September is Looking Particularly Volatile

The relative performances of various equity markets in August would have surprised most. Whilst Australia, Japan and India closed the month somewhat higher (though in all cases, looking fragile, particularly towards the month end), Hong Kong and China were lower. Basically, Australasia underperformed, whilst US markets rose yet again, as did European markets. However, amongst the best performers were EZ markets and, in particular, the peripheral EZ markets of Italy and Spain – reflecting the announcement by the ECB that they intended to buy their short dated government bonds, subject to, inter alia, that the relevant countries reached agreement on the conditions to be imposed by the EZ’s bail out funds, the EFSF and the ESM. Indeed, Mr Draghi’s comments at the last ECB meeting, whilst initially totally misunderstood by analysts were, indeed, particularly bullish.

September has always proved to be a difficult month for markets. Will it be the same this year?. Personally, based on the information at hand, I believe that trying to guess how September turns out will prove to be more of an exercise in guesswork, rather than rigorous analysis. Ignoring geo political issue (a possible Israeli strike against Iran, for example) of which there are many, the key issue will, in my humble opinion, be the decision by the German Constitutional Court (“GCC”) and the ECB’s subsequent actions. More on this later.

There has been a perceptible change in attitude/ sentiment towards Australia, the reason – Australia’s increasing dependency on China. Lower demand for base metals/coal from China will have a material negative impact on the Australian economy. Indeed, a number of the miners have cancelled major projects (BHP), given very likely slower demand. We know that a number of Chinese importers have either tried to defer imports of base metals and/or simply defaulted. Stockpiles of iron ore, copper and coal are high and supplies are increasing – not a recipe for a bull market. The Chinese government has announced a number of stimulus measures, but none with the same impact as those implemented in 2008/9 and, in addition, there is significant uncertainty as to the financing of these projects. At the same time, Chinese exports continue to decline to Asia and, in particular, to European markets, though exports to the US have held up. Over the weekend, Chinese manufacturing PMI came in at 49.2 for August, below forecasts of 50.1 and a 9 month low. With no respite, certainly in the short term, the situation will continue to deteriorate unless the Chinese announce realistic measures to stimulate their economy and, in addition, further monetary easing, in addition to the 2 interest rate cuts, combined with lower RRR requirements that they have announced so far this year.

Without a growing China, Australia will struggle, in particular, given the mix of its economy. The A$ is off its highs and signalling weakness. Without exports from its mining industry holding up and/or, indeed, increasing, Australia will face increasingly large trade deficits. In addition, the country and its banks, require capital inflows. If, China does not ramp up its fixed asset expenditure, the country will not be able to achieve the politically important balanced budget that it is striving to achieve. Furthermore, foreign investors own a large chunk of Aussie government debt, given the previously strong economy, though if interest rates are cut by the RBA,(to deal with a weaker economy), as I expect, (narrowing the interest rate differential), investors will sell their Aussie bonds, weakening the A$ further. Aussie banks are dependent on wholesale financing and whilst the RBA will provide financing if necessary (through a QE programme, most likely), the highly rated Aussie banks will take a hit. (For full disclosure purposes, I’m short Aussie banks and the A$).

Reverting to China. The recent manufacturing PMI data reveals that the employment sub-index came in at 49.1, lower than the 49.5 in July, suggesting that manufacturing companies have and will continue to shed labour. With a major change in political leadership due later this year/early next and the Chinese Communist party’s No1 objective of maintaining social order, I continue to believe that China will have no choice other than to undertake another major fixed asset programme, combined with a possible removal of at least some of the previous restrictions imposed on the property sector, which were put in place to curb property price increases. However, I had thought that the necessary policy actions would have been announced some months ago, which has not been the case. However,……..

The Chinese understand the predicament they are in. If the ramp up fixed asset expenditure unnecessarily, as was the case a few years ago, inflation, which has been contained, will rise adding to potential civil disorder. In addition, bad debts which have accumulated within the banking system and which are significant and ever rising, will grow materially, as most of these projects will not produce an economic return. However, if unemployment rises, which will be the case unless the Chinese embark on a stimulus programme, the Chinese face the threat of civil disorder. No great choice, but the problems reflect the grossly distorted economy and the major policy mistakes of the past – which I have banged on about ad nauseum.

