Sunday 15 December 2013

Why The Fragile US Economy Isn’t Impacting Stocks - Yet

There is a reason why asset management firms don’t employ legions of economists to do their investing. Providing accurate economic forecasts is very useful, but financial markets generally don’t reflect the state of the world.

US stock markets have rallied strongly over the last two years, while economic growth has been weak. Appetite for stocks has been driven by central bank action, not forecasts of skyrocketing consumer demand. The Federal Reserve has held its interest rates close to zero for the last five years while implementing vast amounts of quantitative easing - printing money to buy government bonds.

These purchases effectively lower bond yields, resulting in lower financing costs for companies while simultaneously encouraging investors to buy assets such as stocks since the return on fixed income is so low.

Moreover, when economic news does noticeably move markets, it is typically due to “surprises” in data releases rather than the absolute level of growth. So if the economy is weak, but a GDP figure is unexpectedly strong, markets will often rally and appetite for riskier assets increases. A longer-term rally can ensue when an economy appears to be on a turning point; transitioning from recession to a period of growth.

In recent years US markets have also been boosted by upbeat corporate earnings that have continually surpassed estimates. While this is clearly beneficial for stock market performance, it does not necessarily reflect well on the economy.

The focus on quarterly results has led to aggressive cost-cutting, aiding corporate profits. Earnings per share have also been augmented by a large number of stock buybacks, in which repurchases by companies lead to fewer shares. This can be beneficial for shareholders, but is not an indication of improvement in a company's performance.

Worryingly, earnings have been rising but revenue has remained little-changed. Hence, earnings have grown while actual demand for a company’s product has not. Moreover, there has been no increase in private sector capital expenditure in 2013; something that will be necessary to fuel economic growth when the Fed reduces its monetary stimulus.

Strong momentum and near-zero central bank rates may see the stock market rally continue into 2014, but without an active consumer the longer-term picture is not so optimistic. While the US unemployment rate has declined to 7%, much of the job creation has been in low income roles, and the rate is enhanced by a fall in labor force participation to its lowest level since 1978. Notably, real median wages (adjusted for inflation) have fallen just over 3% since the start of 2009.

There was a better-than-expected retail sales number for November and consumer confidence improved, but Morgan Stanley forecasts that this year will see the weakest holiday spending since 2008. In addition, projected gift spending per person will decline for first time since 2009. The possibility that a reduction in the Fed’s bond-buying program may lead to rising yields is not a good sign for the housing market. This year’s jump in long-term yields, spurred by the Fed’s first mention of “tapering” in May, has resulted in a slowdown in US housing activity as higher borrowing costs make homes less attractive. For example, in May a $1,000 mortgage payment could attain a house worth $225,000, while the same payment now buys a $195,000 house.

However, an important milestone was reached this week following the release of Q3 data showing the first rise in outstanding mortgage debt since the beginning of 2008. Over the last five years, the US has been in a deleveraging phase in which the private sector focuses on minimizing debt, thus sacrificing spending. But the recent rise in mortgage debt indicates that US households are making some progress in their deleveraging efforts and are demanding more credit. This is good news, but the growth in credit demand is from extremely low levels.

Some additional optimism has been fueled by a rise in US household net worth in Q3 to $77.3 trillion, an increase in approximately $2 trillion from the previous quarter. Proponents of the “wealth effect” theory assume that an increase in households’ net worth will lead to a rise in consumer spending. However, the source of last quarter’s increased wealth should temper cheer.

Rising stock markets were attributable for $917 billion of the wealth increase, while $428 billion came from higher house prices. Essentially, most of the increased in wealth is going to the population that invests heavily in stocks - the wealthy. They will likely use this new wealth to re-invest in stocks, helping to fuel the bull market momentum. Since rising house prices accounts for a much smaller percentage in added household wealth, most Americans will not feel much wealthier and consumer spending will unlikely see a sizable increase.

The outlook for US economic growth remains positive for 2014, but not strong. Most forecasts fall below 3%, yet the absolute level of growth won’t impact the stock market. Instead, momentum, central bank action, earnings and data surprises will likely dictate movements. For the rally to sustain beyond next year there will need to be more consumer spending, otherwise companies will have to increase their own expenditure as they run out of methods to artificially boosting earnings.

Monday 9 December 2013

Eurozone: A story of stability in 2013, but aggressive action awaits

It all started in October 2009 when George Papandreou’s new Greek government revealed a black hole in their accounts that was vastly underestimated by the previous administration. Several years of tumult followed, bringing the eurozone project to the brink of failure. But 2013 proved to be a lucky year for the 17-nation group. Relatively few economic surprises and heightened attention on events elsewhere brought a welcome calm to European financial markets.

