality of financial help can be forward looking? How can peripherals countries commit credibly to reform in the future (once growth improve), despite the fact that most of the countries we are talking about have a terrible track record at implementing reforms…?

PIMCO’s Bosomworth has written a great piece on the subject. I agree with everything he says so I am not going to rewrite it. Some of the key conclusions are: 1/ “The eurozone’s challenge is to balance conditionality, mutualization and democracy, which will require national legislatures to hand over more responsibilities to a centralised chamber of governance and enable its citizens to participate in choosing who to represent them in it. Without democratic representation, the eurozone cannot consider a common fiscal capacity.” 2/ “Without political commitment to a common fiscal destination, the long-term instability and market distortions within Europe’s capital markets are likely to intensify”. => In other words, to solve the crisis, some kind of fiscal / transfer union is necessary and that will necessitate some transfer of sovereignty.

To underscore the critical importance of this political process, there is an interesting statement from Martin Schulz – president of the European Parliament – in the FT he said “The consensus on Europe is in freefall”, “The EU is really threatened by failure”, “I think we should not underestimate the dramatic reality”.

Some tend to believe, that Germany is going to lay down, and abandon its requests and the principle of conditionality. “Ultimately, Germany can’t really force France to do anything politically. I mean, once France turns against Merkel’s policies it is pretty much over and Germany will have to acquiesce” according to BCA research. I frankly have big doubts about that. First the “Swabian housewife” model seems very popular in Germany, and even the German Social Democrats are unlikely to accept France’s requests. Second, the whole issue at stake here is whether or not the generous European welfare state models are still affordable, and everybody but the French socialists know it is not (actually most of the socialist leaders know it is not, but just pretend to the contrary). So it doesn’t make sense for Germany to just accept to finance a system in structural deficit, particularly if there is not at least a credible commitment to reform things in the longer term.

2/ Consequently, the relevant question is, how likely is France to accept a transfer of sovereignty?

I would be quite surprised (but very pleased) if that was occurring without a major recession first, at least with the current majority in French Parliament.

To start with, it is important to remark that France – like Japan – is a country that is known to need crisis / complete paralysis to be able to reform because the system lacks flexibility and pragmatism. For instance, France has had many revolutions 1789, 1830, 1848 and you can count 1871 as well. For instance, in France, almost every September you have “general strikes”, usually from the public civil servants, that paralyse the country, sometimes for weeks (though that has diminished in the last few years). So from an historical / cultural perspective, it looks unlikely that major changes will be supported before there is a deeper sense of economic crisis.

Let’s note as well, that there has been interesting proposals for a more integrated Europe from the Germans (Schaeuble plan) and from the Gang of 4, and France has not reacted or proposed anything concrete (to my knowledge), just calling for more “solidarity”. For instance Florence Autret, political reporter of the French business newspaper La Tribune wrote  when the two plans were proposed in October: “Nobody in Europe can have any doubt: France has no “grand design”, no “secret plan” to lay the foundations for a new political and institutional deal reconciling European social market economy and the constraints of Darwinian globalization.[…] Under the old French majority, as in the present, the crisis has shown that Paris was simply not ready. Here, the comparison with Germany pushing since 2009 for a wide debate on the objectives of the Union and now openly calling a Convention to which it is prepared, is once more cruel”.  Not too encouraging.

To explain why the French political elite (not just the left) seems opposed to endorse such a European project involving some sovereignty transfer, she makes an assumption, she believes that French politicians are “Gods who hate to leave their Parisian Olympus”, “they hate to leave the easy and well defined grounds of French politics where everybody has his pre-define role”. So according to her it is likely due to “a mix of laziness, provincialism, pride and complacency”.

Maybe other assumptions can be considered, quite rational ones… Maybe the elite fears losing its power if it starts sharing it through sovereignty transfers ? Opening a closed system is always a major risk. Martin Schulz in the FT article quoted previously said that France was in a “deep psychological crisis created by a justified mistrust for a political system that has created a political class that is completely disconnected from the rest of the country”. Frankly, few French people I know would disagree.

To understand what he means by “political system” and “political class”, and consider the assumption above, one needs to know a few facts about how France is managed (government and large companies). To discuss that I will quote a few facts from a great paper called “Are economic elites still so different in France and Germany? “ (it is in French).  The author finds that “The [French] model of elite formation, whether political, administrative or economic, always seems to be characterized by social closure resulting from a meritocratic approach exclusively based on results at school”.  He finds three interesting system specificities in France: 1/ “In France, the tyranny of diplomas – According to Joly (2005), about 70% of the directors of ministerial cabinets were énarques (ENA school) in the 1990s”. 2/ “Early selection of French elites- Once the student preparatory class is “admitted” in a grande ecole, two or three years after graduating, at the age of 20 or 21 years, its future as a leader in the administrative, political or economic sphere is assured”. 3/ “A specifically French feature is the migration of political and administrative elites of the ENA and the great bodies of the state to the positions at the top of the major French private companies.” “In the early 1990s, only 3.5% of the leaders of ‘Top 200′ came from the German government, against 44% in France”.