The Chinese are (quietly) trying to devalue the Yuan against the US$, in particular. Europe remains China’s major trading partner and a weakening Euro, combined with the deteriorating European economy, is playing havoc with its exporters who are also facing higher labour costs, as a result of government policy. It is widely rumoured that China has been buying Euro’s/EZ debt to avoid a collapse of the Euro – cant see that changing. However, devaluing the Yuan materially against the US$ – good luck in an US Presidential election year, in particular, given previous comments by Mr Romney, is a whole new ball game. Essentially, China has no easy way out and, whilst I believe that the Chinese authorities will be forced to embark on a stimulus programme, accompanied with further monetary easing measures in the near future (bullish), I remain bearish on China in the medium to longer term. However, I have learnt not to try and predict such a move, but rather play it when it happens.

A short view on India. Inflation remains high, the government will not meet its budget deficit targets, the current account deficit remains a problem, remedial policy action remains unlikely due to a paralysed government, corruption scandals abound, etc, etc. What a pity, as India’s potential is significant – quite probably much more than any other country in Asia, in particular, given its size and its young population. The new finance minister is rated highly, but I remain unsure as to whether he can navigate the minefield prevalent at present. Essentially, there are far better opportunities internationally, rather than having to delve too deeply into India, at present.

The Russian market is by far the cheapest of all the BRIC economies and, in addition, not as dependent on energy as most think. However, the perception of the country is negative, which has and will continue to influence investors.

Brazil has reduced interest rates down to a historic low of 7.5% and 2nd Q GDP was, based on the headline number, better than anticipated. However, there are signs that inflation will rise and the country faces enormous structural problems.

I remain of the view that it is not the time to play the EM’s – they remain subject to developments in the US and Europe. No more silly talk of decoupling, please.

Recent data suggests that Japan is facing yet another bout of deflation. Political differences (the opposition wants to call an election) has left the government in limbo. The Central bank seems to be slow to react and its stated policy of increasing inflation to 1.0%, seems farcical. Demographics remains problematical. My very cued up Japanese friend, Mr Dennis Loh, reminds me that the population in Japan is expected to decline from 127mn in 2010 to just 85mn over the next 40 years. However, I will watch carefully for the moment.

Of the global economies, the US remains, as Mr Bill Gross of PIMCO puts it, “the best dirty shirt in town”. 2nd Q GDP was revised higher, from +1.5% Q/Q initially to +1.7%. Unemployment has stabilised, but is not coming down as fast as it should in a normal recovery, post a recession. The US Presidential campaign is creating uncertainty, which has resulted in most US businesses delaying their investment programmes. However, the US consumer remains resilient, in spite of high fuel prices. Indeed, University of Michigan consumer confidence came in at 74.3 for August, higher than the 72.3 in July. Major chain store sales numbers for August were also better and at +6.0% (ex drug stores), was the strongest reading since March 2012. The problems relating to the “fiscal cliff” continue and will not be addressed ahead of the Presidential election – an extremely sorry state of affairs. The serious lack of cooperation between political parties will remain a significant threat.

However, the FED is as dovish as ever and Mr Bernanke’s speech last Friday suggests that the FED will ease monetary policy further, if necessary – indeed, the threshold to act has been set at a particularly low level. There remains a huge debate as to whether the FED will announce QE3 in mid September. Personally, I believe that they will – certainly the moves in the bond and gold markets on Friday suggested precisely that. However, I also believe that the FED will announce QE3 for another reason (discussed below), relating to the impending decision by the GCC, in respect of the establishment of the ESM.

However, the key to a meaningful recovery in the US remains the improvement in the housing market. Whilst the debate continues, I believe there are clear signs that the housing market has not only stabilised, but is improving. The lack of credit, combined with the tougher lending criteria, will continue to act as a constraint, but I believe that the market will continue to improve – short of some disaster in respect of the fiscal cliff, in particular.

The UK bumbles along and whilst 2nd Q’s GDP was revised higher, the UK remains in recession. However, unemployment has not risen, which suggests that the data may be painting a more beak picture than is otherwise the case. Having said that, political concerns are rising. The ruling coalition seems to have lost its way and papers talk of the imminent demise of the leader of the Liberal party Mr Clegg, together with cabinet reshuffles. However, the UK will bumble along and be subject to events in the EZ, in particular. Sterling looks remarkably stable at present.

In my view, (ex any geo political issues) the performance of markets in September will depend on the decision by the GCC (on 12th September) and the ECB’s policy decisions thereafter, in particular. The ECB will meet on the 6th September and much is expected. However, the ECB has warned that they will announce their various policy actions, only once they are aware of the decision of the GCC, which suggests to me that too much optimism is priced in for the moment.

