RMG Weekly Reports
It's been a busy week with lots to report on. Rather than cover just one topic, we thought we would touch upon some of the noteworthy news and then share some of our observations. We'll start with the US, move on to have a quick look at the UK and finish up with Europe and then our conclusions. The European section is a bit longer than the US and UK, but there is just so much to talk about there!
First, last week we explained at length why we remain bearish of Spain generally, although we noted the oversold condition of equity markets in Europe and that this was the reason for reducing our bearish positions temporarily. Blowout results from Apple and a dovish Ben Bernanke (more on that below) helped markets rally, and we re-entered our bearish positions in Spain and Europe on Wednesday and Thursday.
Thoughts on the US
The economic data in the US continues to disappoint - two thirds of data points have been worse than expected in the last month. Q1 GDP rose by 2.2% it was announced this week. This data, was also below the expected 2.5%, but in a world where growth is at a premium, this was by no means a disaster.
The Federal Reserve's policy committee met this week, and managed to confuse the market despite their commitment to greater transparency. Interest rates were left at 0% to 0.25% and there was no change to unconventional policies - all as expected. The committee also released their updated economic forecasts which show that they expect slightly better growth and slightly lower unemployment in the quarters ahead. Their inflation forecasts were nudged higher and are at or just below their target of 2%. All in, the members of the committee brought forward their forecasts for when interest rates should start to rise. This, we thought, would mean that further quantitative easing would be off the agenda. Then, Ben Bernanke spoke at the post meeting press conference and, in answers to questions, said that he remained ready to do whatever it takes to ensure the US economy remains on a steady footing. QE3 therefore remains on the agenda!
It would therefore seem that the committee is split, with the majority forecasting modest improvement and no need for more quantitative easing whereas Bernanke remains hovering over the printing presses with the engineers ordered to keep them oiled and warmed up. A divided FED is not a positive long term development.With regards to what we need to watch, the unemployment data is becoming more and more important. We believe that if the unemployment rate moves higher in the next few months, the FED will print more money. If the rate declines, the FED will not print. It is as simple as that. Not only is the unemployment picture key for trying to gauge whether there will be more money printing, it is also key for the direction of the equity market. The chart below shows the US equity market with the weekly jobless claims numbers. If jobless claims start rising (they have been rising for two months or so) then we can expect the S&P to come under some downside pressure.
Thoughts on the UK
The data released this week shows that the UK economy is in recession. Some will argue that construction spending impacted the data negatively. We would say that construction is booming ahead of the Olympics and will grind to a halt afterwards. No matter what is said, the UK economy is not doing well, and the outlook is deteriorating.
The UK economy is very reliant upon our friends in Europe so the economic circumstances there should be a serious headwind for the UK in the months ahead. Furthermore, despite EUR 1 trillion of fresh liquidity from the ECB, European banks are still very vulnerable. With the banking sector in the UK being so important to our economy and so interlinked with the European banking system, there is a growing vulnerability that will increase the headwinds coming across from Europe.We remain slightly perplexed at the strength of Sterling on the foreign exchange markets, and in particular against the US Dollar. With the US economy growing at 2.2 % and the UK in recession, we would expect Sterling to be moving a bit lower, not higher. In particular, with the problems afflicting European banks, we would expect Sterling to be lower than it is currently. The chart below illustrates the correlation between European banks' share price performance and the exchange rate between Sterling and the US Dollar. The only time in the last 12 months when Sterling looked this "expensive%u201D compared to European banks was in August last year just before a 6% decline for Sterling. We think that Sterling is vulnerable on this basis.
Thoughts on Europe
It is generally understood (outside of Europe at least) that putting a currency union together before there is full fiscal and political union is a nonsense. When times are tough, voters will naturally vote for policies that benefit themselves rather than policies that hurt them. Austerity policies are crucifying the periphery countries, will hit the core too and there is no sign of any improvement - in fact, things may be getting worse. It should therefore not be a surprise to see voters in France move away from the centre to the extremes. Approximately one third of voters voted for either the left or right wing candidate in the first round.
The second round vote in France is on the 6th May and Greek voters go to the polls on the same day. It is likely that Francois Hollande will win in France and his policies are anti austerity (which will not sit well with Brussels, Berlin and the ECB) and pro income redistribution. This is clearly pro French as opposed to pro EU and could be economic suicide at a time when growth is required. On the Greek front, the two main parties that garnered 77% of the vote in the 2010 election are polling at a combined 35% or so. The left and right wing parties combined are polling at about 42%. There is a real chance that Greece will elect officials that decide that they cannot bear the economic cost of remaining in the Euro.
The markets were also shocked by the Dutch coalition budget talks collapsing. Here is a country that has been at the core of Europe since the beginning and has been a beacon of fiscal rectitude. Not only are they struggling to meet the fiscal criteria set out in the recently agreed "fiscal compact" but the politicians are struggling how to make the necessary adjustments. Holland is already in recession and an austerity programme will make matters worse with fresh elections to be announced.
It just gets worse and worse for Spain. On Thursday night Standard and Poors downgraded Spanish debt and retained a negative outlook. It is likely that the other ratings agencies will follow (Italy may get downgraded too). On Friday, Spain announced that their unemployment rate rose to 24.4% (higher than the estimates of economists at 23.8%) which the highest in 18 years. Youth unemployment is at 52% which is simply staggering. Earlier in the week, the Bank of Spain confirmed that growth was negative in the first quarter and that the economy was back in recession. Retail sales were released showing them to be down 3.7% on the same period a year ago, the 21st month in a row that sales have fallen. "In Spain today, a cycle similar to Greece is starting to develop" said HSBC chief economist Stephen King.
Europe is in recession and the periphery is in a depression. Voters always shift from the centre ground to the extremes in this environment ("it's the economy, stupid" as Clinton once said). We believe that as countries veer away from Brussels and become more nationalist, the breaking up of the Euro gets closer.
ConclusionThe rally in European equities early last week was well within our expectations and we used that strength to re-establish the bearish positions that we had exited the week before. Europe (and the UK) is getting worse, and even the mighty US may not be doing quite as well as the most bullish commentators believe (although much better than Europe and the UK). Equity markets look vulnerable in the weeks/months ahead especially without any imminent central bank money printing. Elsewhere, Sterling is looking vulnerable against the Dollar and could reverse lower at any time.
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