Of course I am not a sociologist or political analyst, so keep in mind that this is a gross oversimplification, but it is true that these facts and figures tend to support the view of some political critics of the French system who have long considered that there is, to some extent, a closed group at the top in France – made of top civil servants, top government decision makers, and ex-government officials now at the top of major companies – that have all gone to the same school, and who have been primarily selected based on their grades when they were 21 and on who they know, rather that on what they have achieved in their career. The critics call it a kind of “oligarchy”. To what extent is it true? Nobody can say (it is the nature of sociology), but few French people would disagree with the fact that it is at least partially true. My point is that if that is true, it surely wouldn’t make sense for members of this closed elite at the top of the system to be willing to share power, unless it is forced to do it. Like all closed systems, it has to remain closed to last. Again, I am no specialist on that, but it definitely looks like a plausible explanation for the refusal to consider sovereignty transfers by the French political elite.

So could French people themselves be the catalyst for a change? Don’t they want more Europe, and don’t they understand that the French Social Model is not sustainable and thus has to be reformed to be saved? Highly unlikely I think unless a great pedagogue comes up (or the sense of crisis worsens significantly). To illustrate that, I will just give an amazing quote of Olivier Blanchard – French, ex MIT professor, and now head of economics at the IMF: “France is characterized by a surprising lack of understanding of economics. Probably due to the importance of Marxist tradition, as well as the consequence of the small place given to the teaching of economics. […] French politicians from left and right are partly responsible of this lack of understanding. They prefer to confort the opinion in its ignorance rather that use pedagogy”. [Capital n°184 (01/2007) - p.138-140 "La France se porte mieux qu'elle ne le croit"]. Quite striking statement! To illustrate his point further, it is funny to  note that “contrary to anywhere else in the world, where a consensus of economists agrees on a majority of economic subjects, it is only in France where disputes amongst economists persist” [on oudated debates on economic questions that have been solved a long time ago]. [In “who is benefiting from the lack of economic understanding of the French?”  / A qui profite la sous-culture économique des Français ? – Problèmes économiques n° 3030, 18/May/2011].

3/ So is everything doomed?

At least I can finish on a positive note, the just announced nomination of Jean Pisani-Ferry as an advisor to the French government is very encouraging. His article where he lays out how he recommends pre-commitment to reform in the long term rather than austerity in the short term as the conditionality framework is exactly the kind of solutions that have to be adopted.

Let’s hope that Hollande’s government will have the political room to implement such a program, that their commitment will look credible enough for Germany, and that the Germans will finally trust their partners and agree to stop focusing on austerity in the short term.

More generally, let’s hope that given the severity of the crisis, some thought leaders on the right and left in France will emerge, with an articulated vision for Europe, that would recognize that reforms of the French social model are needed (not just tax hikes) in order to save it, that some amount of sovereignty transfer is now needed, and that would have some great pedagogic skills to compensate for decades of ignorance.

Enough of the Ostrich policy.

Key Takeaway :

How Franco-German dialogue evolves is going to be the key in the resolution of the European crisis. If as I expect, Germany continues to refuse to abandon conditionality, and France continues to refuse to consider reform on the political side (not just the economic one), then it means that we are surely going to enter into a new phase of the crisis. And the market is not pricing that at all right now.

The willingness of France to consider some political reforms at the European level is central in this process, and we have seen no encouraging signs yet, on the contrary. So far the ECB (OMT) and the BOJ (or to be more precise the expected but not yet materialized outflows from Japanese Investors) have saved the day, with some OAT yields now at record lows. Given the economic slowdown, that will last only for a time.

Driver Update – US data, a pivotal day,

A month ago, I wrote an update about the three main market drivers. So far, I was right on two of them – Europe (crisis of the resolution framework) and China (tightening not positive in the short term). Now we are going to know about the third factor – the impact of the US fiscal drag. Today’s data are likely to be pivotal. Non US market might start bottoming, OR conversely US equity market will start breaking on the downside (watch 1540). Indeed, most economists have remained positive despite the disappointing run of data in the last few weeks, and the S&P500 has traded in line with that view. However economists recognize that the risk is that this temporary weakness could actually be a spring slowdown, or even worse a delayed reaction to the fiscal tightening. Today’s Phily Fed and Initial Claims will be key. I favor the bearish outcome.

Already in March Dudley was warning, “I note that the recent improvement in payroll employment growth, which gets much of the attention, is out-sized relative to the growth rate of economic activity that supports it. We have seen this movie before. When this happened in 2011 and 2012, employment growth subsequently slowed (see chart). Because growth this year will be constrained by fiscal consolidation, there is a risk that this could happen again. As a result, it is premature to conclude that we will soon see a substantial improvement in the labor market outlook”.

