Continuing improvement in US employment

Hi there,

China reported a trade deficit of US$31.5bn in February, the largest since 1989 and well above the estimate of a deficit of US$5.35bn. Imports rose by a massive +39.6%, (down -15.3% in January), whilst exports rose by 18.4%. Analysts had expected that exports would rise by +31.1% from the previous year and imports by +31.8%. January and February’s data are affected by the Chinese New Year holiday, though even combining the 2 months data, suggests that Chinese exports are declining materially. The Chinese Economy Minister reported last week that boosting trade by 10% this year would require “arduous efforts” ie virtually impossible. Exports to the US rose by +22.6%, from the previous year, to US$19bn (+5.4% in January), but exports to the European Union rose by just +2.2%, to US$19.4bn (a drop of -3.2% was reported in January). This reconfirms the diverging economic strengths of the US (growth) and the European Union (a slumping economy). The higher oil price increased the deficit.

The Yuan has declined against the US$, YTD, as the authorities try and curb its gains against the Euro – some hope, given the (I believe) ever weakening Euro. It is clear that the Chinese are trying to slow down the appreciation of the Yuan against the Euro, in particular, as Europe remains its largest trading partner. The PBoC announced that it would widen the Yuan’s trading range – in my opinion, giving the authorities the opportunity to weaken their currency. Further cuts in RRR’s are very likely. Inflation declining to +3.2% YoY – it does mean that Chinese inflation is lower than the 1 year deposit rate (for the 1st in a very long time), but I expect inflation to rise, as food (over 60% of the inflation basket) and energy costs rise. Food production in China is expected to be materially lower than official Government forecasts – drought and pollution issues remain a constant problem . The prospective rise in inflation limits the authorities flexibility to ease monetary policy materially – other than reducing RRR’s, though a number of analysts are forecasting stimulus measures and further fiscal and monetary easing. All I can do is repeat my views that the Chinese authorities have no good policy options – every (necessary) option has a material adverse impact on their grossly distorted economy – all they can do is pick the least harmful;

The Indian Central Bank, the RBI, unexpectedly reduced its cash reserve ratio to 4.75%, from 5.5%, allowing a further US$9.6bn to be lent. There has been a shortage of cash which has been negatively impacting the Indian economy – the cash reserve ratio is the lowest since 2004.

Well finally, ISDA has opined (unanimously) that the Greek PSI (together with implementing CAC’s) was a credit event (hallelujah), which triggers CDS’s – though they took a mighty long time on Friday to agree to something which was pretty obvious. They had no choice as there would have been an uproar if they had not. Auctions will be held on the 19th March to establish the pay outs. Some US$3.16bn of (net) and 68.9bn of gross exposure is outstanding, though the actual payouts are expected to be less than the net exposure – in addition, most of the exposure is collateralized. US$5.2bn was paid out as a result of the Lehman collapse, by comparison.

The EU/ECB has been totally opposed to implementing measures that would trigger CDS’s, though, as yesterdays response revealed, it was no big deal, though I must admit the announcement by ISDA was widely expected (and priced in) and the ECB’s 3 year LTRO has stabilised financial markets. Investors are likely to demand changes as to how ISDA operates – the 15 person committee currently is made up of representatives of banks and investment funds – basically, the guys who sell the product – conflict of interest do you think !!!.I certainly will not touch the product, until the rules are changed – a view I expect will be shared by most investors, particularly and, importantly, by large fixed interest institutions. Amongst the European banks, Unicredit will take the largest hit (E240mn), though Deutsche and BNP’s exposure is E77mn and E74mn respectively. The biggest winners are HSBC (E194mn) and RBS (E177mn) according to the EBA.

EZ finance ministers agreed to release E35.5bn in sweeteners to complete the exchange. However, the IMF is clearly fed up with Greece – who can blame them. They intend to reduce their contribution to just E18bn (out of the E130bn) of funds for the 2nd bail out – just 14% of the total, as opposed to 27% in the 1st E110bn bail out – still subject to board approval. The PSI deal will reduce Greece’s debt load by some E100bn, from its current E350bn burden. It will also mean that the private sector is far less relevant re holdings of Greek Sovereign debt in the future. The Greek bonds to be issued in exchange for the old ones were trading around 20 cents (mid price, but a huge spread) on the Euro in grey market trading on Friday. Maybe the EFSF/ESM should buy up these bonds at roughly that price and, then swap them, reducing Greece debt burden even further – a solution for Portugal for example, I would argue. Could well mean that Portuguese bond yields decline by the way – a potentially interesting play, in due course.