However, if one ignores the Courts decision for the moment, Mr Draghi’s remarks at the last meeting on the 2nd August, suggest (indeed effectively state) that the ECB will:

a) buy short term debt (undefined as to maturity) in a size which will be sufficient, but is unlikely to be pre-announced, if the relevant country first seeks assistance and, in addition, makes itself subject to the conditions imposed by the EFSF/ESM – which it would be required to stick to. Furthermore, the ECB has stated that the final decision remains with itself, to ensure that the conditions imposed by the EFSF/ESM are not watered down completely and to maintain its independence;
b) retain the flexibility not to sterilise the proceeds of its bond buying programme – personally, I believe that the ECB will not sterilise purchases ie the ECB will introduce QE;
c) ensure that government bonds bought by the ECB will rank parri passu with other bondholders in the event of a restructuring – indeed, Mr Asmussen, the other German (other than the head of the Bundesbank, Mr Weidmann) at the ECB (indeed, one of the 6 members of the executive board) said precisely that late last week;
d) buy bonds with a view to target some kind of maximum yield, though the debate has moved between a number of alternatives and the final outcome is uncertain at present;
e) relax the collateral rules for banks wanting to refinance assets at the ECB; and
f) consider another LTRO programme, presumably with more relaxed collateral rules, though Draghi suggested that there were other (unnamed) policy actions;

As a result, none of the above will be news – however, Draghi is unlikely to spell out further details on the 6th September, which could cause some market disappointment, as a number of participants remain of the view (why you may well ask, given that the ECB has leaked that it will only announce its policy decisions following the decision of the GCC) that he will.

The ECB will, sooner rather than later, cut interest rates further – indeed down to US and UK levels, which will add to the pressure on the Euro. Inflation is above the 2.0% threshold at present, but Draghi has, in the past, suggested that he will consider forecasts when deciding upon monetary policy and the ECB has indicated that inflation will be below 2.0% early next year, quite possibly sooner. Importantly, Mr Draghi has the (now pubic) backing of Mrs Merkel, which will help him enormously. Mrs Merkel has also supported Mr Weidmann, though more for domestic consumption purposes. In any event Mr Weidmann is her man – he was previously her adviser. Rumours that Mr Weidmann had threatened to do a Weber and resign have been denied. However, to date Mr Weidmann has lost the argument at the ECB and, indeed, his fellow German, Mr Asmussen, has supported Draghi.

My real fear remains the impending decision by the GCC. In particular, I fear that the GCC, whilst allowing the German President to sign off on the ESM, (thereby making it effective), will impose some (restrictive?) conditions. It should be noted that, in the past, the GCC has imposed conditions, which has set a precedent for all to see. The main reason for my concern is as follows. We all know that the ESM, which will have a max capital of E500bn at best, has insufficient firepower to undertake its task. Its resources must be increased. The EZ countries will not/cant, in a number of cases, contribute more. As a result, the ESM must leverage itself, either through obtaining a banking licence and then borrowing cheaply from the ECB (as is the case with the European Investment bank, which, by the way lends directly to governments), or through the issue of bonds which is purchased by the market, though possibly by the ECB as well. The German’s have steadfastly opposed this idea, though it is clear that Mrs Merkel, privately, will not oppose such a measure. To date, her opposition has been for domestic public consumption, rather than otherwise. The judges at the GCC will surely know that and may, for example, force Germany to seek prior approval from the Bundestag (God forbid the consent of the Bundesbank) or limit Germany’s exposure in some way, unless approved by the Bundestag/Bundebank/the people……. If this or something similar is the decision by the GCC, uncertainty will prevail. Medium to longer term bond yields of the peripheral EZ countries will rise (soar?) and unless resolved, these countries will be forced to borrow at the short end (given ECB support), which clearly in untenable.

Recently, the German Finance Minister Mr Schaeuble has raised the possibility that Germany would need a referendum to progress further the fiscal, banking and ultimately political union, that clearly German politicians are pushing. In terms of upholding democratic principles he is right. However, my problem is the most politicians in the EZ have trampled on the democratic principles in the past, preferring to impose their will, without consulting their people. This change of heart worries me – do the Germans believe, for example, that the GCC will impede their plans? I just raise the question.

I am neither a lawyer, nor an expert in any way on the German constitution or the GCC. I know that most analysts are not either. However, I do fear the prospective decision by the GCC for the reasons set out above. Whatever, if the GCC allows the German President to sign of on the ESM, without restrictions, markets, particularly the peripheral EZ markets, will soar, as will higher beta risk assets. If otherwise………The real problem is that, based on current information, I do not believe that it is possible to assess the likely outcome, with any degree of confidence. As a result, I am particularly liquid, having cashed in on my higher beta plays in particular.