Since then, the run of bad data has been quite impressive: Conference Board confidence dropping from 68 to 59.7, Chicago PMI dropping from 56.8 to 52.4, ISM from 54.2 to 51.3, Nonfarm Payrolls down from 268k to 88k, small business confidence (NFIB) from 90.8 to 89.5, Michigan confidence from 78.6 to 72.3, NY empire survey from 9.2 to 3.1…

After all, with Europe and China slowing significantly, even without the US fiscal drag, it wouldn’t be so surprising to see a slight growth deceleration. But the big issue is the effect of the sequester and tax rises. Most economists seem to hope that it was just a one month psychological effect. But they recognize that over the last few months, the economy may have been supported by temporary factors such as post hurricane rebound, dividend payments before the fiscal cliff, post-election confidence relief…

Actually, what matters is not that much that the economy might slow somewhat, but the fact that the US equity market has not priced that risk at all. The fact that the tail risk of global slowdown might be rising (triple hit of China’s slowdown, European austerity folly, and US fiscal drag) is not priced properly. One reason to explain that contrast is that we just went through the earnings season, and many earnings were good. The problem is that these announcements were mostly artificial as a staggering 78% of companies have issued NEGATIVE earnings PREannouncements. Worse, according to Reuters, “There have been 4.7 negative first-quarter preannouncements for each positive one, according to Thomson Reuters data, the worst ratio since the third quarter of 2001.”

Conclusion:

Today’s US data are the first important ones covering April. Economists say that one month of data weakness doesn’t make a trend… today’s data if they are weak would signal a second consecutive month of weakness. So growth revision would follow.

A rebound is possible of course, and as I said in my last post, that would stabilize commodity and European markets for a time (they already had a significant correction, most are now on key support levels, so now need the US to join the move or they might rebound – that’s why it is pivotal).

But given 1/ the S&P’s current level, 2/ the run of bad US data last month, 3/ the weaker data out of Europe and China, I believe there is more value from a risk/reward perspective in playing the downside. If this scenario of a temporary loss of momentum in the US was confirmed for the coming weeks, I would recommend to short US equities, Oil and Metals and buy the USD/MXN and the USD/CAD.

RV – Is it finally THE commodity bear market?

One month ago I wrote “I would tend to believe that the commodity super cycle is over. That doesn’t mean that we are already in a bear market. Unless investors lose faith in the asset class.” There are signs that it is happening, so there could be value in riding the unwind wave. Let’s see why.

A month ago, I read an article on project-syndicate.org stating that “the commodity super-cycle is not over”. I reacted and explained why I disagreed, particularly for three reasons that were not covered by the author. Here is a copy of my text (which is still on the website in the right hand corner) which is I think a good overview of the commodity drivers, and quite relevant following the recent market moves.

MacroTTT: “You are definitely right on global demand for commodities as a whole, but that doesn’t mean that prices will rise further. I believe there are three important issues that you are not treating – 1/ China’s investment cycle, 2/ the rise in production capacity, 3/ Investors’ exposure.

THE most important factor is that there has been an investment boom in China that is not only not sustainable but threatening Chinese growth. Even the Chinese authorities accept that fact. This boom had an exceptional impact on metal demand (read RBA’s research for instance). The biggest part of this demand is past. And even if urbanization programs are going to compensate some of that demand, it will probably not fully replace it.

The second one is the opening of new capacities that occurred through this demand shock (tar sands in Canada, Shale Oil in the US, new mines everywhere in Australia, Africa, etc…). It is not just a question of demand, but supply as well. And supply capacities have increased significantly in the last few years. There is a reason why ALL the board of big mining groups have been replaced last year. It is because they all over-invested because they had excessive faith in the super-cycle.

Third, the level of market expectations reflected in current prices is already very high. More specifically, the amount of money invested in commodity funds (see IMF data for instance) is staggering. If investors start reducing their exposure to that “miracle” asset class, then we will see a much bigger drop.

So all in all, like the RBA, I would tend to believe that the super cycle is over. That doesn’t mean that we are already in a bear market. Unless investors lose faith in the asset class.”

That was a month ago, so now let’s give a bit more material on each of the different points and an update.

1/ On China:

To illustrate the first idea – the colossal importance of China’s investment cycle in the commodity super-cycle – here are a few charts. This IMF paper gives a quite good overview. As an illustration, the two first graphs show the rise in China’s Copper demand relative to the global demand, and also how steel consumption is split by economic sectors (2003 data). The third chart (from the RBA’s Monetary policy report – with more recent data) also suggests that despite the urbanization urge, the overall commodity demand is likely to be affected by the switch in China’s growth policy.