EZ and German politicians and officials (not too subtly) warned Greece to perform – too true. Ollie Rehn, the EU’s economics commissioner stated that “I now expect the Greek authorities to maintain their strong commitment to the economic adjustment package and to rigorously and timely implement the policy package” – some hope !!!. The German finance minister, Mr Schaeuble made similar remarks. Greece is in detention at the moment – failure to comply will result in expulsion.

S&P downgraded Greece to selective default. “Selective default”, they should have announced that the country is bankrupt, will default again in the not too distant future, a complete mess etc, run by a bunch of crooked politicians etc, etc. Unfortunately Greece will pop up again, and again and….The market certainly believes that – the shortest dated (11 year) new Greek bonds are yielding between 18% – 21% in the grey markets on Friday, higher than the 14% for Portuguese 10 year paper, for example. However, the new Greek bonds, swapped for the bonds subject to PSI, will be subject to English law and with EFSF involvement – makes a subsequent default much more difficult, I must admit.

No doubt the market will move on to Portugal – clearly the country needs to reduce its debt load by at least 40%. The EZ continue the B/S that Greece is an “unique situation” – yeah right. However, Portugal and for that matter Ireland, can be sorted out, though Spain can’t and unfortunately, I really don’t see a manageable solution – a problem (very likely) in Spain will have a material negative impact on Spanish and some European banks etc, etc. The situation is even worse, as EZ countries are fiscally impaired and lack the financial wherewithal to recap their financials. Spain’s FROB (its bank bail out fund) , for the last time, is NOT FUNDED. They have to borrow the money. The good news is that I expect the EFSF/ESM to increase their firepower to above the current E500bn (with contributions from the IMF, as well), which could relieve some of the pressure, as its far too much for the private sector. In addition, with Draghi at the ECB (who is far more market savvy), rather than that lunatic Trichet, a solution is more likely – that’s the good news. The Euro declined materially on Friday (off over 1.0%), particularly following the news re Greece – still a lot lower to go, in my humble opinion. In addition, the CFTC reported further Euro shorts;

Interestingly, a recent poll, suggests that Sarkozy will be only 2 points below Hollande in the 1st round of the French Presidential elections. Early days – the 1st round is in late April. However, this election could well be significant, particularly as Hollande has stated that he will renegotiate the fiscal compact – not going to go down well with Mrs Merkel. Interestingly, both Mrs Merkel and Cameron are (openly) supporting Sarkozy, in spite of their less than favourable opinion of him – better the devil you know policy, essentially;

Personally, I believe that yesterdays US February NFP data was much better than the initial headlines suggested. 227k jobs were created in February (233k in the private sector), somewhat higher than the 210k forecast – OK, not a blow out number, but look beneath the numbers. Net revision to previous months (December and January) were +61k. The household survey suggested that 428k jobs were created – though a further 476k workers entered the labour force, resulting in the unemployment rate remaining at 8.3%. The underemployment (U6) rate declined to 14.9%, from 15.1% previously and the participation rate rose to 63.9%, as opposed to 63.7% previously. It is generally accepted that heading into recessions the headline data flatters the reality of the situation, though in a pick up the reverse is true, as the establishment survey, does not pick up the small and medium seized start ups in particular – I would argue that the household survey provides a better picture. Then there is the infamous birth/death adjustment.

The data suggests stronger 4th Q 2011 and 1st Q 2012 GDP data, though the wider February trade deficit (US$52.6bn, as opposed to the forecast of US$49.0bn – the highest since October 2008), as a result of higher imports, (which suggest that the US economy is improving) and lower inventory build (+0.4% in January, as opposed to the +0.6% expected), will likely more than counteract the improvement from the jobs data – indeed, GDP forecasts have been reduced by 0.2% – 0.5% for the 1st Q 2012, to around 1.5% – 1.8%, by GS and JPM respectively. Employment data for the last 6 months has shown the best improvement since 2006 – some 1.2mn jobs have been created and a total of 3.9mn privates sector jobs since employment bottomed out 2 years ago. Interestingly the 4 States hit the hardest by the housing crisis (California, Arizona, Florida and Nevada), created the most number of jobs.

