The US Congress agreed on a bipartisan compromise to fund the US government until 30th September. US retail sales rose by +0.2% in December as opposed to a downwardly revised increase of 0.4% in November. Core retail sales also increased, suggesting a broad based improvement in sales. Sales data which feeds into GDP rose by an impressive +0.7% in December, much better than the rise of +0.2% in November. Import prices were unchanged in December, following declines in the previous 2 months. Prices declined by -1.3%% Y/Y. Inventories rose by +0.4% in November, lower than the +0.8% in October. Better news from small businesses. Sentiment improved by +1.9 points in December and is up +5.9 points Y/Y. Following 2 monthly declines, PPI rose by +0.4% in December, in line with expectations, or +1.2% Y/Y, slightly higher than the +1.1% expected. Excluding food and energy, PPI rose by +0.3% M/M, the most since July 2012. Initial jobless claims came in at 326k roughly in line with expectations and is yet another indicator that the very weak December non farm payrolls number was a one off, distorted by bad weather. US December CPI came in at +0.3% M/M (+1.5% Y/Y) mainly due to higher energy prices, with core inflation at just +0.1% M/M or +1.7% Y/Y. Inflation does not appear to be a problem. The Philly Fed index rose to 9.4, from 6.4 previously. Industrial production rose by +0.3% in December, in line with estimates and the the 5th monthly rise. Industrial production in Q4 2013 was the best Q since 2010. Home construction fell to 999k on an annualised basis, better than forecasts of 985k annualised pace, though lower than the 1.11mn pace in November. Building permits came in slightly lower than expected at 986k, less than the 1.01mn pace expected. In summary, the data suggests that the US economy is improving.
The FED’s Beige book reported that the US economy continued to grow at a moderate pace from late November, through to the end of the year and, in addition, that “the economic outlook is positive in most districts”, with some districts reporting that they expected a “pick up”. Importantly, the report stated that 2/3rds of the FED’s 12 districts reported that employment was increasing. The Empire State manufacturing index rose to 12.51 in January, from just 2.22 in December. Importantly, the new orders, employment and shipments components all rose, indicating further prospective strength in the region.
EZ seasonally adjusted November industrial production came in at +1.8%, better than the +1.4% expected and a revised -0.8% in October. The better data from Germany, in particular, helped. Y/Y industrial production increased by +3.0% , as opposed to the +1.8% expected. Spanish data continues to improve. Q4 GDP rose by +0.3% according the the Economy Minister, much better than the increase of just 0.1% in Q3. Spanish inflation was just +0.3% Y/Y in 2013, though higher than the +0.2% expected. The improvement in Spanish data helped Spain to sell 3 year notes at the lowest yield on record (1.595%), as the government upgraded the country’s prospects. It also sold some longer dated bonds. However, demand was weak – the 3 year issue was covered just 2.2 times. I suspect that the ECB’s threat that they will not deem sovereign debt as risk free has resulted in domestic banks refusing to participate. EZ inflation came in at +0.8% Y/Y, in line with expectations, though well below the ECB target of 2.0%. German 2013 GDP rose by +0.4% according to the statistics office, lower than the forecast of +0.5% and the lowest since 2009. However, recent data has been positive and the Bundesbank forecasts the GDP will rise sharply to +1.7% this year. The French President announced more business friendly measures, including a Euro 30 bn cut in payrolls tax and an aim to reduce government spending by E50bn by 2017. However, such measures will take time to feed through the economy and, I remain sceptical. Greece is likely to be back in the headlines. There are reports that the country will require a further bailout – it has received 2 already.
Bloomberg reports that the ECB will impose a 6% capital ratio when they conduct their stress tests, the results of which will be out in November this year. The 6% ratio is higher than the 5% ratio which the European Banking Authority had used to conduct their farcical stress tests in 2011, though is not as robust as was expected given Mr Draghi’s comments that the ECB’s stress tests would be “credible”. There are no details as yet as to the treatment of government bonds held by banks – Mr Draghi has indicated that such assets should not be treated as risk free. In addition, the important issue of what counts as capital is still to be clarified. It is imperative that the ECB’s asset quality review and the following stress tests are credible, or the ECB’s own credibility will be questioned and the markets will remain cautious on the European banking sector. A number of German, French, Italian and Spanish banks look vulnerable.
For the 1st time since November 2009, inflation in December in the UK declined to the BoE’s target of +2.0%, better than the forecast for CPI to remain unchanged at Novembers 2.1%. Core inflation declined to +1.7%, from +1.8% in November. Disinflationary pressures persist in terms of factory-gate prices which declined by -1.2% Y/Y. The house price boom in the UK continues, with home prices rising to its near 2002 high. In certain parts of the UK, London in particular, house prices have rocketed which poses a problem for the BoE, which is trying to maintain interest levels at low rates and continue with its accommodative policy. UK retail sales increased by +2.6% in December M/M, the best since December 1996 and much, much higher than the rise of just +0.3% forecast. Sterling strengthened on the news unsurprisingly.