2/ On excess supply:

Every day in the FT you have articles about over-supply in commodities – particularly metals. Read for instance “Copper miners forecast years of surplus”.  The CEO of Glencore talking about the CEOs of other large commodity groups said that “the big guys really screwed up”, and that “We’ve got to learn about demand and supply.” It is funny really; you have here a live demonstration of how self-interest from CEOs and short termism in management can lead to massive excess supply through a cycle. It is human nature, and it’s not their company so why should they care? Anyway.

3/ Are long term investors finally getting out?

The IMF chart of flows below (from WEO 2012/01 – unfortunately I have no recent data) shows that there were unwinds in mid-2011, but far short of what had been accumulated in the 5 prior years. The price action over 2012 / 2013 (decent rebound) would tend to suggest that there was no capitulation on the asset class yet, so long term investors are probably still very long.

4/ Why did this month drop occurred?

It has a lot to do with China’s policy following the leadership change in mid-2012. Commodity investors got scared in 2012 when China growth slowed, there were unwinds, but not capitulation. Then the government temporarily made a small scale remake of 2009 policies (see below), this was obviously positive for commodities, and the party resumed – metals and miners were up sharply. But it now finally appears that the old growth model is over. China is changing, growth has to be rebalanced from investments to services and consumption, and overall growth has to slow, in a world where investors are still massively long, and excess supply is obvious. I guess that as long as the demand for commodities generated by the new urbanization policy is not clearer, commodity markets (metals in particular) will remain weak.

Pimco’s Toloui has a great description of the recent policy shifts, so I’ll quote him. “Policy in 2012 was essentially a downscaled version of that in 2009, when China’s policymakers relied upon a massive credit expansion aimed at public investment to counter the global financial crisis. The difference in 2012 was that the credit flowed not through the formal banking system, but rather through off-balance-sheet vehicles, colloquially known as the shadow banking sector. Most of that credit flowed into infrastructure investment undertaken by provincial governments. In 2013, we are likely to see a reining in of these expansionary credit policies and a consequent fading in the strength of the economic recovery. China’s economic leadership is cognizant of the risks of continuing policies dependent upon investment – which is already almost half of GDP – and perpetual debt creation that could undermine financial stability. In addition, the excess liquidity that has resulted threatens to push up politically sensitive food prices and push property prices further out of reach of the Chinese middle class. So whereas slowing growth was the primary risk in 2012, the focus is shifting to systemic stability in 2013. Policymakers will seek to tighten enough to wring out excesses, without tightening so much that it produces liquidity problems and financial distress among banks and companies.”

Conclusion / where next?

Overall, I tend to believe that the down move will gather more momentum only once the US equity market joins the move. With the end of the earnings season soon, and the shift to negative surprises on US data (sequester effect) and continuous disappointing data in China, we could have the right catalysts.

Consequently there is a good case for trying to ride the down wave. In terms of timing – it seems that the HF community is already quite short the asset class, so one should keep tight stops, and attempt to build short exposure mostly on rebounds. Moreover $325 on Copper, and $100 on Brent are big supports and so are unlikely to break at once. But it will an important signal to get active once they break. Commodity currencies could also be good vehicles to play that move – even if some have broken their correlation to commo recently, that was during the range so will likely prove temporary - I think for instance of CAD, AUD, BRL, even MXN.

What’s the potential? In the medium term, it is definitely a case of adjustment to: 1/ the shift to the new growth policy in China, 2/ excess supply following years of investments coming into the market, 3/ and investors’ positioning adjustment, 4/ plus eventually, negative data surprise in the US. So, new lows are likely, but, I wouldn’t call the move “THE structural bear market” (for metals in particular) as yet, because we need to see first how the urbanization policy in China is going to affect its commodity demand. One thing is sure; the switch in China’s growth policy means that the best part of the super-cycle is now over for many commodities.

Driver – Can the Great Rotation avert a US equity correction?

As the divergence between US and European and Chinese equities becomes acute, the idea of the great rotation continues to be widely used to explain the US market’s resilience. As I wrote before, such a portfolio adjustment towards riskier assets and away from safe havens could surely limit the extent of any consolidation. But what are the evidences that it is taking place?

In my March 6 Global View, I wrote that the main risk to my consolidation scenario was that buying flows could prove overwhelming. These flows would correspond to portfolio adjustments following the fading of tail risks on the global scenario. This risk is surely not taking place in European or Chinese / mining equities, but the resilience of US markets means that it is worth having a detailed look at flows. The great rotation can be broken down into three main sources of flows – out of bonds, out of central banks’ balance sheet, and out of cash.

