Unsurprisingly, the US is focused on the impending Presidential elections. The latest polls suggest that Mr Romney is in the lead, but the odds on Intrade, which I follow, suggest that President Obama will win – the President is currently priced at 62% (and declining), down from a high of over 70% ahead of the first TV debate, which President Obama clearly lost. A number of Americans believe that Romney will surprise everyone and win the election, though I will stick to Intrade at present. However, the uncertainty as to the winner of the impending Presidential elections has resulted in US businesses freezing all investment and hiring programmes. In addition, US businesses are cautious given the deteriorating global economic conditions.
Last weeks NFP data was greeted by much disbelief, but the conspiracy theories that swirled around, post the announcement are a nonsense – the numbers are what they are – they are not perfect by any means and will be revised, as they always are. Furthermore, one should not focus on one data set, but rather on the trend, though given the boost to the Obama campaign following the announcement of the sharply lower unemployment rate (7.8%) in particular, a number of commentators have suggested all sorts of scams designed to portray a better number. In particular, alleged rigging of the NFP numbers by Washington, made by the former CEO of GE, Mr Jack Welsh, attracted much attention, but his criticism generally has backfired. A number of allegations have reemerged as to Mr Welsh’s use of “creative accounting” in respect of published earnings reported by GE, when he headed up the company !!!. The much debated September NFP data will mean that the October NFP data (to be released on 2nd November) will be watched even more closely, as will the remaining 2 TV debates between the President and Governor Romney.
We are in US 3rd Q earnings season and the reported results to date, together with the accompanying statements, suggest that corporate earnings are worsening and that the ridiculously optimistic 4th Q earnings forecasts will have to be revised materially lower. Analysts continue to play the game of forecasting much higher earnings, only to revise them lower over time, following “chats” with the investor relations departments of most US businesses. The end result is that most companies either “meet” and/or “beat” the reduced forecasts. Furthermore, operating earnings, which is the number focused on, are “managed” to the such an extent that everything the CEO/CFO do not like is considered an exceptional item and excluded from the published number. Quite frankly, operating earnings are a complete sham and should be disregarded in most cases – personally, I follow cash flow, rather than earnings. The bottom line is that US earnings are coming under pressure, which clearly will be a negative for markets. Furthermore, insiders are selling and/or not buying, which is another significant negative.
I attended Barry Ritholtz’s excellent “Big Picture” conference in New York last week. The (seriously) bearish predictions would make you want you to slit your wrists, throat and possibly something else. Sure, there are problems, but I believe the game, in the coming 3 to 6 months, is going to be played outside of the US. The risks to the US are clearly to the downside (especially if the fiscal cliff issues are not resolved, though markets believe that they will be, at least partially), though potential (positive?) events in Europe and China (see below) will prove to be more important. Essentially, I believe investors should focus far, far more on Europe and China in coming months. If Mr Romney wins the Presidency, the initial euphoria could well give way to selling, if tougher spending plans, combined with stricter budget deficit targets are introduced. A win by Obama may result in an initial sell off, but I do not believe it will last long. In any event, the outcome of the elections may well unblock the freeze in spending/hiring by US businesses, which should provide some impetus for the US economy.
US businesses are on hold due to the upcoming Presidential elections and slowing global demand – essentially, US businessmen recognise that the US economy is not as isolated from the global economy as was the case some years ago. The economic situation in Europe, in particular, though also in countries such as China, will impact the US increasingly in the future. However, the US remains the “best dirty shirt in town”, as Mr Gross of Pimco describes the situation, though economic growth will remain anemic – around 1.0% to 1.5% at best, unless the fiscal cliff issues cannot be addressed, in which case the economy will slip into recession.
Housing remains the key – I continue to believe that US housing is improving and, furthermore, will continue to do so. Inventory levels are declining, with prices rising and whilst the availability of mortgages is limited, due to stricter lending standards, the situation should continue to improve. US homeowners continuing to refi at lower rates, increasing disposable income, though banks are not passing on the full effects of the FED’s actions and, furthermore, are taking their time to process the refis. However, the backlog of refi applications should clear sometime next year and I believe that competition subsequently will force US banks to reduce their currently strict lending standards and begin to lend more, a further help to the US housing market. There is certainly demand out there.