The Japanese current account deficit increased to a new record high of Yen 593 bn in November, much worse than the deficit of Yen 369bn expected. The trade deficit (mainly due to the increased price in Yen terms of imported energy, following the closure of its nuclear electricity generating programme) also increased to Yen 1.25 tr. The current account deficit means that Japan will have to reduce its holdings of overseas assets over time. Furthermore, the current a/c deficit if maintained (which is likely) will ultimately force the country to seek foreign capital, though admittedly this is some time off. However, at that time, no foreign investor is going to buy 10 year bonds at around the current rate of 0.65%, with inflation likely to be significantly higher. You will recall that Japan finances over 40% of its budget through the issue of bonds and that the current level of debt is more than double the size of its economy. Furthermore, how will the Japanese Central Bank exit from its vast holdings of government debt, without causing a major spike in yields. Fitch reports that Japanese debt to GDP will rise to around 245% of GDP by the year end. Consumer confidence declined marginally to 41.3, from 42.5 previously. I remain particularly bearish on Japan and Abenomics and the BoJ policy.
There was some positive news for Japan. Machinery orders increased by +9.3% Y/Y in November, a 5 year high and well above market expectations of an increase of just +1.9%. The weakness of the Yen has encouraged companies to invest in the country. The weaker Yen is also feeding through into corporate goods inflation which rose by +2.5% Y/Y, though less than in previous months.
Chinese December aggregate financing came in at Yuan 1.23tr (US$205bn) in December, lower than the Yuan 1.63 tr the year earlier, though higher than the estimate of Yuan 1.14 tr. New loans fell to Yuan 482bn, lower than the estimate of Yuan 570 bn, the lowest since December 2012. M2 money supply rose by +13.6% Y/Y, slightly higher than the Central Banks target of 13.0%. The Chinese central bank, the PBoC has been trying to reduce the level of lending. Total forex reserves rose to US$3.82 tr, a record high in December.
I have been bearish on the A$ against the US$ for very many months as you will be aware. The latest data reveals that unemployment in Australia increased unexpectedly by -23k in December, the 1st time since 1992 and as opposed to the gain of 10k expected. Novembers job gains were revised lower. Full time jobs declined by -32k. The markets are now inclining to the view that the Australian Central Bank will cut interest rates from its current level of 2.25%. Australia is dependent on China and with that country slowing, the Australian economy should slowdown as well.
An IMF report suggests that economic growth of a number of Asian emerging markets, including China and India, but also including Indonesia, Malaysia Thailand, Vietnam and the Philippines, will slow. I totally agree and remains one of the major reasons I remain bearish on these and emerging markets generally. In addition, all of these countries have not introduced the structural reforms that are so very necessary, which is also a major cause for concern. The IMF has also warned about the possibility of defation.
The World Bank has raised its forecast for global growth to +3.2%, as opposed to their June forecast of +3.0% and as compared with just +2.3% in 2013. The increase is mainly attributed to the US and an improving Europe. They warn of the risks of a major reduction in capital flows into emerging markets, if Central Banks in the developed nations (US, in particular) reduce their monetary accommodation too quickly. This issue remains one of my key reasons that I believe emerging markets will continue to underperform this year.
Banks have been given a reprieve by the Basel Committee. The Committee has altered the definition of its leverage ratio which will, in effect, enable banks to report lower risk levels. Essentially, the new rules no longer require banks to account fully for their off balance sheet assets, such as derivatives. In addition, the Committee will allow the netting off of securities financing transactions, including repos. As a result, there will be less pressure on banks to sell assets or reduce lending materially. Share prices of banks rose following the news.
Overview
The US bank results were mixed, indeed generally worse than expected, which has not helped markets, with the S&P lower on the week. Other corporate results have not been positive. More surprisingly, the US 10 year bond yield is just 2.82%, which suggests that some investors are seeking protection. The VIX is also rising.
In Europe, the economic data is improving, though from a very weak base, but political risk is rising. Catalonia announced that they would call for a referendum to separate from Spain. In May, Europe holds elections for the EU Parliament. With the weak EU economy, nationalist parties are likely to gain votes, which will be a major problem for the EU.
The US$ weakness following the release of the employment data has, as I expected, reversed, in particular against the Euro and the A$. Sterling benefited from the strong December retail sales data.
There are reports that Russia will agree an oil swap deal with Iran. If that is the case, more production will come on to the markets. Brent declined to US$ 106.50.
Chinese trade data is notoriously unreliable. Capital inflows into China have been classified as exports, as Chinese businesses import cheap capital into the country to take advantage of higher interest rates and a strengthening Yuan. Whilst its early days, the PBoC seems to be rethinking its strong Yuan policy. If this is indeed the case, upcoming trade data should report a decline in export growth and an increase in imports. A number of analysts will suggest that an increase in imports is a sign of a stronger domestic economy – however for the reasons suggested above, I would be cautious about such comments.
Whilst I have been bearish of the global economy on a fundamental analysis basis (excluding the US and the UK, in particular), I have suggested that investors remain long equities, as market momentum was positive. However, I get a sense that sentiment is changing. The US 10 year yield at 2.82% has really surprised me, given more hawkish talk by a number of FED members of a larger and quicker tapering programme. Most including myself were expecting the yield to be around 3.0% at least. US earnings season is still in full flow and may turn out some positive surprises, but it has been lackluster to weak date.
I believe it may now be time to start taking some profits on equities, in particular the higher beta names and emerging markets, and buying longer dated protection ie the VIX. The major markets have not corrected for over a year, which increases the risk that one is due and valuations look extended. I continue to favour the US$ against all the major currencies.
Kiron Sarkar
18th January 2014