* The first proposition, which is actually the core idea, is that investors are going to get out of government bonds to buy riskier assets. First remark, eventually, I fully agree with that proposition. But, the only thing is that the sequence can be broken down. Most participants seem to expect a simultaneous drop of government bonds and rising equities. I think that is not likely to happen this way. Instead, investors will first get out of bonds and raise cash levels, and then once things stabilize get into equities. Second remark, as anyone can see, government bond yields remain extremely low with the 10Yr Treasury at 1.85% (record low at 1.40% in July 12), and 10Yr Bunds at 1.27% (record low at 1.17% in July 12). Bernanke in his recent speech on Long Term rates showed an interesting break down of risk premiums on Treasury (see chart below) and they remain at record lows. Third remark, EPFR data show that bond funds inflows have actually continued to increase in the last few months. Note, that Gold – the purest bubble safe haven asset – has corrected from its 1900$ tops, but at 1600$ remains far above its levels of a few years ago. All that to say, that so far, we are not exactly seeing a rush out of safe havens.

* The second proposition, is that the huge liquidity – the $5 trillion – created by central banks which has been horded in cash and Treasuries is about to be switched into risky assets (read equities). I must say I am somewhat puzzled by the suggested mechanics behind this assertion. Indeed, for this to happen, it would mean that Banks would have to put their reserves – currently held at the central banks – into riskier assets. First, I guess that given the regulatory environment (no more proprietary trading, increased risk ratios) that would not be that straightforward. Second, if they do, it is primarily going to be in credit (remember the velocity concept). Third, and most important, there is absolutely no sign so far of a significant reduction in non-required reserves (see chart below). So this source too doesn’t seem relevant as yet.

* The third source of flow, the most relevant (but one that was not envisioned initially in the great rotation framework) is that cash levels are going to be reduced in favor of risky assets. As I have said before, this has been happening. The EPFR data indeed show that there have been some outflows out of Money Market funds. I have seen the entire data set (but can’t show it here unfortunately), and the recent reduction is nothing huge. More important, there is probably a level below which the cash levels are unlikely to be reduced further. For instance, the Merrill Investors survey’s cash level remained close to its lows of 3.8 in March (see chart in this post). And the Fed’s data (Z1 flow of funds, and H6 Money stock measures) show that Retail Money Funds are already below 1997 lows (see chart below)! And institutional money funds are below 2007 levels. So yes cash levels have been reduced, but based on the data I have, it seems unlikely that this could go on forever and in proportions significant enough to prevent a US equity correction.

* This issue of cash levels brings me to another source of the equity rally which has nothing to do with the great rotation – share buybacks and corporate profitability. Dudley in his as usual enlightening speech, explains that “U.S. corporate profits relative to national income are at an all-time record and cash balances are very high. As uncertainty recedes and the outlook improves, I expect business will increasingly shift towards real investment from mainly buying back shares and hoarding cash.” I find this statement very interesting because it deals with two important sources of the equity rally. First, as the economy improves, cash will increasingly be used in Capex (that’s what most forecasters expect), and share buybacks will slow. Second, corporate profitability tends to rise strongly during the first part of the recovery, as long as the labor market remains weak. That is what has happened so far, but also in the two previous business cycles. But the chart below shows that corporate profitability tends to peak after wages start rising… and they have started rising. Moreover, the current record profitability probably has something to do with the exceptional hit to the labor market. But the flip side of this hit is that once things normalize, the peak in profitability will likely be reached faster.

Key Takeaway :

When I read that the great rotation and the central banks liquidity wall is going to fuel the risk rally and prevent any imminent correction, I have my doubts, because I see no signs of that anywhere. The drop in bonds – and structural bond bear market will surely happen, but that seems too early, and in any case that will likely start by rising cash levels, and will not flow directly into equities. The reduction of cash levels has been a relevant factor behind the rally’s strength. But there is a limit to how low they can go. Finally, shares buybacks and corporate cash and profitability are all likely closer to their peaks, as we are starting to see a normalization in the US wages / labor market.

So all in all, I stick to my Global View scenario (likely correction – see two previous posts) as this risk factor (global rotation triggering overwhelming buying flows) appears to have limited substance so far. As an indicator of Run on European banks I will of course focus particularly on the OIS/Euribor Spread in the coming weeks.

Global View Update – 3 structural shifts to watch this week…

I see at least three major issues this week that could trigger the start of important price trends.

First, the big question – what’s up with QE prospects following continuously strong US data, and will the 10Y USD continue rising? The theme started appearing last month with the Fed’s minutes, was then quelled by Bernanke and Yellen’s dovishness, but came back to the front stage last Friday with very strong NFP. Is the market about to worry about an earlier than thought QE? Or to put it another way, is the market going to shift from structural complacency to reservations on the level of long term yields? It is surely what the sharp move in the 10Y USD on Friday suggests. It is also in line with the break in correlations I mentioned in my last post. Moreover, it is the first time in a while that a strong data is not associated with higher equity prices! 10Y USD vols also seem to have bottomed as the chart below indicates (1Y10Y USD Vol). All are indicators that we might be about to shift to a new regime. So, it is true that some suggest that the NFP report had some elements that were not that strong, with for instance the drop in the labor force participation, or the sharp rise in part time jobs (and decline in full time jobs) maybe as some have argued because of Obamacare’s effect. But it was strong nonetheless, and all data have been very strong. So the debate about the timing of QE ends should last. If that is the case, 10YUSD could rise further and break the 2% threshold for good, then it would affect all valuation metrics, in particular, it could have consequences for corporate bonds, EM bonds currencies and equities and DM equities. This is something to watch particularly finely. Of course at this stage it could be only a risk scenario for later this year (H2?). Indeed, some economists seem to be expecting a slowdown in US data – because of the fiscal drag and a seasonal effect in Spring. But so far the data remains very strong.