Moving on to China. Not withstanding the better September export data (likely due to seasonal factors) released yesterday (exports rose by +9.9%, up sharply from +2.7% in August), Chinese economic data continues to indicate a weakening economy. Excluding the injection of liquidity by the PBoC and a meaningful increase in fixed asset spending on the railways, the Chinese authorities have not announced a significant stimulus programme to date, as was expected. A number of provinces have announced jumbo building programmes, but one must treat such announcements with a great deal of cynicism, due to their lack of finance.
The Communist Party Congress has been called for 8th November and the authorities will deal (likely very harshly) with Mr Bo ahead of that. After all, he threatened the establishment by actually seeking support from the people !!!! one of the most heinous crimes you can commit in China. In addition, it looks as if the new leaders of China have been chosen. A stimulus programme (very much needed, given the sharply deteriorating economic situation), will have to be put in place, but only once the new leaders are in power – after all, they will want to take the credit for the measures. That suggests an announcement or, more likely, a series of announcements sometime in the 1st Q of next year, though there is an outside chance of some policy measures being announced later this year. In addition, I cannot see how the authorities can continue to bear down materially on the housing sector. Whilst they remain concerned not to allow price increases to rise materially, they clearly will be keen on a pick up in prices, which will feed through to greater economic activity domestically. In summary, China needs a stimulus package and I for one believe one is coming. Whilst I remain neutral at present, I will become increasingly bullish on China, in the short term once these policies are announced.
However, as you all know, in the medium to longer term, I continue to believe that China will face significant economic problems whatever the authorities do and remain particularly bearish. Their economy is so distorted that any remedial action will have a material adverse consequence – China’s only choice is to pick the least worse option(s) – the problem is that even the least worse are bad. Essentially, China is not the master of its own destiny and will need a sharp recovery in the US and Europe, if it is to recover. Furthermore the near +10% growth rates are a thing of the past – I believe that GDP will decline to +5.0% or even lower in a few years time – consider the political consequences of that.
The EU and the EZ, in particular, continues to disappoint. The region is in recession, with the situation deteriorating, unfortunately far, far faster than analysts can announce their economic downgrades – you really need a Bloomberg terminal to keep abreast of the situation. However, I sense (its still very early) a change may be coming.
Mrs Merkel’s visit to Athens (she faced an extremely hostile crowd) is a clear sign that she is determined to assist Greece – certainly in the near future. Remember that Mrs Merkel faces elections in autumn next year. As a result, it looks as if the Troika’s report will be fudged so as to allow Greece to receive its next tranche of aid, most likely in November. It will be interesting to see how the IMF handle this. It’s not going to be an easy ride, given the sceptical views of Holland and Finland, though do not underestimate Mrs Merkel – the odds are that she will push it through. Will Greece meet its targets subsequently – well, if you believe that……….The real issue is that Mrs Merkel does not want Greece to default ahead of requests for bail outs by Spain and others, which will need to be approved by the her Parliament, the Bundestag. It makes approval of further bail outs (and a number will be coming imminently), much, much more difficult. a number of members of her coalition, the FPD and, indeed, her own party, remain sceptical and will become even more emboldened to block further bail outs if Greece were to default.
In the past, Mrs Merkel has had to rely on support from the opposition (SPD) to pass the necessary legislation in respect of bailout packages for EZ countries and other related matters. However, with a new leader in place, Mr Steinbruck, (who is deemed fiscally credible), the SPD wants “political concessions” from Mrs Merkel, if they are to support further bail outs, even though the SPD are more pro EU/EZ than Mrs Merkels party the CDU – indeed, Mr Steinbruck accused Mrs Merkel of not doing enough for Greece, which was another reason why Mrs Merkel visited Athens last week. The German population are becoming increasingly reluctant to bail out other EZ countries, in particular Greece. They are all to aware of the cost of bailing out E Germany and they were their countrymen. Furthermore, not even Germany has a blank cheque book.
OK, so Greece lives another day, but post the German general elections in autumn next year, will it remain in the EZ. I continue to believe not. Irrespective of the statements by Greek politicians, Greece will need additional funds – whilst Mrs Merkel may push through measures to release funds already allocated to Greece, its a very different matter to suggest that she will be able to sell the idea of a third bail out package for Greece. A recent poll suggest that only 25% of Germans approve providing further assistance to Greece and the vast majority of Germans do not believe that Greece will repay the loans already provided to the country – well they are right – the Greeks wont. There will be yet another restructuring of Greek debt, this time to include official sector loans – the former Greek finance minister stated exactly that. The current debt load – forecast by the IMF to raise to 150%, is unsustainable. The IMF is pushing for official sector involvement, OSI, (though clearly they will expect their money back), but the EZ politicians and in particular Mrs Merkel, for the reasons set out above, are totally opposed to any haircut on official sector loans – very difficult to explain to your public. The ECB has refused to extend the maturity of debt owned by Greece, claiming that it is tantamount to financing of governments, which is illegal under its constitution. There is talk about Greece buying back its own debt, which is trading at a major discount to par – sensible, if Greece has the funds available, as it will reduce debt to GDP.