The only less than positive data I picked up, was that average earnings rose by just +0.1% MoM, or +1.9% YoY (lower than inflation) which will curb spending power. It also suggests that low paid jobs are being created, in the main. Temp jobs (which is a good sign as they partially revert to full time jobs in due course) rose by +45k, larger than the +32k in January. Interestingly, construction shed -13k jobs (the largest decline since January 2011), though it was up by +20k in January.

Housing may turn around and become a net contributor to GDP this year, rather than being a drag on the economy – however, a number of people disagree with this view – they believe that residential housing remains in the doldrums – personally, I’m a bit more optimistic. Stabilisation (and, in particular a pick up in housing) will have a material positive impact on the US economy.

The number of new household formations declined significantly following the financial crisis, as individuals remained at home and/or shared more homes. Goldman’s estimates that normal household formation would result in between 1.3mn – 1.4mn households being formed every year, as opposed to the (conservatively, as they assume just 150k of new jobs added each month) 0.8mn they forecast for the current year (1.1mn for 2013) and an average of 1.1mn for the next 5 years on average. Inventory of homes is estimated at 2.5mn (I have seen a number of 2.8mn) and assuming 300k new homes are built every year, the current excess surplus would take 3.5 years to clear. However, a number of the surplus properties will never be sold (thereby reducing the actual surplus) and with increasing rents (making buying a better option), combined with improving (albeit moderate, at present) employment prospects (the key group are the 18 to 34 year olds) and pent up demand, together with the proposed bulk sales of properties, annual household formation could well rise above these numbers and, as a consequence, residential sales. Financing remains an obstacle, but is improving and changing social trends (falling and later marriage trends) are delaying household formation though. Whatever, a number of homes are being refurbished, as a number of people cannot move due to negative equity problems – good for building materials (safer than home builders, if you don’t buy a potential recovery in the US residential home sector). I’m long the building materials sector, though a UK company, with significant US operations, Wolseley (ticker WOS), though CRH is another play. My friends at Credit Suisse are also very keen on WOS.

The better employment data will be a boost for President Obama’s reelection hopes. However, economists expect that the employment numbers will slow down in coming months though;

Interesting views by the FT and Goldman’s on the WSJ “speculation” (yeah right – a private briefing by the FED to the WSJ, almost certainly, to float the idea before introducing it – old trick) that the FED is thinking about sterilised QE (buying MBS’s presumably to hold down mortgage rates). In reality, the FED will pledge collateral from its vast holdings of Treasuries, borrowing funds from its reverse repo counter parties. The result, is that the FED will add assets to its balance sheet, with borrowings on the other side. Why do it – well its a perception issue – sterilised QE is seen to be “better” by investors and may not raise inflationary expectations, which clearly the FED is getting increasingly worried about. It does improve the functioning of the money markets, as a wider range of financial institutions become counter parties to the FED. Clearly QE has increased asset prices (including commodity prices) which have resulted in higher inflation – denied officially, but there is clear evidence, in my view. It could also make money for the FED, if they mismatch maturities – which the FED is well placed to do. However, this scheme is essentially a bit of “smoke and mirrors”, me thinks. Notwithstanding, I expect that this policy will be enacted – also better in a Presidential election year, rather than outright unsterilised QE.

To date, Mervyn King (Governor f the BoE) has refused to buy any other assets, other than gilts, as part of the UK’s QE programme. However, this cunning FED plan could well help in the UK, particularly as UK mortgage rates are rising rapidly, impacting RPI. In any event, the BoE will find it difficult to buy gilts exclusively and it too must be worried about inflation. With limited earnings increases expected for some time, lower mortgage payments should help consumption. However, to date Mr King has been opposed to buying anything other than gilts on the grounds that MBS’s increase credit risk – true, but UK mortgages generally have performed reasonably and criteria could be set to buy only performing MBS’s;

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