 

Second, at the European Council meeting will there be signs that structural deficits (reforms) are becoming more important than nominal deficit targets? That would be very encouraging for Europe, both in terms of growth prospects (less austerity), and in terms of credibility of the EMU crisis resolution framework (OMT etc) following the Italian elections. If so, that could be quite positive for European spreads, and by contagion for the EUR, but also more globally for global growth prospects.

Third, in Japan, we have a new dynamic in place since the nomination of Kuroda as BOJ governor, it is not the JPY anymore that is driving everything else. Now the lower 10Y JGB yield is driving (since talks of unlimited JGB purchases) first the Nikkei, and then the JPY. That is acting as a new and more legitimate engine of JPY weakness (as I said in my JPY piece, it is monetary policy that has to weaken the JPY, not the other way round). Of course the market doesn’t care at this stage that contrary to the US, lower long term rates will probably not achieve anything (no mortgage market impact, and yields already at 0.60%), as that is a question for later this year. In the meantime, there are now talks about the use of derivatives… interest rate swaps apparently, but would that mean also FX options or cross currency swaps? There has been suspicion in the past of such behavior by Japan – never confirmed to my knowledge. But the reported positions are not well covered by the BIS / IMF cofer data, so it could be a way to do FX market tweaking and stay below the radar screens. In anycase, it is important to monitor what the BOJ is up to, what it is going to buy and in what amount, and even more important, is it going to prove beyond or below market’s expectations?

Less likely to be driving this week, but fundamentally very important, we have :

• The US fiscal fight starting, with two budget deals being proposed, and Obama in PR move towards Republicans.
• Uncertainty on the duration / scope of China’s tightening, following recent spike in Inflation (Hang Seng China’s rebound looking fragile, and Copper still at its recent lows).

Global View – Correlation breakdown, stay tactical

A month ago I wrote that I would wait for the end of Italian elections to rebuild exposure to the theme of a lengthier global growth cycle, and in the meantime switched to a tactical and RV strategic stance. So is it time to jump back in? This structural case is more relevant than ever BUT the 5 days consolidation in the US markets, and the correlation breakdown between markets are worrying. Particularly so given the developments on the global scene in February. Trading tactical and RV still looks like the best risk/reward strategy at this stage.

 

Lost in correlations…

US stocks are making new highs and corrected only for 5 days when Italian markets were collapsing. The EUR/USD – SPX’s best friend – lost 7 big figures, and stayed there while the SPX reached new highs. Copper made a 5 months low, and Miners collapsed following the Chinese tightening. Finally, even more telling IBoxx (Corporate bond index – see below) topped in October 2012. What a mess!

Unless you are buying (again) into the (false) idea that the US can totally decorrelate and stay isolated from what’s going on into the two biggest other regional zones (Europe and China) – then you should have doubts. And if anything this kind of decorrelation is not what is supposed to occur when the markets are convinced by a major global theme (the engines of big lasting trends).

 

Technicals, Internals and all these trading tea leaves…

First, let’s review the Technicals. Yes we are making new highs on the SPX, and the Nasdaq ex-apple (or equally weighted nasdaq). And we are likely to make higher highs in the short term. BUT…

1/ Sentiment in US equities is not far from extreme levels (see AAII and others…).

2/ More meaningful, cash levels are close to extremes (see chart below – from the Merrill survey in Feb – the levels are the same at 3.8% in March) (I am happy to receive it if someone has it).

3/ EPFR flow data confirm the idea that retail investors have reduced holdings of money market funds and increased exposure to equity funds. (And by the way there has been no “great rotation” yet out of Govies and into stocks, it is all money out of cash).

4/ I heard that there was evidence of sector rotation into more defensive sectors (I am not an expert on that, so I am quite happy to have color from readers), at least that’s what the FT argues.

5/ And a 5 day drop with no movement in volumes (chart below of SPY ETF), hardly qualifies as a consolidation for a market that has rallied by 15% in 3 months, and 100% in 3 years, and is right at its historical highs…

If it is retail investors that are getting into the market at these levels, it is often a good contrarian indicator. In the meantime, and the very short term, buying attracts buyers, and 1550 on the SPX is a done deal, while 1600 is also very likely.