Whatever, the EZ is heading into recession. The situation in Spain, Italy, Portugal and Greece continues to deteriorate, though there are some tentative signs of stabilisation, indeed even a modest improvement, in Ireland. Spanish policy continues to perplex most who follow the country. Recently, the Spanish authorities announced that they would establish a bad bank, reneging on a commitment by the PM, prior to the general election that he would not do so. In addition, Spanish authorities say that they have recapitalised Bankia, one of Spain’s most troubled banks, without aid from the EZ. However, the size of the recap is unknown – surely that’s crucial information that needs to be disclosed. Depositors in Spanish banks continue to withdraw funds at alarming rates and there are fewer and fewer buyers of Spanish government debt. The fiscal position of Spain’s regions continue to deteriorate, with the chances (indeed likelihood) that the targets will not be met, extremely high. This will result in Spain itself being unable to meet its fiscal target for the current year, though the charade continues. Debt to GDP continues to rise at an alarming rate and, not only will exceed 90% (indeed there are arguments that it exceeds that level even now), but will rise to above 100%. I cannot see how Spain turns this around, given an employment rate in excess of 25% and an economy which was heavily reliant on construction (now as dead as a dodo) and consumption (which is collapsing). Yes tourism remains positive, but…….I remain of the view that Spain is very likely to have to restructure its debts – quite probably Portugal as well.

The situation in Italy remains uncertain, but Italy has greater flexibility. Greece, well Grexit is coming, in particular, if the EZ can establish a firewall to avoid the effects of contagion. The EZ continues to delay its decision on providing further aid to Greece, as politically a number of EZ countries will find it difficult.

Even Germany is not immune. Whilst there is clear evidence that German production/export machine is slowing/declining, their domestic economy has held up to date. However, last weeks negative retail sales data suggests that German’s are reverting to their normal cautious behaviour of cutting back on spending, when times start getting tough. Unemployment looks as if it will nudge higher, as well. The German construction sector has also been the star performer, given the low prevailing interest rates – however, even construction seems to be slowing. The austerity measures imposed by Germany/the EZ are beginning to bite. Whilst countries are cutting back on spending, revenues are declining faster, which is making the situation even worse. Pretty soon, the EZ will be forced to enact some growth measures.

On the 12th September, the Dutch head into a general election. The most recent polls suggest that the lefter leaning parties will gain the most, though will not win enough seats to form a government – it is common in Holland to have a coalition comprising many parties. However, the Socialist Party (currently in the lead in the polls), together with the ultra right wing party are both Euro sceptic – they are opposed to austerity measures, bail outs for the peripheral EZ countries etc, etc. Its going to get interesting.

2nd Q earnings, revenues and, in particular outlook statements, suggest that 3rd and 4th Q earnings forecasts will have to be reduced ie not supportive of markets. Indeed, markets are responding primarily to government and central bank policy action. I suspect that that will be the case for quite some time yet.

Given the uncertainty, volatility should rise in September. Events in Europe are likely to dominate the headlines. I will sit back impatiently and wait.

The Euro has appreciated in recent weeks, (trading above US$1.26 at present), due to the prospect of intervention by the ECB. If the GCC allows for the establishment of the ESM (unfettered), the Euro should rise further – if not ……. However, I remain of the view that the Euro looks and, indeed is, fundamentally weak and will decline to US$1.20 or below by the year end.

US, German and UK government bond yields have come off their highs on the prospect of additional QE in the US and ECB action in the EZ. The BoE is likely to increase QE in October/November – however, it will own around 40% of the UK gilt market at that time and the question must be asked as to whether additional purchases of gilts will be effective. Does it really make sense for the BoE to increase its ownership of Gilts to say 50%. Amazing stuff. I would have thought that the BoE should emulate the FED and buy other debt securities, but the Governor is concerned about credit risk.

A number of investors have raised Gold as an investment recently. The argument to support gold is that inflation will rise. Personally, I believe that inflation will decline in the 1st instance, though the solution to this global debt crisis is higher inflation, which will happen thereafter. As a result, the gold bugs will have their day, but, personally, its premature at present.

September is going to prove to be a particularly volatile month – at present, there is insufficient information to assess whether markets will head to the upside or otherwise. As a result, I would prefer to remain excessively cashed up and wait for the relevant news, (in particular, the decision by the GCC) before deciding as to how to act.

Kiron Sarkar

2nd September 2012

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