This year the eurozone emerged from six quarters of economic contraction and the weaker nations enjoyed a strong rally in asset prices. Stock markets in the so-called PIIGS (Portugal, Ireland, Italy, Greece, Spain) have all rallied more than double figures year-to-date, while demand for each nation’s sovereign bonds has risen strongly, resulting in a significant decline in their borrowing costs.

Structurally, notable progress has been made on the enormous budget deficits that plagued the region. Optimism has been augmented by the imminent exit of Ireland and Spain from their respective EU/IMF bailout programs, with both countries set to make the transition to self-financing without the safety net of an emergency EU credit line.

The catalyst for positive sentiment came from the European Central Bank in July last year when president Mario Draghi said the phrase: “the ECB is ready to do whatever it takes to preserve the euro”. Those words were soon supported by a conditional bond-purchase program called OMT ( Outright Monetary Transactions) - a facility that has yet to be used.

The ECB’s actions signaled to financial markets that the central bank would indeed be a “lender of last resort”, effectively acting as guarantor for assets if the eurozone did verge on collapse. With that reassurance, markets have instead focused on the probable unwinding of the Federal Reserve’s bond-buying program and the slowdown in emerging market economies. 

Yet even though there is less likelihood of a eurozone breakup, eventually markets will demand to see evidence of a return to eurozone prosperity. Incongruously, that objective is being hindered by the nation currently driving growth. Germany, the region’s largest economy, is expected to grow by 1.7% in 2014, which should lead to a 1.1% eurozone increase. However, Germany is vastly imbalanced - it has a huge current account surplus of 6.3% of GDP, meaning that it exports far more than it imports from the rest of the world. (A current account surplus of more than 6% is deemed excessive by the European Commission, but this limit is not enforced).

The strong influence of Germany on eurozone policy directives has resulted in the weaker nations enduring strict austerity and relying on export-led growth. The austerity has somewhat succeeded in reducing labor costs, thus boosting the competitiveness of eurozone products in global markets. Subsequently, most periphery nations are now running current account surpluses, but instead of stable economic models, these imbalances highlight worrying vulnerabilities. An over-reliance on exports may work for a strong economy such as Germany, but it is impossible for the whole eurozone to rely on such a model; the region is simply too big. There can not be enough continuous demand from the rest of the world to provide prosperous stability for all individual eurozone economies. 

An absence of strong domestic demand makes eurozone growth extremely fragile. Additionally, austerity without stimulus leads to weak consumer spending and risks facilitating a deflationary environment. The eurozone is nearing this scenario. The ECB predicts eurozone inflation of 1.1% in 2014, significantly below its 2% target. The weak number is a symptom of high unemployment and stagnant household income growth, highlighting the fragility of the region’s recovery.

Deflation is harmful to an economy as expectations of falling prices make consumers less inclined to spend. Moreover, deflation is particularly damaging for the periphery economies since it is difficult to further enhance competitiveness by cutting depressed wages, while the value of debt burdens cannot organically erode. 

The ECB reacted to the deflation concerns in November by cutting its benchmark interest rate (at which banks have to pay when they borrow money from the ECB) from 0.5% to 0.25%. This cut has come too late. The move was opposed by the German, Austrian and Dutch central banks, illustrating the divide between the sturdy and struggling eurozone economies. Germany’s resistance to an easier monetary policy comes from a fear of hurting their exporters’ competitiveness and perhaps lingering ghosts from the nation’s struggle with hyperinflation in the 1920s. 

Such was Germany’s influence over the ECB in 2011 that the benchmark rate was increased 0.5% over the year to 1.5%. Mario Draghi’s presidential appointment in late 2011 has resulted in a much-needed decline in rates, greater ECB commitment to eurozone stability and a decline in Bundesbank influence. 

Now the ECB must do more than prevent a eurozone collapse. The region cannot export away its problems; real growth must be spurred from within. The delay in reducing its benchmark rate may now force the ECB into unconventional action. Among the options are quantitative easing (creating new money to lower bond yields and borrowing rates), negative deposit rates (effectively charging banks to keep excess cash at the ECB) and long-term refinancing operations with strict lending conditions (providing cheap funding to banks that agree to lend to companies). 

Financial markets should maintain a favorable view of the eurozone into 2014 as exports help steady, if slow, growth. But the time will come when slow growth is not enough, forcing the ECB into a standoff with Germany over aggressive stimulative actions. It may have been avoided if smaller measures were made earlier.