 

So what about the fundamental macro drivers?

It is absolutely true that US data have been great (core durable, pending home sales, business and consumer confidence, Case Shiller…), moreover they have been suggesting that the recovery is mostly based on domestic engines (housing in particular, but also increasingly capex). So the market is logically reacting to what it sees. The worry is that markets tend not to take into account risk scenarios. And there are still many factors of uncertainty that have been discarded a bit quickly. Let’s review the usual drivers:

1/ Europe:

There are positive developments. Yes, the Italian election is behind us, and no parties want reelections, so they should end up finding an agreement. (But, the 5 star movement is against a coalition, so it won’t be straightforward). Yes France missed, its growth target (and deficit goal), but the EU seems prepared to give it a delay. And Rajoy and his government are still there despite the scandals.

BUT, the big development is that the “crisis resolution framework” in Europe – austerity against funding – is now questioned following the Italian election. Germany and the ECB still have to validate the new framework – reforms against funding or maybe funding against nothing… It is not guaranteed that they will, particularly given markets’ complacency. The OMT in particular is based on strict conditionality criterias, mostly based on austerity. Whatever the form of the new Italian government (minority with an appointed leader?), there is no way that more austerity is going to take place in Italy even if yields skyrocket. So of course, one might rightly argue that Merkel has scope to relax its austerity demands in an election year, as its opposition is less obsessed by austerity than her. And Bruxelles should not be too tough either as a crisis in Italy would be fatal for Europe. But given the time it usually takes to find a political agreement in Europe, it seems too early to give the all clear signal (particularly when one looks at the dreadful data out of Netherlands).

2/ China:

The most important economic reforms are not there yet, but there have been many meaningful tests of Xi Jingping reformist stance. Political ones have been obvious: 1/ condemnation of North Korea following the Nuclear test, and agreement of Sanctions at the UN; 2/ likely reform of the labour camp (laojiao) system; 3/ and the most stunning – authorization of free elections at foxconn’s union! [A free vote for 1.2m workers, that’s amazing in China. Particularly given that free unions and free press are two of the basic blocs that NGOs working for democracy advancement recommend]. But also on the economic scene: 4/ regulation of shadow banking; 5/ reform of the bond market to finance properly the urbanization program; 6/ recent regulatory tightening of the real estate market. The bottom line is that all that looks encouraging for the economic reforms that are necessary to rebalance growth towards domestic consumption – something that would be a great engine for global growth.

That being said, investors should keep in mind, that these reforms won’t take place overnight, as they necessitate a strong political will – SOE and some in the political establishment will do all they can to avoid them. Moreover, in the short term the tightening (reversal of what took place in the middle of last year) might not be over, and is certainly not positive either for Chinese or global growth (as Copper prices rightly suggest, but it is also true for European and US exports to China).  I will write shortly on China’s reforms, in the meantime here is my favourite chart on the subject showing the breakdown between the different sources of investment. Urbanisation is going to be the key source of investment – not infrastructure like in 2008/09- but it has to be managed and funded properly – that’s what the coming reforms are about.

3/ US:

And finally we still have the US fiscal drag. The payroll tax increase apparently didn’t have any impact. The sequester started last week, appropriation agreements have to be made before March 27 (otherwise a limited government shutdown will occur), and there are apparently zero odds of an agreement about tax increases from the austerity obsessed Republicans. (As I wrote previously, from the perspective of their coming reelection battles, it is rational). Despite that, every economist I talk to seem to expect this fiscal drag to have only a minor impact given the accelerating growth, and that the serious risks will only start in August with the debt ceiling threat. Maybe, but that frankly seems surprising, in particular not seeing any confidence impact from a government shutdown. Look at Yellen’s chart on the current fiscal drag compared to previous recoveries… how can that have no effect at all?

 

Takeaway:

Maybe I am wrong of course, and buying flows are going to prove overwhelming – a bit like July 2009 (a bear nightmare)…  and in that case it won’t be too late too jump onto the money train. But the big difference with July 09 is that equities are now back to their historic tops, the Fed has already given all it could, and it is now retail money that is powering the rally… not the Fed. So yes we might get to 1600 on the S&P500 soon, but in all likelihood we will need clarity from Europe and China before a sustained global rally can develop.

All that to say that, yes, I remain convinced that it makes sense to play a scenario of “lengthier than expected global growth” and the drivers are really all going into that direction. But the short term outlook remains cloudy, and I am left unconvinced by the lack of depth of the consolidation that occurred in February and the correlation breakdown between markets. I consequently continue to think that for now the best risk/reward strategic stance is to trade tactical (swing) and RV (ideas like shorting the CAD or GBP)…

RV – Buy USD/CAD but keep an eye on the WTI/Brent spread

The CAD and the 2Y CAD Swap rates have room to drop when one considers: 1/ the situation in the Canadian energy sector following the Shale gas / Oil boom in the US; 2/ the recent regulatory efforts by the government to tame excesses in the housing market; 3/ the recent justified dovishness by the BoC.