OK, so the Greek can is kicked down the road. Then comes Cyprus and quite possibly Slovenia, though I will just concentrate on Spain in this note. The former regime in Spain was “economical with the truth”. The current regime is in denial and dithers endlessly. Spain will NEVER meet its budget deficit targets for this and/or next year, by a very wide margin. That is clear, but the Spanish authorities remain in denial. However, they will need a bailout – most likely a precautionary line of credit from the EFSF/ESM sometime in late October/November – after the regional elections on the 21st October. Yes, the ECB’s statement that they will buy short term debt of countries that request assistance from the EFSF/ESM has reduced tail risk and, indeed, stabilised bond yields. However, Spanish debt to GDP is rising at such an alarming rate, which, combined with large private sector debt (which, worse still, is concentrated), suggests that the situation in Spain will deteriorate much, much further and faster. I do not believe that Spain will be able to repay all of its accumulated debt in the future, which suggests to little old me that Spain will have to restructure its public sector debt in due course. The country does not have the economic capacity to repay its debts – in the past GDP was heavily reliant on construction – great that’s disappeared for a decade at the very least. Furthermore, the Spanish banking system is insolvent – they have not recognised the true value of their assets, though the same can be said of a number of banks in Europe, I accept. The E50bn+ suggested as sufficient to recap Spanish banks is totally ludicrous – the real number will be well in excess of E100bn. Last week, Spain was downgraded by S&P, with a negative outlook ie a downgrade to junk is coming. The clouds are gathering.
The Spanish PM faces a political dilemma in that he promised, prior to the general elections, that he would not allow for “supervision”/oversight of Spain by other parties, such as the EU/ECB/IMF. In addition, he faces regional elections on 21st October and does not want to be seen to request aid ahead of those elections. He is trying desperately to deflect potential criticism/stigma by suggesting that both Italy and Spain request aid from the EZ at the same time – no chance Senior, as the Italian PM, Mr Monti, has told him. Mr Rajoy faces breakaway threats from Catalonia, though such threats should be ignored. Catalonia will not be recognised as an independent country by the EU and will not be able to raise finance in capital markets if it achieved independence. In addition, over 70% of its trade is with Spain, making it vulnerable. The EU would not want to encourage breakaways and will covertly stop Catalonia from becoming an EU member. However, Catalonia could demand additional fiscal concessions – which would just aggravate the Spanish central budget – a real threat. Not a great scenario.
OK, so Mrs Merkel/Schaeuble know that Spain will need a bail out, but want, for domestic political reasons, to deal with all such issues at one time, given they are facing a more sceptical Bundestag. They really want to deal with all of the relevant countries at one time. As a result, some time in late October, though most likely in November, Spain will request aid from the EZ and will receive a “precautionary line of credit” in the first instance. That will enable the ECB to start buying up to 3 year Spanish debt in the markets, which should stabilise the situation, certainly for a while.
The market has not focused on France for the moment. As you know, I believe France to be the real political, economic and financial threat to the EZ. Its economy is deteriorating and worse still, the downward trend can be described as “awful”. A Socialist President will help, as the public will know that he will be inclined to be more proactive – however, the kitty is bare. Monsieur Hollande has already upset the unions – just look at Peugeot. He has upset the rich, who are voting with their feet and exiting the country. His ratings have slipped precipitously. In due course, President Hollande will admit to his people that the economic situation in France (which he will state he inherited from President Sarkozy) is much much worse than initially thought and that he will have to impose additional spending cuts. A Socialist President has a better chance of getting away with this, that would have been the case with Mr Sarkozy, but its going to be tricky. The French are known to take to the streets and coming months will clearly be critical, especially as we head into spring next year. However, the political and economic situation in France, the key country (with Germany) in the EU will, I believe, force EZ politicians to reconsider their current austerity measures and, more likely, ease such policies, in exchange for countries promoting structural changes, including labour reforms. It will remain difficult, given the inherent culture in these countries, but austerity, by itself, has past its sell by date. The EZ clearly needs to introduce growth measures and focus more on structural (including labour) reforms.