 

1/ The energy sector is hit by the US Shale Gaz boom

The most striking recent structural change in the Canadian economy has to do with the consequences of the US Shale gas boom. The chart below (from last BoC MPR) reflects well the situation: because of new Oil production in the US and bottlenecks in the transportation / refinery sector (see risk section below for more details), the WTI trades about 20$ below the Brent, and the Canadian reference price (Western Canada Select) trades currently 36$ below the WTI!

For investors who are not too familiar with the CAD drivers, I have to point out that the two biggest influences on the USD/CAD parity are 1/ Oil prices (Brent or WTI usually) and 2/ expectations about BoC monetary policy (take 2Y Swaps). You can make a quite robust 2 factors model simply with these two inputs. To reflect the current situation, I have charted below where the USD/CAD and WCS (the point in purple) are trading… The equivalent USD/CAD level is about 1.25 (of course it is meaningless and purely illustrative)!

No need to be a great economist to understand that as long as this lasts, it is having important effects on the Canadian economy, in terms of exports, investments, employment etc… And we are starting to see just that. The BoC (see above) signaled that the decline in drilling activity was affecting investments. But overall the Bank expects the WTI/Brent situation to normalize. There is no signs of that so far, and the currency and rates markets have not priced in the situation, that’s why the trade makes sense (see other factors below).

But indeed, it is important to be aware that a normalization of the WCS/WTI/Brent spread is a RISK factor to watch. So what could tighten it, and why did it get distorted in the first place? To summarize (and simplify), it became distorted for several reasons: 1/ the new technics of horizontal drilling used for Shale Gas fields are also used for Oil and resulted in a boom of Oil production in the US, 2/ Crude oil has to be carried (by pipeline) either to export hubs or to refineries, 3/ Crude oil exports are banned in the US, so crude has to be refined first (exports of refined products are allowed). Consequently, two main developments could change the picture: First, the opening of new pipelines (there is glut in Cummings in particular – see this excellent article for details of the Canadian situation and this one on the new US pipelines). Second, and more important (because it can happen much quicker), a regulatory change in the US with a lift of the crude Oil export ban (read) that would reduce the glut in the refinery system and in the pipelines to the refineries.

But these things take time to change, and as long as the spread remains wide, the impact should be felt on the Canadian economy, and consequently there is room for an adjustment on both the Rate and the Currency side.

 

2/ New regulatory efforts to deal with the housing bubble

The economist recently singled out Canada as one of the most overvalued housing market. More recently Moody’s downgraded (from top levels) some of the largest Canadian banks because of the housing market and associated household debt.

Given the concerns, the government changed in 2012 the rules for government-backed insured mortgages, and the guidelines on residential mortgage underwriting. This seems to be having an effect with a decline in household credit growth (residential in particular) and stabilization in the housing market (see the last Financial System Review pg24, for a full analysis of the real estate market and its importance for consumers).

If regulatory measures are used to tame a housing / credit bubble, this should obviously have consequences on consumption. That is what we see in several data (chart above for instance). And indeed in its last Monetary Statement, the BoC signaled: “Caution about high debt levels has begun to restrain household spending”, and “Consumption is expected to grow moderately and residential investment to decline further from historically high levels”.

That means that two of the most important engines of Canadian Growth (consumption, and the energy sector) are likely to be in pause.

 

3/ BoC dovishness

To finish with, could the BoC be constrained about inflation? The BoC signaled (last statement) that “Core inflation has softened by more than the Bank had expected, with more muted price pressures across a wide range of goods and services, consistent with the unexpected increase in excess capacity”. And indeed, inflation trends (chart below) are quite concerning. So the Bank has scope to be accommodative.

Finally, given the growth outlook discussed above (energy sector and consumption), the most likely growth engine is likely to be external growth. And it is important to note that the BoC already signaled that the CAD strength was a problem: “and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar”.

Their conclusion is clear: “the more muted inflation outlook and the beginnings of a more constructive evolution of imbalances in the household sector suggest that the timing of any such withdrawal is less imminent than previously anticipated.

 

Conclusion

Despite all that, the 2Y swap rate remains stuck at 1.40% (which is about its average for 2012), and the CAD around 1$ – close to its 10yr highs. As data disappoint, I think there is scope for a further correction of investors’ expectations – a correction of the 2Y Swap rate and concomitant weakness in the CAD (USD/CAD to 1.05?). The break of 1.01 would be a good confirmation signal – probably after a consolidation below that level. But again, keep an eye on the WTI/Brent spread.

[Last point, beware of flows in the very short term - a squeeze of USD/JPY positions would push the USD/CAD lower (now that Abe’s govt recognized that it will not buy foreign bonds, and that big HF talk publicly about their JPY shorts)].