However, far more importantly, is that I sense the beginnings of a change in policy. The IMF has admitted (in its latest World Economic Outlook) that they have been wrong and that austerity measures, such as tax increases and significant cuts in public spending, may well be self-defeating and, indeed, doing more harm than good. The reason is the effect of the fiscal multiplier, which the IMF data suggests could be around 0.9 to 1.7 times, much higher than the estimate of around 0.5, previously used. In other words, for every $1 of tax increases/spending cuts, the underlying economy will contract by between 0.9 and 1.7 times the amount of the austerity measures ie $0.90 or $1.70. The negative effect is particularly pronounced when interest rates are near zero and when other countries are also reducing their budget deficits at the same time, as is the case at present. The IMF data has been questioned, including by the EU, though I believe it to to be true and evidence from Spain, Portugal and Greece suggests exactly that. The IMF report suggests that austerity measures should be phased in over time, rather than front end loaded as at present, with a focus on structural (including labour) reforms, certain a view that I also share.
At the last ECB meeting, Mr Draghi advised that the conditions to be imposed on EZ countries, whose bonds are to be bought by the ECB (on the basis these countries ask for a bail out and are subject to continuing review), need not be particularly austere. He added that it was far more important for such countries to phase in the austerity measures over time whilst introducing structural (including labour) reforms and growth measures. In other words, do not worry about reducing the fiscal deficits as fast as currently planned, but get on with much needed structural reforms. I very much agree with Mr Draghi.
It looks as if Europe is backing off implementing the Basel 111 criteria. Certainly will ease the pressure on European banks, who are faced with having to shrink their balance sheets.
Countries within the EZ have agreed to a fiscal compact, which is designed to force countries to meet certain predefined targets, in particular, budget deficits. We all know, that Greece, Portugal, Spain and France will not meet their targets, quite likely others – Holland, for example, will struggle. Indeed, the only country in the EZ that has met its target is Ireland, though the country faces yet more austerity measures – not going to go down well, to say the least. Indeed, there are signs in Ireland that the population, which to date, went along with the measures have had enough. As a result of increasing opposition to austerity measures, new negotiations will be needed, most probably starting late this year into early next. Targets will have to be revised and set at realistic levels. In addition, the EU will be able to supervise national budgets much more closely (a condition of the fiscal compact) – clearly will be hated by the relevant countries, but that the way the EZ is going. What better time, to relax on pure austerity measures and focus on structural, in particular, labour reforms.
There is speculation that Germany may announce tax cuts for its people – well Mrs Merkel is facing a general election in autumn 2013. German GDP forecasts, as is the case with other countries in the EZ, are being revised lower – likely will have to be reduced even further. Essentially, Germany is not immune from the global economic slowdown, in particular in respect of its materially important export sector – there is clear evidence of weaker demand from countries such as China, clearly from the rest of the EZ and, if the US is weaker, well……..To date, the German domestic economy has, held up, but unemployment has begun to rise and I would expect that consumption will weaken. To face an electorate with a deteriorating economy is not an appealing position for politicians . Accordingly, I believe that Mrs Merkel may well be “convinced” by the likes of Mrs Lagarde and Mr Draghi that the current policy of severe austerity, without any growth measures, may well be past its sell by date. Mrs Merkel is not a dogmatic politician – she will change, if circumstances require a change in policy. Most importantly, the thought of going down in history as the first political leader of an united Europe (a role she most certainly covets) must appeal.
If I’m right (in particular in respect of China and the EZ, in particular) and I admit that the above views are more speculative at present, policy may well change within 3 to 6 months. The alternatives – well there is clear evidence that a number of EZ countries are increasingly opposed to the austerity measures and that China will slow down to even more dangerous levels. Rising civil disorder will be the name of the game, if the current situation remains – OK, so we are coming into winter and strikes and demonstrations will be limited – though by next spring !!!!. However, if policy remains unchanged, increasing civil disorder will be the name of the game. On balance, I believe that the EZ and Chinese policy will change ahead of such events – I just don’t believe that they have other credible alternatives.
As a result, I’m not in favour of US markets at present, especially the NASDAQ, though will be looking to increase my holdings in Europe (financials?) and derivatives of China – probably close my A$ short, at least. It may well be that China and European markets outperform the US next year, particularly in the 1st half.
Have a great weekend
14th October 2012